Thursday, December 31, 2009

2009 Top Blog Posts

Based on total number of unique visitors to each of my blog posts through the year, here are the most popular posts of 2009.  Enjoy!

1.   TOP TEN 2010 TRENDS FOR ENTREPRENEURS - We received a lot of very positive feedback on this blog post as well as a radio interview request.

2.   LESSONS LEARNED AFTER 1 YEAR ON TWITTER - This blog post was updated throughout the year as we met more CFOs on Twitter.  Yes, there are some CFOs that have not only engaged in social media, but who are also pretty good at it.

3.   STAFFING THE ACCOUNTING/FINANCE DEPARTMENT IN START-UPS - This post offers insight into how a start-up should scale into its accounting/finance department.

4.   I CANNOT PREDICT THE FUTURE - BUDGETING IS WORTHLESS! - Predicting the future is actually easier than most think, and what you learn in the process makes the whole experience invaluable.

5.   WORKING CAPITAL - LESS IS OFTEN MORE - A different twist on cash flow management and liquidity improvement techniques.

6.   KEY BUSINESS METRICS EVERY ENTREPRENEUR MUST KNOW - Dashboards and business intelligence are becoming more critical for entrepreneurs.  Here is a roadmap for how to get started.

7.   HOW TO SPEND $195 INSTEAD OF $30,000 TO FILL A NEED - We received a lot of personal attention to this blog post - This gives us some insight into one business lesson learned from a family vacation.

8.   THE PROBLEM IS... - Be a problem solver, not just a problem finder.

9.   3 REASONS YOUR QUICKBOOKS STATEMENT OF CASH FLOW IS WRONG - Some technical information, but very necessary to understand if you are using QuickBooks.

10.  DOES TOO MUCH CAPITAL & SUCCESS TOO EARLY HURT START-UPS? - Interesting thoughts on what each business learns in its early bootstrapping days!

All the best for a prosperous 2010!

Saturday, December 26, 2009

Lessons Learned After 1 Year on Twitter

I created my Twitter account @_KenKaufman on December 26th, 2008.  After one full year, this is what I have learned:

Twitter is like every other form of connecting with people (yes, I'm excluding all non-person driven Twitter accounts).  Whether it be face-to-face, over-the-phone, through social networking, or via some other medium, connecting with people professionally and personally is about BUILDING RELATIONSHIPS.  That's it.  No secrets or amazing revelations.  But here are some thoughts on how Twitter has helped me to build more and better relationships during the last 12 months.

As my vision for my Twitter usage began to take shape, I found that there were some people with whom I wanted to connect that did not seem to feel the same way towards me.  It did not take me long to realize that they had nothing against me, rather, they did not understand the need to create and foster relationships.  They thought Twitter was a race to gain the most followers and that somehow that would be fulfilling.  Let's be honest...most of those people have gained thousands, if not tens of thousands, of followers only to find that they were getting a lot of noise, or tweets, but they really didn't have anyone with whom they could connect and create anything of value.  A lot of these folks have even written blog posts about how they have either unfollowed everyone to try and de-clutter their account and start building real relationships or they have started completely new Twitter accounts so they could start fresh with relationships, not numbers, as their focus.

Whether in business or in personal matters, just building relationships is highly ineffective.  You end up knowing a lot of names but aren't able to add much value to any of them.  Building relationships of TRUST generates very effective relationships, the kinds of relationships we all want.  Twitter is a tool; it is still up to each end-user to build the best kind of relationships.  So, here is a brief list of the some of the key elements of building relationships of trust and how we can apply them to our relationships on Twitter.

Consistency - Be a regular, even if it is for a short time each day.  Respond to your @replies and Direct Messages (not the sales-oriented and spammy ones).

Add Value - Do not just listen to the conversation.  Jump into the fray and communicate.  Add value to what others have to say.  Say things that are valuable in the first place.  Re-tweet the really good stuff you come across.  Add value to the conversation.

Be Genuine and Real - There is no faster way to destroy trust than to fake it.  Be yourself.  If you do that, you will be happy with the relationships you have built.  I sure am after my first year.

Stay Away from the Trash - Yes, there are certainly some undesirable Twitter accounts.  Just block them and move on.  Filter and flourish.

Help Others - Think about what others are trying to get out of Twitter and help them get it.  If they want exposure, then help them with re-tweets and #followfridays and whatever else makes sense.  This is an old concept, but it applies to Twitter just the same - help others get what they want and they will help you get what you want.  Sounds a lot like building relationships, to me.  If your only Twitter efforts are self-promoting, then you're not going to attract many trust-based relationships.

Use the Tools - I love using Tweetdeck.  The search tools help me stay on top of my keywords and accelerate my efforts to connect with the right kinds of people.  There are many other applications and tools for making your Twitter experience successful.  Find what works best for you.

In conclusion, let's consider the many advertising and marketing initiatives we have seen on Twitter.  Some have gone very well, and others have left a bad taste in our mouths.  Just like any other broadcasting medium (by the way, all of their revenue models are built around marketing and advertising), the ones who are building relationships of trust are the ones we listen to and the ones from whom we buy.  If that is true, then we need to try and be just like them.

Monday, December 21, 2009

2010 Trends for Entrepreneurs

With 2009 coming to a close, we look ahead to what we can expect and should plan for in 2010.  Here is my list of the top ten trends founders, CEOs, and entrepreneurs of start-up, emerging, and medium-sized businesses should consider as they prepare for the new year.

1.     The recession will not end, regardless what anyone says - There are just too many issues that still need resolution before this economy can rebound, like the write-down of ALL of the bad assets on the books of the financial institutions.  The fact that they are still not lending much to existing or new customers should be a sign that they know they still have a lot to lose before they can begin to gain again.  In addition, the new business models that are emerging in this recession are leaner and meaner than we have seen in a long time, meaning they aren't going to help unemployment any time soon.  The effects of this recession could last quite a while.

[Author's Note:I realize I will take some heat for this prediction, but please know that I am only bearish on a macro-economic level.  There are and will continue to be many businesses that grow and thrive through this time, and I applaud them all for it!  If more businesses were like them I would be much more optimistic about an economic recovery.]

2.     Bootstrapping will be king! - Usually you will hear me say that cash is king.  In 2010 the entrepreneurs that have learned to boot-strap will be king - because boot strapping is the best chance for cash generation.  Many of their competitors have gone out of business or are in some sort of a death spiral.  Those who made changes early and are continuing to adapt to the changing economic market are going to win.  I hear lots of businesses take the mentality of: "If we can make it through the recession will be poised to do well."  That attitude is just not going to cut it.  Survival cannot be the only goal - those that can figure out how to generate positive cash flow in the tough times are the ones that will win when things turn around.

3.     Solving lots of customers' needs will raise capital - If you are starting a business and your whole focus is on raising capital, you will not get any in 2010.  If, on the other hand, your focus is on getting and satisfying customers with a great product or service, then you have a much better chance to get the money you need (if you even need it).  Ben Peterson, a successful entrepreneur and angel investor, identified one of the major sources of this problem.  He said that the focus in business schools and entrepreneurial education is on teaching how to raise money, not how to grow a successful company that is actually worthy of investment capital.  Get to work, and the money will follow you if you can take care of lots of customers and your need for capital will really add value to your efforts to serve your target market.

4.     Business Lending requirements will increase - It got a lot tougher to borrow money in 2009, and it will continue to become more difficult in terms of requirements and complexity.  For example, a business just obtained a small $125,000 line of credit and the legal documents the bank sent to their customer were over 150-pages in length.  Even though the mean credit score in the US is on the decline, banks have raised their requirements on business owner credit scores and they are mandating more collateral (as a secondary source of repayment) than before, especially if it is real estate.

5.     The cloud will continue to gain a share of all things computer - We are seeing more and more companies abandon traditional software and convert their operations to the cloud.  This is a great trend for entrepreneurs who can accomplish just as much as big businesses for a lot less expensive cloud-driven solutions.  Here is just one example: 2 years ago almost every business used Outlook or some other computer-based email client for its employees.  Today we are seeing some companies, especially those with entrepreneurs under the age of 40, switch to web-based and SaaS applications.  Google Apps seems to be the most popular for now, but the point is clear - the practices of purchasing expensive software to load on each computer and servers to host all of the company's data are becoming antiquated and cumbersome.

