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Adventures in Small Biz

I’ve been deep in a small local biz (revenues < 500K annually) and it has given me a good view on some specifics of why small business is so difficult. I’ll put high on the list the challenge of not being able to afford full-time people. Instead, small business is a cobbling-together of part-time and volunteer labor. Volunteer labor is particularly important, I have yet to encounter a small business or startup that does not in some way utilize it: the founder working for no or low pay for starters! Usually a family member or good friend will pitch in, and frequently dedicated customers as well. I have yet to see any studies on this, and I was saddened to see KIRO try to make a fuss over the use of volunteer labor in a local NW business.  That business was able to go back and pay everyone minimum wage, but most businesses would not be able to. It’s part of what makes a local business connected to and accountable to the community.

The part-time labor is also a challenge. Coordinating tasks and turning things around get more complicated when the designer only works on Mondays and the Project Manager for a particular project only works on Tuesdays. There’s pretty much a minimum one-week turnaround to get anything done because it takes that long for all the relevant staff members to cycle through! Need to contact a small business? Try to have a little patience when they’re not online 24/7, and realize they probably don’t have all your info and transaction history in a database at their fingertips. We’ve been trained to expect that by larger companies.

Both an upside and a downside is that jobs really are about individuals and not pure roles. In this manufacturing business, labeling is not a bottleneck because of Josh, he’s a champ. However nobody else can label as fast as he can, so should we budget for a labeling machine or should we budget for a food processor? Credit is very personal at this level as well – a startup doesn’t have the history or credit for formal bank lending. Credit is the personal credit of the founder – in a formalized way through personal guarantees or personal assets, and in an informal way by getting favors from other vendors based on personal relationship – being able to delay a payment, or borrowing equipment, or negotiating a lease.

I’m really noticing how growing a business is about steadily reducing risks – growing to hire people full time so they’re more likely to be there for you when you need them; having buffer room in the budget so unexpected expenses hit the balance sheet and not the owner’s pocket; being able to experiment more on product or placement innovation; being able to sign more contracts and get preferred pricing. Those are the efficiencies of scale – it’s about negotiating power more than just about volume, and about focused attention and commitment from stakeholders & partners that reduces frictional costs.

One way to get past many of these things quickly is to raise a bunch of equity and start operating at a higher level, but food businesses tend to be low-margin