6.     Social media overload will drive users to the best content sources and filters - Even status updates in LinkedIn are tough to keep up with anymore.  The flow of information through social media tools has grown so dramatically that most feel like they are on overload and like it is impossible to keep up.  While providers are trying to figure this out, we are all going to be driven to the sources of the best and most reliable content, especially if it allows us to filter it quickly and effectively.

7.     Health insurance will continue towards high deductibles and consumer-driven care - I have long been an advocate for high deductible health insurance plans with HSAs or other medical savings accounts.  Yet such plans represent such a stretch from traditional health insurance that adoption rates have been very low.  It seems like employers and employees alike are warming up to this idea and the popularity of these plans will continue to increase.

8.     Being big will become less advantageous to being small - Big will no longer necessarily be better.  There are many reasons for this, but here are the main two - small and medium-sized companies are often more flexible and more hungry to satisfy their customers and big-company economies of scale are becoming less relevant.  For example, with its use of remote, flexible, and contract workers, Jet Blue is able to do more for its customers than any of its larger rivals - and that is in a very capital-intensive business.  Service businesses may find even greater advantages as compared to their larger competitors.

9.     Focus on relationships will pay- Relationships have been and will always be the key to building a successful business - mainly because they help us establish trust.  I've included this on my trend list because it seems like to some the practice of building trust is a lost and fallen art.  Obtaining more followers on Twitter and increasing your pool of friends of FaceBook are only relevant if we build relationships in the process.  We will see relationships and trust-building come back to the forefront of business as filtering tools allow us to connect with those who matter most and with whom we want to foster and strengthen our relationships.

10.    Knowledge workers will take more contract and less full-time work - This recession is helping to accelerate our economy to more of a knowledge-based worker model.  These knowledge workers are finding more benefits in contract and part-time work.  Some appreciate the flexibility, while others feel their value-added to and sustainability in these roles are more secure and potentially more profitable.

Monday, December 14, 2009

The Problem Is...

As I sat trying to explain the deal points of a transaction for one of my clients to a business attorney, I was amazed at how he began every sentence with: “The problem is…”  He spent my entire time with him explaining all the problems with the deal, so I invited him to share some solutions.  He offered none.   I’ll share how this story ends, but first I want to address the challenges that professionals who only focus on problems create for themselves.

Have you ever had an experience like this with a professional service provider like a CPA, attorney, insurance agent, banker, etc?  Were you as frustrated as me?  Please know that I have a lot of respect for all of the professionals I know and with whom I associate, but my philosophy on hiring a professional is more than just to define problems.

Sure I want them to use all their expertise, experience, and wisdom to help me identify existing and potential problems, but I am also looking to them to solve those problems.  The more people focus only on problems and not on solutions the less value they bring and the less we want to work with them.

My point is that only focusing on the problem leaves everyone with a bad taste in their mouth.  If a professional in any field dares to point out a problem, then they need to be ready and willing to design and implement the solution to that problem.  If not, then they will slowly lose their influence and they will have fewer and fewer opportunities to discover any problems at all, let alone solve them.

So, how did my experience at the beginning of this post end?  The attorney had done some work for the company before, but he was clearly not experienced in transactions.  After a brief discussion with the client, I approached another attorney with a lot of background in our type of deal.  After just 30 seconds with him he said he knew exactly how to draft the document and would have it done for us in a few days.  Did he think there might be some problems with structuring the deal correctly?  I’m sure he did.  But is he going to focus on solving all of them so this transaction can close by the end of next week.  You bet he is, and he’s going to get more business from us as a result!

Friday, December 4, 2009

Working Capital, is Less Actually More?

Although the phrase "working capital" is common in business and finance circles, it is often very misunderstood.  Here's an example: if I asked you if you would rather own a business with a lot of working capital instead of a little working capital, what would be your answer?  Most people would prefer the business with a lot of working capital.  But the answer is not that simple, and, in many cases, smaller working capital actually indicates better management and cash flow generation.  I will take a few paragraphs to discuss the two main reasons why working capital is misunderstood and then discuss the best measurement tool I know to monitor it.

WORKING CAPITAL DOES NOT EQUAL CASH
Working capital is often misunderstood for cash.  Working capital is the difference between all of your current assets (cash, accounts receivable, etc.) and your current liabilities (accounts payable, accrued expenses, etc.).  Notice that cash is actually only a part of this equation, and it is usually a smaller part at that.  So, what in the world is working capital?

The easiest way to explain it is in terms of the number of days difference between when you pay for things and when you get paid.  Here is a simplified example:

Cash goes out to pay for parts and labor to build a widget.  After 10 days the widget is ready to be sold.  It takes another 20 days to sell the widget to a customer on credit (net 30 terms).  The customer pays early - in 25 days.  The total working capital cycle is 55 days.  Hence, the business needs to have enough "working capital" to fund this transaction until it gets paid.

WORKING CAPITAL IS A CYCLE OF CASH FLOW
Based on the example above, a business will need a certain amount of "working capital" to handle this 55-day cycle.  But what if the company can improve its manufacturing process and get paid a little earlier, reducing its working capital days to 42?  This means the company would need less working capital to fund its operations.  Since most people confuse working capital for cash, we think a bigger number is better.  But companies that run an efficient working capital cycle require lower working capital, the sign of a well-run and efficient business.

HOW SHOULD WORKING CAPITAL BE MEASURED?
There are lots of measurements that comprise working capital - days sales outstanding, inventory days, payables days, and more.  Trying to look at all of these and make sense of the company's working capital progress is tough.  So, we use a ratio that measures working capital days - one number to illuminate the entire working capital cycle.  This puts the number into context and makes it easy to initially spot issues and challenges.

Very simply, the formula for working capital days is:

(Average working capital for a period/sales for the period)*(# of days in the period)

If I told you that you have a working capital balance of $500,000, it would be hard to understand if that was good or bad until you compare it to other periods of time in your business.  If you are growing or shrinking, it becomes more difficult to know if your working capital cycle is accelerating or decelerating, or if you are squeezing more or less cash out of your operations.  Here is a quick application of a real company's working capital days:
CFO University 12.02.09 - Working Capital Mgmt

HOW SHOULD WORKING CAPITAL BE FINANCED?
Financing working capital is actually quite simple once we understand the working captal days ratio.  At a company's maximum efficiency, there is a minimum number of days in its working capital cycle - maybe it is 15 days, or maybe it is 60 days.  Regardless of the number, this part of working capital should usually be funded with permanent debt or equity.

I have yet to see a business that can function at their most efficient working capital cycle for very long.  This is caused by spikes and drops in sales as well as new opportunities and new challenges that often arise daily.  The days in the working capital cycle above this most efficient level are usually best financed with lines of credit or other revolving debt facilities.  Sometimes it is financed with retained earnings or equity, but that may not be the most effective use of the firm's capital.

CONCLUSION
Working capital is a measure of the firm's ability to streamline its operations to generate cash as quickly as possible.  When understood in this light, less is actually more.  Business is, ultimately, about cash generation.  The working capital cycle of a business can either gobble up more than its fair share of cash or it can be managed as an efficient cash flow system.  If managed, it can become one of the company's most significant competitive advantages.


AUTHOR'S NOTE: This discussion assumes that the company keeps a target balance of cash and cash equivalents and either invests the rest into fixed assets or growth or distributes cash in excess of the target balance to owners or other operating entities.  Target cash is frequently set at between 2-4% of annualized revenue, with many exceptions based on industry, growth/shrinkage rate,and several other factors.

Friday, November 27, 2009

An Entrepreneur's Dilemma--Grow with People or Technology

Two different companies, each in a different industry, face the same dilemma.  Growth and success have created significant pressure on their business, specifically their people and their technology.  In order to solve the short-term constraints as well as build the most scalable solution for the long-term, how much investment should be made into new technology and how much should be made in people, or human assets?

Both companies have found a shortage of "off-the-shelf" software to solve their technology needs, so they have built powerful databases and other platforms from which they run their business.  It seems that many entrepreneurs under 40 have the attitude that they should hire a full-time programmer and build their systems from scratch, which often ends up much more affordable in the short-term.  The spirit of bootstrapping is alive and well, even in young entrepreneurs.

The challenge, however, with this scenario is what happens after a year or two.  In both situations, the customized solution has already become antiquated and the company is beholden to the developer who, after some analysis, used non-traditional coding and programming language that is difficult to comprehend and unwind.  These developers often become a little lazy and create shortcuts and work-arounds that begin to rear an ugly head in the most inopportune moments.  What worked in the short-term may not be the viable long-term solution.

Both companies are very conservative in their hiring practices, careful not to over-staff their operations.  Yet failing technology systems put so much pressure on their staff that the entrepreneurs begin to hear things like: "I'm going home at night and on the weekend and working several extra hours each day remotely to try and keep up.  We need to hire more people or I'm going to burn out."  Often we hire more people to keep our staff happy, but we are actually perpetuating the problem created by insufficient technology.

I tend to operate under the following two premises when it comes to people and technology in a business.  First, use technology to automate as much of the business as possible so that the company can focus on hiring bright, smart, talented employees to help the company grow.  Second, do not buy or implement technology to solve your problems - your employees need to solve the problems first, then you can purchase and implement technology to automate the solutions they develop.  Each of these is worthy of a separate blog of their own, but we'll let this serve as the basis whereby we approach this dilemma.

Obviously the answer to this dilemma will differ with each situation, but I challenge all entrepreneurs to think hard about the investment they are making into people and technology.  If we are confident that your technology can support the next five to ten years of growth in terms of scalability and relevance, then we are in a fantastic position.  If we are not confident in this and we are just doing the necessary things to "band-aid" our way through each day, month, and year, then ultimately we will probably have to scrap that system and start all over again, anyway.  And we'll spend a lot of money on people trying to hold it all together in this process.  We should seriously consider getting it right the first time if at all possible.

In addition, we need to strongly consider which operations performed by employees could be automated, and we need to start down the road of automating those functions.  Our competitors are going to do it, and we will need to eventually, as well.  For almost 2 years I put myself through college in a call center for one of the largest investment companies in the world.  At the time, automated telephone systems were becoming popular and many of my co-workers thought they would lose their jobs to automation.  Not only was this not true, but we also found that instead of wasting our time answering questions and resolving concerns that the automated systems could handle we could focus on the more value-added elements of the company's service mission.  The point - our knowledge worker society will progress only as fast as we automate the simple stuff and add more value to our customers with our human assets.

Wednesday, November 18, 2009

Staffing the Accounting and Finance Department

CFO WISE - How Properly Staffing the Accounting & Finance Function Will Help Entrepreneurs Solve Problems


I have had a lot of conversations recently about staffing the accounting and finance function in the company.  As companies grow and shrink, their needs in this area change.  We certainly do not want to be over-staffed, and we also want the most cost-effective staff doing as much of the work as possible.  For example, we typically do not want our Controller or CFO entering payables - this task can easily be delegated to a much lower cost employee.

This is a simplified organization chart of the different accounting and finance functions in an organization.  The reality is that most start-up and emerging companies cannot afford all of these positions.  My purpose in this post is to explain how to fulfill all of these necessary functions throughout the life-cycle of a start-up company.  I am making the assumption that we all understand the purpose of the accounting/finance function as well as the assumption that the company has or will hire the appropriate outside professional(s), like a tax CPA, to help the company remain compliant.

Even at the earliest stages of a start-up, it is usually best to hire a part-time bookkeeper to fulfill all of the roles listed above.  They usually do not have the expertise of a high-level controller of CFO, and they will be slightly over-paid for doing some of the more clerical tasks.  But the bookkeeper gives an affordable and flexible option to start-ups.

As the company grows and has revenue, the company should begin to look to hire full-time clerical staff to handle most of the AR, AP, and payroll tasks while the bookkeeper remains part-time and delegates everything they possibly can to the in-house staff.  One of the major challenges that usually emerges during this process is that the part-time bookkeeper will begin to struggle to keep up, especially with the monthly financial statement preparation and analysis as well as other management reports on how the business is doing and what improvements should be made to maximize cash flow.

Often the next best step is for the company to consider engaging the services of a part-time CFO.  This individual will be a strategic direction to this department and may only be needed about a half-of-a-day per month.  As the company continues to grow, the part-time bookkeeper will need to be replaced by a full-time Controller or Accounting Manager.  All of the full-time accounting staff will report to this person.  In addition, this position will take direction from the CFO.

Friday, November 13, 2009

Can a Lifestyle Software Business Really Exist?

A respected professional @chrisknudsen said something to me a few months ago that I have reflected on several times since that occasion.  We were discussing a company that has amazing, break-through technology with a wide-open market space.  Their leadership just does not seem to be in a hurry to seize the opportunity.  They're growing at about a 7% rate through the first 10 months of 2009, which is not bad in slow economic times, but they could be doing so much more.

Before I jump too far into this thought, let's make sure we are on the same page about what a "lifestyle" business is.  Wikipedia has a great explanation of a lifestyle business.  In essence, it is a company that is not designed to grow much beyond the means or capabilities of the founder(s).  A small auto-mechanic shop or a 5-chair beauty parlor would possibly fit this definition along with millions of other businesses around the world.  These businesses do not take a lot risk, where software and technology businesses have to continue to risk everything with each change in the technological marketplace.  For example, the iphone has existed for less than 2 years, yet if your software does not have an iphone app, you are considered archaic.

Now, let's get back to the software business.  The owners are running it like a lifestyle business.  They are not in a hurry to grow, and they are taking only a portion of their relatively minute profits and investing them back into improving their technology and infrastructure.  They have little sense of urgency in sales and they are happy to bring on a few new accounts each month.  Let me repeat - they have amazing technology that could completely redefine their entire market.  However, if they do not act quickly, they will lose their opportunity.

Technology is changing at light speed.  Every software company has a window of time to make their leap and make a run at their market.  If they wait too long or become too complacent, they will miss their opportunity.  In terms of a lifestyle business, if they only rely on their own means and they do not pull the resources together to take advantage of the opportunity, they will not only miss the opportunity but they will likely be out of business in 5 years or less.

Technology is changing too fast and they will not be able to keep up.  The competitors will eventually find their way through the window of opportunity even though their technology is inferior and they under-serve the needs of their customers relative to the company's technology.  These competitors will be rewarded with enough cash and resources to adapt and stay ahead of the changing technology.

So, I ask this question: "Is there such a thing as a lifestyle software business?"

Friday, November 6, 2009

Budgeting is Worthless Because I Cannot Predict the Future

I have heard this statement more often than I care to admit: "I cannot predict the future so a budget would be worthless for my business."

An article entitled How to Create a Budget in BusinessWeek prompted me to recollect some of my experiences with helping people who have the above attitude towards budgeting gain a new appreciation for the process and, more importantly, the results the process can generate.

I have and will continue to make this guarantee to any business in any industry anywhere in the world: if you follow the "best practices" steps to creating a financial plan and operating budget for the next twelve months and you track your monthly progress against that plan, you will know more about your business than 80% of your competitors know about theirs.

Why can I make that promise?  Because the things learned in that twelve months are so revealing in terms of the most effective business model and other competitive advantages that the company cannot help but begin to develop and implement the right strategies for making the business more successful.

Why do most businesses fail to implement this process? I have found that the two main reasons are lack of discipline and lack of resources. This process requires a great deal of disciplined time, including the discipline to review your results against your budget EVERY month. The budget is worthless if we do not do this.  The focus of this monthly analysis should be on the variances in the budget. We need to know WHY we varied from our budget. What can we learn from that?  What can we change to improve our performance in that area?

Some companies lack the resources to be able to analyze their historical data and then easily track their progress. Perhaps they do not have an accounting system in place, or perhaps they do not have anyone that knows how to properly operate their system. The accuracy of the numbers is certainly a critical element to making the budgeting process a successful experience. So, having the right staff and a functioning accounting system are critical to this process. Even QuickBooks allows its users to enter in budget information and then run reports to track the monthly progress and variances.

If anyone reading this post doubts me, I challenge you to try it for 12 months. In my experience the value derived from the budgeting and variance analysis process has improved the bottom-line dramatically. I think you'll experience similar results.

Monday, November 2, 2009

Build Your Business Model Around People

This is a real situation experienced by a real emerging company.  Names and figures have been altered to protect anonymity.

A company has a new opportunity and they create a financial model to try and forecast how their general assumptions for this opportunity will materialize.  Specifically, they made significant assumptions about the direct labor costs of the opportunity based on the historical performance of their other product lines.  Less than two months into receiving real data against which they can either validate or invalidate our assumptions, they began receiving feedback that the employees were under-paid and that their competitors had better compensation programs available.  How was this missed in the model?

First of all, let's be clear that this is not the first or last time something has or will be missed in a financial model.  They are based on assumptions, not fact, and, therefore, are subject to error.  The most inaccurate assumption made was that the number of units per direct labor cost was off by a large margin.  We could break it down to show that on average during the first 2 months 1.33 units were produced per person per day.  The model assumed that a minimum of 2 units would be produced per day.  With a piece-rate structure to the compensation program, this meant the employees of the company were taking home about 1/3  less pay for the same amount of work as the company's other products.

This company quickly made adjustments to the business model, and realized that even with a change in the production rates the new opportunity would be very profitable.  As such, they changed the compensation program, the employees were happy again, and the company is profiting from their new product line.

So, what take-away can we gain from this story?  Labor is almost always one of the two most expensive inputs into a business.  It, unlike any other asset of the firm, is often the most critical of all of the inputs.  If we want the best output, then we need to make sure to help our employees win within the structure of our business and financial model.  If our employees cannot win in a model that helps only the company win, then the company should not pursue the opportunity.

Monday, October 12, 2009

Does Too Much Money Too Early Hurt Startups?

I attended a presentation at UVEF today by Skullcandy Founder & CEO Rick Alden.  By the way, Rick is being considered for the Entrepreneur of the Year award for 2009 by Entrepreneur Magazine.

Rick brought up a thought-provoking question that no one had an answer for, including himself.  We have all heard of the start-up companies that started in the Founder's basement and grew into wildly successful and profitable ventures.  But how many success stories have we heard of companies that start with millions of dollars in the bank and an "A" management team in place?

We can logically build out a sound reason why both situations foster success, but the underlying premise is that perhaps early-stage success has less to do with lots of capital and an impeccable management team.  Perhaps the struggle to scrape by and bootstrap at the beginning builds a discipline that makes the start-up more likely to succeed.  Maybe well-funded start-ups don't appreciate the struggle most encounter to raise capital and they spend it unwisely.  Or, we may find that having all the capital and the complete management team improves a ventures chances for success.


HERE IS SOME OF THE FEEDBACK I HAVE RECEIVED IN ADDITION TO ANY COMMENTS TO THIS BLOG POST:
@greggwitt: absolutely too much capital can hurt. saw it happen first hand.
Paul Herron: I like the analogy of an infant becoming a toddler, child, adolescent, and adult. You start with a newborn invention or idea and a founder's vision of how "success" will ultimately be achieved. Execution of a business plan in a nurturing environment may lead to tangible, measurable accomplishments, and each step toward maturity is rewarded with greater resources and more variables to manage. If milestones are met and feedback is positive, healthy growth takes place. Slow and steady progress is always preferred, but every industry has examples of erratic, unexpected successes and failures. Drug development, for example, is a very high-risk proposition, requiring close parental supervision all along the way (and perhaps just a bit of luck). Accordingly, many "infants" just don't survive.
John Kogan: The garage/basement, scratching month-to-month teaches you good habits and forces you to make tough decisions. This all leads to maximizing capital efficiency and your own inventiveness. When there are plenty of funds around you tend to substitute money for work and thought. It's not that you aren't putting in the hours, it's that you don't have to consider every decision quite as hard. Also, it's much easier to say "we'll hire someone" or "let's pay someone outside to do this" rather than hunkering down and doing it yourself - which is how you really learn when you are a young startup.
Could too much success hurt? Sure. But I think it would hurt for the same reasons as too much money, and primarily b/c it would bring a flush of funding and the sloppiness that follows. Of course that's just my two cents (and as a scrappy startup, we can't afford a penny more).
Larry Davis: I have worked with more than two dozen start-ups since 1999, and I find that the probability of success is driven more by the perceived tangible beneifts of the product in the eyes of potential customers as opposed to the amount of capital raised or the quality of the management team. If you are developing a product that offers measurable ROI or enhanced performance, you will generate revenue more easily than many others can offer. Then, it's a matter of controlling costs so that your venture is profitable.
To answer Ken's question directly, I would suggest paying attention to Ning. This is yet another social media company, but it is headed by internet legend Marc Andreesen, who has no trouble attractive investors and certainly has plenty of money of his own. Thus, Ning has plenty of capital and as "A" CEO as a company could have. Let's see how they do!
Mark Macleod: I think it's way better to start off without a lot of capital for many reasons:
- keeps you focused
- keeps intensity up
- keeps your ownership high
In the bubble days I was in a startup where we raised too much money. We got defocused and comfortable. Startups do best when they are lean and mean. So, I come down very strongly in favour of the lean approach.
Twitter is one example of a company with may more cash than it needs now. We'll see whether they execute and deliver on their billion $ promise.

Tuesday, October 6, 2009

Times Are Changing, Are You Keeping Up?

When I was young and received a new baseball hat, I would work the bill of that hat until it formed a symmetrical arch - in the general shape of a rainbow.  This was accepted as the best and most stylish thing to do at the time.  Today no young people engage in this ritual.  They take their new hat, flat bill and all, and put it right on their head – and they never work the bill into an arc.  It is straight-as-an-arrow and, in my opinion, not very attractive.

This is a small example of a world that is constantly changing.  Business is no exception to this rule.  In fact, unlike popular fashions and trends that may come and then go as quickly as they came, business change is about finding more value, efficiency, cash flow, and profit.

Some of the traditional business models, or old ways of doing business, are under serious overhauls in our new economy with the help of technological advances, social media growth, and a general philosophy that leaner is not only meaner but powerfully more effective.

Here is an example: the professional services industry, as a whole, has been shifting towards a flat fee business model in opposition to its entrenched hourly-rate model.  Those leading this charge are seeing phenomenal success.  Those unwilling to change will continue to see their revenues, and more importantly, their profits fall.

I recently met a manufacturing firm that has had the same ownership and leadership since 1976.  This is impressive, with the exception that the leadership has failed to adapt their business to more effective business models through the years.  Their inefficiency, lack of technology, and resistance to change in general has them teetering on bankruptcy.  In other words, they are still focused on putting the arch in their baseball hat when the rest of the market, especially their competitors, has a new and better way.

I’m not going to change the way I wear a baseball hat – I guess that makes me old and I am willing to deal with the very minor repercussions of my decision.  Some changes in business are fads and will not have any impact on the most effective model for an industry.  But some of these changes are monumental and must be adopted if a business hopes to survive.  The executive team is to continue to drive the business model towards acceptance of those changes that will bring great value and true competitive advantages.  This should be at the premise of any strategy  a company develops for its future.

Thursday, October 1, 2009

QuickBooks Statement of Cash Flows is Wrong for these Three Reasons

The statement of cash flows is the most valuable, the most under-used, and the least understood of the three main financial statements (profit & loss, balance sheet, statement of cash flows). Since a lot of businesses use QuickBooks, I feel it is critical to make sure we all understand what needs to happen to make this reporting feature more accurate.The statement of cash flows is the most valuable, the most under-used, and the least understood of the three main financial statements (profit & loss, balance sheet, statement of cash flows). Since a lot of businesses use QuickBooks, I feel it is critical to make sure we all understand what needs to happen to make this reporting feature more accurate. It is likely that our QuickBooks-generated statement of cash flows is incorrect for the following three reasons:

CLASSIFICATION OF ACCOUNTS
Each time a QuickBooks user creates a new account the system looks at the type of account and, if that account type is on the balance sheet, it is classified into one of the three sections of the cash flow – cash from operations, investing, or financing. QuickBooks is often right in its inclusion of accounts on the statement but it can be very wrong on the section of the statement in which the account should be included.  For example, a working capital line of credit is often coded as a current liability. QuickBooks assumes this account should be in the operating section of the cash flow, but that is not always the case. A line of credit is usually reported in the investing section of the statement.  The classification of all accounts can be manually changed in QuickBooks by going to Edit, Preferences, Reports and Graphs (Company Preferences), and then click on the Classify Cash button in the Statement of Cash Flows section. An account is placed on the report when a checkmark is next to the account in one of the three fields, which represent each section of the report.

DEPRECIATION
The whole purpose of the statement of cash flow is to adjust the net income reported on the profit and loss to the cash position of the company. Depreciation is a non-cash expense, and, therefore, is added back to net income as a first order of business on the statement of cash flow. Since depreciation is not a balance sheet item, QuickBooks, by default, does not even include it on the statement of cash flows. QuickBooks does, however, include accumulated depreciation on the report, but it is reported in the investing section (depreciation is technically part of the operating section).  To correct this situation, two things must be done. First, follow the instructions above and remove the accumulated depreciation account from the report. Second, add the depreciation account to the operating section.

CHANGES TO PRIOR PERIODS
This issue causes problems with all three of the financial statements. Once a period is complete, all of the accounts are reconciled, and financials have been issued, there should be no more changes to that period or earlier. By simply using the Closing Date and Password functionality of QuickBooks, the company can lock prior periods and protect them from any attempts to add to, delete from, or change any transactions in the closed periods. This is easy to use and can save the business from a lot of headaches in the near and long-term, not to mention safeguard the accuracy of it’s reporting. This is done by going to Edit, Preferences, Accounting (Company Preferences), and then clicking on the “Set Date/Password” button in the Closing Date section. This will allow you to set the date of the close as well as only allow people to make changes prior to that date if they know the closing date password.

CONCLUSION
If I could only receive one of the three financial statements, I would always pick the cash flow statement. It is the most valuable for any business, especially start-up and emerging businesses. It is the best measurement tool of cash sources and uses for any business, especially start-up and emerging businesses.  By setting up QuickBooks correctly and then using it correctly it is capable of cash flow reporting that will help entrepreneurs and CEO maximize their cash flow.

Wednesday, September 23, 2009

How I Saved Almost $30,000

We (meaning my family) had a need.  We just added a sixth child to our family and our faithful minivan, with a total of seven seats, was no longer sufficient to safely hold our entire crew.  Without too many 8-seaters on the market, we started looking for a new vehicle to purchase.  We found a very nice lightly-used suburban for $30,000, and it filled our need and then some.

However, something stopped us from actually making the purchase.  Sure, all the bells and whistles of the new vehicle were nice, I just could not get comfortable with spending $30,000 for another seat.  The suburban was certainly worth $30,000, but when cast in the light of our actual need, it was quite excessive.

We received a referral to a qualified company that does seat covers and installations.  For $195 we had an additional seat retro-fitted and installed between the two captain chairs in the middle row.  We did not need a new suburban because our minivan had everything else we needed, except for an eighth seat.

So, what is my point?  Too many companies focus too much on selling their product or service rather than meeting the needs of their customers.  Most customers do not know exactly what they need – they suffer from information overload.  They want an expert to get to know them and their situation, and then recommend exactly what will best fill their needs and bring them the most value.

I failed to mention our good friend who helped us through the experience.  He wholesales cars and, as an expert, helped us find the best value to fill our need.  He earned NOTHING on this transaction, but he has earned our business for life because he took time to learn about us and then, without trying to force one of his cars or other services upon us, helped us find the best deal for us.

The marketing and sales process often fails to identify the core needs of the customer.  Whether we are selling too much or too little, our best long-term proposition is to know the needs of our customers and fill them.  Up-selling is okay as long as we do not overlook the needs of our customers.

Sunday, September 20, 2009

The Difference Between a CFO and Controller

Ben Paramore wrote a post he titled: Difference Between CFO & Controller.  He does a great job explaining some critical differences between these two vital roles, and his chart at the bottom should be the basis of expectations whereby each are judged. Here are some additional thoughts to add to his:

There are really a limited number of CFOs worthy of that title.  The reason is because it take a special breed who can master the technical elements of the accounting and finance trade, but also be visionary about how everything will work together and how the organization can best maximize its value in both the short and long term.  Many long-time CPAs get a rude awakening when, after 20 plus years in public accounting, they take their first CFO role in private industry.  Many have commented to me how it is a profession unto itself that has certain elements that can only be learned through experience.

Here is an experience I had that may help to clarify just one of the differences.  The Controller of an organization was overwhelmed by a particulalry difficult month to close.  The trial balance was all out of whack and several major balance sheet accounts were not reconciling very easily to the detail statements.  After much work on her part, she successfully balanced and closed the month.  She was so excited she rushed to the CEO's office and exclaimed: "The month is closed.  I am finally done."

After thanking her for all of her diligent efforts, the CEO asked: "So, how does the month look?  How did we do?"  The Controller's response, "I don't know, but it finally balances."

This gap in communication was not intentional, but it highlights the difference in both perspective and priority of between the CEO and the Controller.  I have found that CEOs, founders, business owners, and entrepreneurs can sometimes become very frustrated with this gap between the Controller and their perspective.

A CFO fills this gap in a very unique way.  You see, a CFO knows how to speak in the language of accounting, and a CFO also knows how to speak the language of business ownership and CEO.  We sometimes call this the language of entrepreneurship, too.  This is the reason I made the statement earlier that there are really a limited number of folks who can successfully and productively fill this role.  It is rare when someone can understand and even perform all of the technical aspects of a CFO, let alone the strategic vision and leadership to help the executive team guide the organization to success, too. The combination of these two skills makes anyone ideal for a CFO career.

We often hear that CFOs become CEOs.  I know that this is probably not as frequent as some would hope, but hopefully you can start to see why a great CFO is often a great candidate for a CEO role, and sometimes the best for that role.

Wednesday, September 16, 2009

Entrepreneurs Need to Know these Five Business Metrics

Imagine you own a successful business but become stranded on a deserted island.  The only communication you receive about your business comes once a week on a sheet of paper in a bottle (yes, a message in a bottle).  What information would you need and want on that paper?  When you remove the subjective elements of running a business and try to do it on objective data alone, how does that change your ability to make the right decisions?

DASHBOARD
For the purpose of this article, we will refer to this piece of paper as a dashboard report, although it may also be called a flash or KPI (Key Performance Indicator) report. The dashboard should be critical in assisting an entrepreneur or business owner predict sales, cash flow and profit and gain clarity on the performance and direction of the company.  In addition, it should be a critical decision-making tool used in the day-to-day operation of the firm that empowers CEOs and business owners to make the best decisions for their respective companies that will drive cash flow and profit.

There are three main steps to consider in building an effective dashboard.  First, we should know the averages and benchmarks for our industry.  Second, we should know what our historical performance on these same averages and benchmarks.  And third, we have to develop what many call a balanced scorecard that comprehensively examines the whole company, not just one or two parts.

SOFTWARE AND TRACKING TOOLS
The answer is not to initially buy a business metric or dashboard software program.  These tools are valuable, but every business needs to initially determine what metrics it should track.  In fact, it is always best to use Excel or even a pen and paper to initially track several different metrics. It is nearly impossible to know which metrics will be the most effective until we get some experience with it.  We can save money on the software for now and focus on finding the best metrics for our business.  Once we know the metrics that are the most effective for our business, then we can consider investing in a dashboard tool.

Marketing, sales, operations, and financial are the four main categories every business needs to include if we want the dashboard to adequately inform us on our deserted island.  We will briefly discuss each of these areas below:

MARKETING AND LEAD GENERATION
This is where it all begins.  We need leads if we ever hope of acquiring customers.  Our dashboard should include the top two to four metrics for measuring our lead generation.  These may include number of visits to our website and percentage of those visitors that become qualified leads.  The key here is to focus on the processes you are currently employing to market and generate leads and measure on your dashboard the efficacy of these efforts.  The cost of acquiring a lead should be included if it is measurable (and it almost always is).

SALES
Obviously a lead is still useless to our business if we cannot convert the lead into a paying customer.  Conversion of leads to customers is a critical element of most dashboards.  In addition, total sales should be included so we know how our volume is doing on at least a weekly basis.  Sales should be communicated in terms of dollars, number of sellable units, and average pricing.

OPERATIONAL EFFECTIVENESS
Since sales is responsible to turn the leads into a paying customers, we desire to satisfy and retain the customer as long possible as effectively and efficiently as possible.   The point here is to structure our business model so that we deliver everything we promise for as little cost as possible.  Let’s review a couple of examples.

If I am a professional service firm that is mainly selling time in exchange for services, then I am concerned about my average cost of paying staff per hour as it relates to my average revenue per hour.  I will also be very concerned with ratios like revenue per employee and sales-to-wages.

If I manufacture products, then I will want to understand the efficiency of all of my inputs, including materials (and scrap), labor, contractors, and other direct costs.  In essence, we need to look at the major determinants of our gross margin.

We should consider three additional metrics on our dashboard that deal with operations.  First, an indicator of our current utilization of our total available capacity.  Second, customer satisfaction and retention metrics are a valuable barometer for ongoing sales.  And, third, a measure of product or service quality levels.

FINANCIAL – CASH, PROFIT, & HEALTH
We should know what is happening with all of our major current assets, which usually includes cash, accounts receivable (AR), and inventory.  We should quantify the performance of our AR in terms of total % over 60 days past due as well as the Days Sales Outstanding (DSO).  We should understand if our inventory levels are at efficient levels.

We may want to include some of major current liabilities, like accounts payable and line of credit balances.  This information leads to the tracking of the firm’s current ratio on a weekly basis and other versions of the current ratio that traditionally predict cash flow with some accuracy.

CONCLUSION
If we received a weekly dashboard report with all of the information above (tailored to our industry and business model), how well do we think we could manage our business from a deserted island?  Now, we should imagine having all of that information every week along with being in our business every day.  Not only will we feel empowered to make the right decisions to improve cash, profits, and financial health, but we will see our level of anxiety (which comes from a lack of this information) drop significantly.  Even if the dashboard reports bad news, knowing about it will still reduce our anxiety because we will at least have the opportunity to do something about it before it becomes worse.

Wednesday, September 9, 2009

Key Terms of an Asset-Based Line of Credit

Short term working capital financing is most commonly facilitated with an asset-based line of credit. As its name suggests, the loan is secured by an asset in the business – usually accounts receivable. If you ever consider using this type of a vehicle in your business, here are the 5 most critical terms you should understand and know how to negotiate.

ASSET
What is the asset that will be securing the line? These loans are normally tied to current assets like accounts receivable and inventory, but they can also be secured by equipment and even intangible assets like intellectual property and goodwill.

If we default on our payment of the obligation, the lender will have the right to seize ownership of the asset. Banks and lenders do not want to have to do this and they will be the first to admit that they are not structured or equipped to effectively liquidate such assets. These assets are usually very valuable to the business which makes payments on the line of credit a top priority for most businesses.

BORROWING BASE REQUIREMENTS
Assuming the asset is the accounts receivable of the business, the lender usually sets limits and conditions on the amount of the receivables that can be included in the borrowing base. The two most commonly used limitations are past due accounts and customer over-concentration.

The lender will often only allow current receivables in the borrowing base. This is often set as all receivables less than 60 days old or only receivables less than 60 days past due. Lenders will often limit the percentage of the total receivables that one customer can hold. This is usually set at no more than 20% of the total eligible borrowing base.  For example, if we have total receivables of $1,000,000 and they are all current (very unlikely in this economy), no single customer can account for more than $200,000 of the total receivables. If they do, then all amounts over $200,000 are excluded from the borrowing base.

Once the total borrowing base is established, the lender will then often only allow a certain percentage of those assets as the final base.  On accounts receivable, this percentage usually ranges from 60-80%.  As an additional note, borrowers are usually required to report on the status of the borrowing base on a monthly or more frequent basis.

So, how does all of this work.  Here is a basic example:  let's assume the lender allows us to borrow a maximum of $100,000 against 75% of our eligible receivables.  The lender excludes all receivables over 90 days old and has no limit on customer concentration.  Our total accounts receivable is $150,000, but $50,000 is over 90 days past due and we are about to write it off as bad debt.  This means our eligible AR is $100,000, which means our borrowing base is actually only $75,000 ($100k AR times 75% of eligible AR).

MAXIMUM
This is very simply the maximum amount the lender is willing to lend on the line of credit, regardless of the value of your borrowing base. Most lenders set this amount by looking at their secondary sources of repayment, which are usually the financial strength of the owner(s) and/or the equity in un-related assets (like their home). These are often secured with a personal guarantee.

FEES
Each bank structures its fees a little differently, and it is important to understand these so that we can make an “apples-to-apples” comparison on costs. Most lenders assess an origination fee of between .5-1.5%. In addition, they will often charge document and other fees. We have also seen banks require borrowers to pay an independent third-party to verify and validate the assets in to be secured. We recommend receiving proposals from more than one bank and then comparing the total cost proposal from each potential lender to understand which may present the best deal for you.

INTEREST RATE & FLOOR
When you establish your borrowing base and you draw on the line, interest will begin to accrue. Most banks are setting the interest rate on these lines at prime plus 1.5-2.0%. Prime is currently at 3.25%, so that would equate to an interest rate of 4.75-5.25%. Because these rates have dropped so low, most banks have instituted a floor, or a rate below which they will not drop. Interestingly, those floors are being set at 6.5-7.0% in this market.

CONCULSION
Asset-based lines of credit are an affordable and effective way to finance the peaks and valley in working capital. As a word of caution, most require a personal guarantee from all owners of 20% or more of the business. We recommend you seek legal counsel before agreeing to personally guarantee the debt, especially if the guarantee is unlimited – which means each partner can be held responsible for 100% of the obligation personally.

Wednesday, September 2, 2009

Social Media ROI

If you want to open up a can of worms, ask a group of internet marketers and CMO's how to measure the ROI on social media investment and participation.  There is and will continue to be a heated debate on this topic until we all realize one thing: Social Media is about branding, not advertising.

Traditional advertising defines a specific spend and generally has measurable results. A return on investment is easy to calculate.  Building a brand requires a significant investment, but does not generate track-able results.  The reason a person at the grocery store chooses Pepsi over Coke is a summation of a lifetime of branding messages (sometimes in overwhelming quantity).  How do you measure that?  It is very difficult, although there are many options for understanding the overall value of branding (referred to as goodwill for the accountant types).

We have the same problem with social media.  Social media is about building a brand, with the cumulative efforts assisting to generate sales.  But branding is less directly involved with the final transaction as traditional, measurable mediums.  How much did the direct mail piece I receive influence my decision to call the home security company in comparison to the branding I have been exposed to for the last five years at sporting events, parades, etc?  Hard to say, and even more difficult to quantify.

In its truest form, social media is a venue to add value to the the market in general in the form of free advice, expertise, networking, and communication.  All of this leads to relationship building with a more targeted market that gravitates towards your content and brand.  I am all for measuring ROI, but I also think there is often a lot more at play than a simple ROI calculation will capture.

Social media is here to stay (just watch this video), and businesses need to get involved.  A great example of this is the professional services industry.  The most effective methods for marketing in professional services have long been referrals and networking, but these survey results indicate that more of the networking efforts in the next 6-18 months will concentrate on social media (LinkedIn, FaceBook, etc.).

So, are you still itching to track the ROI of your social media?  Consider a change of perspective from ROI to the overall value of your brand. Then you'll be getting closer to overall value generation than transactionally-based (and often incorrect) attempts to attach an ROI to social media, or branding, activities.

The brand of a firm should have legitimate and palatable value, and that is what I care about.  Ultimately, the value of the brand becomes a long-term and often sustainable competitive advantage that commands premium pricing, better margins, and maximal cash flow!

Wednesday, August 26, 2009

Bridging the Gap Between the Financial Model and Budget

bridging the gapA financial model and an operating budget are two different things, but the two should correlate with and complement each other. I’m going to briefly discuss the differences, what each is used for, and how to use them both more effectively to run and improve your business.
THE DIFFERENCES
Financial modeling/forecasting usually takes a big-picture approach and avoids too many details. The model is used to assess opportunities and the cause and effect of major business decisions. The model is often expressed in terms of yearly performance.
An operating budget, in contrast, is mired in the details. It needs to tie directly to the accounting system’s general ledger, or chart of accounts for QuickBooks users, and is usually a month-by-month forecast of the activities of each account for the next 12 to 24 months. Use of the operating budget includes analysis of the budget vs. actual performance each month.
HOW & WHY SHOULD THEY CORRELATE?
A business needs to have both a financial model and an operating budget. An operating budget without a long-term model/forecast leaves a company pretty directionless and lacking the ability to understand the impact of business decisions on financial performance. A financial model without an operating budget is a “pie-in-the-sky” dream that is not founded in reality. There is no way to track progress towards accomplishing the goals and objectives, if they are even outlined, and it is almost impossible to hold anyone accountable. Every business should have both.
The place where many companies go wrong is that they do not actively use both of them and ensure they “feed” into one another. For example, let’s assume we have modeled $5,000,000 in sales for 2009 but our operating budget calls for $3,500,000. This discrepancy is large and invalidates one, the other, or both!
The operating budget needs to validate and complement the assumptions made in the financial model, and vice-versa. In fact, the monthly review of the budget vs. actual performance can often generate valuable information about our assumptions and can justify changes and updates regularly to the financial model.
For example, let’s assume we project a 50% gross profit in our 5-year financial model. Due to changes in the economy, increasing material prices, and a slight change in mix of products, our gross profit is coming in every month at 45%. We find and track this in our operating budget analysis each month. Since the trend seems to be consistent, we may make a decision to update the gross profit assumption in our financial model.
CONCLUSION
With an understanding of the differences between a financial model and operating budget, we can see the need to bridge the gap between the long-term planning and short-term budgeting so that they complement each other. While this requires some effort and often the expertise of a CFO, the result is always a competitive advantage in terms of a more effective execution of our business model. That means more cash flow and better profitability that your competitors, which results in a sustainable competitive advantage.

Wednesday, August 19, 2009

Three Most Common Mistakes when Modeling the Balance Sheet

Every sensible financial model projects the results of all three major financial statements - the profit & loss, balance sheet, and statement of cash flow.  The balance sheet, not the profit and loss, is what drives the cash flow of the business.  If the balance sheet is not correctly modelled, then the cash flow forecast is most likely inaccurate and worthless.  Yet the balance sheet is the part of the model that is usually the most neglected and least understood.

In order to help get the balance sheet forecasting correct, we have identified three common mistakes that entrepreneurs, CEOs, business owners, and even business financial consultants make: NO balance sheet projections, failure to correlate operating activities on the P&L to changes in the operating assets and liabilities on the balance sheet, and disregard for the debt and equity transactions of the firm.

BALANCE SHEET IS MIA
The most common mistake made is the exclusion of a balance sheet forecast from the financial model.  The balance sheet represents the most complex transactions of the company and may be left out of the model because the company lacks the expertise of a CFO  or financial executive to assemble this critical part of the model.

CORRELATION OF OPERATING ACTIVITIES AND OPERATING ASSETS AND LIABILITIES
The major operating assets include accounts receivable, inventory, pre-paid items, and more.  The major operating liabilities include accounts payable, taxes payable, and other accrued expenses.  When sales go up, accounts receivables go up, and cas goes down.  But does the model capture that?  If sales go up, can we expect our inventory level to stay the same?  Most likely it will need to increase.  The increments of these changes are dependent upon the relationship between our days sales outstanding and our inventory turnover.

As sales increase, our accounts payable usually increase as well.  The timing of our payments against our accounts payable is a major outflow in the cash flow puzzle that is called working capital.  We need to define the relationship that payables have with our operating activities and implement this relationship in our balance sheet model.

There are several other operating assets and liabilities that dramatically impact cash flow.  We will avoid all of the details of each, but it is fair to say that without properly forecasting them, our cash flow forecast will never be accurate.

DEBT & EQUITY TRANSACTIONS
Are we bringing in any more equity investments during the period we are modelling?  What is our dividend policy for shareholders?  Is some or all of the active shareholders compensation coming through equity?  All of these items can have a significant impact on cash flow, although none of them show up on the P&L.

In addition to equity transactions, the structure of all of the company's debts and obligations need to be correctly reflected on the balance sheet.  An interest only line of credit will keep the same balance until more is withdrawn or some is paid back based on the cash flow of the firm.  Term loans need to show the correct amount of principal being reduced every month.

Obviously these items can seriously change our cash flow, and they need to be included in the financial model so we can correctly forecast our cash flow.

CONCLUSION
This list of common mistakes is certainly not comprehensive (you'll notice we did not address capital expenditures at all), but should create a positive foundation to build the balance sheet model.  Accurately modeled balance sheets help businesses get a handle on their companies, make the best strategic decisions possible, raise necessary capital, and perhaps most importantly, track their progress so they can correct problem areas and make more valid assumptions in the future.

Friday, August 14, 2009

Three Worksheets Your Financial Model Must Have

A good financial model should feed into three main pages, which happen to match the three main financial statements of a business - profit & loss, balance sheet, and statement of cash flow.  These three components of the model should never be circumvented nor should we ever try to short-cut the need for all three.

With these three pro forma statements as the final deliverable, there are at least three additional worksheets that need to be part of the model. They include assumptions, marketing/sales/COGS, and payroll.

ASSUMPTIONS
Every working financial model should have one page that contains a majority of the assumptions for the model. Assuming we are using Excel or another spreadsheet template to create the model, these assumptions should be linked throughout the model. This gives us the ability to make a change to any one of our assumptions and then see how that changes our profitability and cash flow outcomes.

MARKETING/SALES/COGS
We need detail! It is not sufficient to say we are going to grow sales by 50%. What are the marketing activities that will drive that growth? How many leads will we need to generate a sale? What is the cost of these leads and other marketing activities? Which product or service lines will grow more than others? How does our gross margin differ on these lines as compared to slower-growth or even obsolete lines? Is there a difference in both the collections and the payment for costs of goods sold between these lines? How will this impact cash flow? These are the questions we look to this worksheet to answer.

PAYROLL
How many people is it really going to take to accomplish what out financial model projects? What are the salary and wage costs to hire all of these people? Are our hiring practices in line with the sales per employee financial ratio according to our industry benchmark? Have we correctly factored in all payroll burden and benefit costs, including FICA, FUTA, SUTA, worker's comp, other state payroll taxes, health insurance, 401(k) match, etc.? Have we correctly forecast all of the costs associated with adding these new employees, including recruiting, HR, and new office and computer equipment? These need to be factored into our plan so that we can demonstrate a realistic cost for growing our firm.

While there are many other supplemental worksheets that may be used to help build a formidable working financial model, these three are a requirement.

Tuesday, August 11, 2009

Two Biggest Flaws with Break-Even

Most of the folks who read my blog know I write from the CFO and entrepreneur perspective on start-up, emerging, and medium-sized businesses.  This post will be no different, and its intent will be to clarify the two most significant flaws entrepreneurs, business owners, and CEOs experience when trying to understand their break-even point, both in terms of sales volume and units.

FLAW #1 - OWNER COMPENSATION
The traditional method for calculating break-even requires us to separate the fixed and variable costs.  These come from the profit & loss statement, or statement of operations.  Often a significant portion of the active owners' compensation, meaning the "wage" for their time and effort working in the business day-to-day and excluding profits and dividends, is pushed through the balance sheet for tax purposes.  Specifically, an S-corp often pays a reasonable salary to the owners to meet IRS requirements and also has a regularly scheduled distribution to make up the difference.

Here is an example.  Let's assume a business that is structured as an S-corp has one owner who requires $150,000/year to pay her bills and do the things she wants and needs to do.  She is advised by her tax advisor to only pay herself $90,000 as a salary.  This flows through the profit & loss and will be included in the break even analysis.  She is additionally advised to take the other $60,000 as a dividend to avoid unnecessary payroll taxes.  So she schedules a $5,000/month dividend to herself and counts on that not as a distribution of profit but as her regular and expected wage.  The challenge is that this $5,000/month flows through the balance sheet and is not part of the break-even calculation, even though it is, for all intents and purposes, just like a fixed cost.

The way to solve this is to add another $5,000 per month to the fixed cost total for running the firm each month.  This will being the break-even calculation to a more correct place.

FLAW #2 - DEBT PAYMENTS
Another fixed outflow of money that is often missed in the break-even calculation is reduction of the principal balance of outstanding notes and loans.  The interest portion of all debt payments shows up on the profit & loss and should be part of the fixed costs of the break-even calculation.  But the principal only flows through the balance sheet.

In some cases the amount of depreciation being recognized as a fixed cost is about equal to the principal reduction, but often it is not.  For example, a business that is paying an extra $3,000 per month towards one of their equipment loans.  The owner has set this as a requirement that the business must meet every month.  When this owner thinks about break-even, she is hoping that this extra $36,000 of principal reduction is considered.  In addition, she is also hoping the fixed dividend of $6,500 she takes every month from the company is included as well.

CONCLUSION
Hopefully you picked up on the place where break-even flaws occur - transactions that only hit the balance sheet.  In some ways, start-up, emerging, and medium-sized companies need to look very closely at both their operational break-even and their cash flow break-even to truly understand the minimum level of sales they can experience and still stay at a break-even from a profitability and a cash flow perspective.  Business finance textbooks teach only operational break-even and they fail to mention the inherent flaws to its calculation.

What good is knowing your break-even?  Besides the clarity and peace of mind it will bring, it can become essential in helping you price your products and services and help you refine your business model to its most efficient and effective state.  There is a power in being able to say: "We need to sell 100 units to break-even this month."

Wednesday, August 5, 2009

Responsibility, Accountability, and Teamwork

Most employees are responsible. Employees will do their job well, (at least they think they are doing a good job.) Employees generally feel responsible. These feelings of responsibility are feelings of obligation, and are pretty much instilled in all of us since childhood.  So why aren’t these employees measuring up? Well, we need to look first to accountability and then past the individual to the team and processes.

Remember you and your employees are in business not busyness. Busy work is not the work of business. Doing the wrong things well helps no one. So responsibly doing busy work is worthless.

So what is the answer? We all need to be held to account to do the work that needs to be done. And that is what accountability is all about. Accountability occurs when managers specify what they want subordinates to produce (quantity, quality, time and resources), judge how well the subordinate worked and thereby manage the employees. A manager may be reluctant to have the hard conversation, but part of the manager’s job is to ensure that  employees are being productive. Human beings are of course social animals. So management must never tolerate or allow bad behavior to be rewarded; think of it as a moral issue for management. No retailer would ever think of using an open cash draw instead of a cash register. An open cash draw rewards bad behavior.

Beyond the individual, most work is done in teams. Again, almost all employees strive to be a part of a winning team. The main inhibitors of teams are unclear work processes, bad incentives, unclear decision making, bad communications and/or lack of knowledge of how the rest of the firm works.  Almost all of the problems and issues happen at the margin or transitions--the handoffs, decision points, approval points etc. If you really want to improve employee performance, look at what happens between the teams. Now as the financial crisis on Wall Street shows, the bad incentives can really mess up ever the most profitable business. Well done financials can, of course point the way.

Fix the process, particularly the incentives and many employee problems take care of themselves.  FedEx is a good example. Here is what Charles Munger, Warren Buffett’s partner said…”the Federal Express system requires that all packages be shifted rapidly among airplanes in one central airport each night. And the system has no integrity for the customers if the night work shift can’t accomplish its assignment fast…”  Federal Express could not get the night shift to get the packages out on time.  “They tried moral persuasion. They tried everything in the world without luck. And, finally, somebody got the happy thought that it was foolish to pay the night shift by the hour when what the employer wanted was not maximized billable hours of employee service but fault-free, rapid performance of a particular task. Maybe, this person thought, if they paid the employees per shift and let all night shift employees go home when all the planes were loaded, the system would work better. And, lo and behold, that solution worked.”  (from an article “The Psychology of Human Misjudgment”).

Monday, August 3, 2009

How Many Forecasts Do You Have?

How many forecasts do you keep concurrently in your company?  If the answer is zero, then we have some serious work to do.  But if your answer is one, you may be falling well short of what is necessary in these difficult economic times.

Here is a real story of a conversation I had with a banker in the last 6 months.  My client needed to finance some heavy growth and we stretching to try and use only bank financing to accomplish this growth.  The banker was concerned about the effects that our plans for growth could have on the business.

He said: "Ken, I have your projections in front of me, and I understand they are conservative, but I'm not going to feel comfortable about this deal until you can show me convincingly that a 25% downturn in this company's top-line will not kill this company."  I agreed to re-work our forecasts based on his request, and I went ahead and ran an additional model with 25% additional growth on top of the already projected growth trends.  In about two hours we went from one forecast to three, and the exercise was overwhelmingly valuable.

In the July/August 2009 issue of CFO Magazine, Tenet Healthcare CFO Briggs Porter said: "Developing a plan on three different levels (baseline, high, and low) is a good idea in any environment, but it is a necessity in this one."  I could not agree more with this statement.  Forecasting is tough enough, but these uncertain times make it even more difficult.  And the stakes are high - if you fail to plan for each scenario, you can quickly put the company in a world of hurt.

Financial modeling and forecasting is an exercise that ultimately only proves beneficial if we use the models and forecast to validate or invalidate our assumptions, make necessary and timely changes in our businesses, and continue to try and stay ahead of the where we are going.  In large organizations, the CFO usually runs and updates the model.

I have and will continue to make this promise to anyone willing to take this challenge: If you will put a forecast/budget in place and track your actual performance next to your budgeted performance every month for 12 consecutive months, you will know more about your business and industry than at least 80% of your competitors and the competitive advantage you gain from the insights and knowledge you will gain during this process will add an overwhelming amount of value to your business.

Tuesday, July 28, 2009

Inequity Among Business Partners with Debt Guarantees

 Here is a real situation that has a partnership of four up-in-arms:

Each partner owns 25% of the business.  Three of the four partners have stellar credit and decent net worth.  The fourth partner had a bankruptcy 4 years ago and does not have much net worth, other than the value of the business, to speak of.
The company has a customer present an opportunity to them to double their business in 12 months.  The catch - they will need to buy over $1,000,000 of equipment to capitalize on the lucrative opportunity.  Even though the credit markets are tough, this company is able to secure the financing it needs under one condition - the three partners with good credit have to guarantee the loans, but the fourth partner cannot.
The three partners have exposed themselves to more risk than the fourth.  So, is the partnership still actually equal?  Not in terms of risk.
In this scenario, the three partners are fine to expose themselves to this additional risk to give the company a chance to grow.  They do wonder, however, if they should in some way receive compensation for taking on more risk than the fourth partner.  If for some reason the company defaults on the loans, then the  three who signed personal guarantees will have to resolve the issue eventually with the creditors.  The fourth partner gets to walk away without these issues.
I have seen some interesting ways to handle this issue, and I would welcome additional feedback on how to best handle this.  Any and all ideas are welcome.
One last thought - if anyone is considering taking on one or more partners in their business, this is an issue that should be considered and can even get in the way of financing your business.  If your partner owns at least 20% of the company, some lending institutions will require that they run a credit check on them - and if their credit is bad, the lender will probably decline the loan!
ADDITIONAL COMMENTS
I received some great feedback on a social networks that I wanted to add:
Mark McLeod says:
Interesting situation Ken. You could approach this a few ways: 
1.) Risk adjusted return on the leverage the 3 partners are taking on: some additional premium either as a % of the loan or non equal distribution of profits from the incremental business
2.) Separating the legacy and new business on paper and again having non-equal profit split on the new piece.
3.) Re-evaluating whether this 4th partner is necessary for the future of the business. Will he drag them down or can he be an equal and full contributor?
Peter Towle says:
Another option to explore IF the other partners want to keep the 'bad-credit' partner in as an equal profit participant (or try to keep it equitable) is to create a side agreement between the partners that encumbers the 'bad-credit' partners assets, future assets, or share of the business should there be a problem.
Richard Wong says:
Some good answers from Mark and Peter, I would also add the possibility of another:
Since this new business will result in a major change in the net assets of the company and I am under the assumption the partners like working with each other and that's the reasons they're still partners that they revise the partnership agreement to show the new partnership percentage based on this, otherwise it may be time to incorporate.
They have a holding company, where 3 of the 4 are given a larger %ge of the shares, a subsidiary (the main operating co.) and then based on some measure ie. net profits of the added customer business dividends could be given to the 3 shareholders who took the credit risk, until the loan is repaid, then based on some sort of gentleman's agreement that the 4th partner earn his way to an equal shareholder percentage. 
Now the above could all be thrown out the window if say the 4th partner is the one who brought in the customer and negotiated the extra business because let's say he's a better salesperson than the other 3? 
Hope you can facilitate a paper solution to this Ken.
Great feedback so far...I'm open to more ideas, thoughts, and suggestions!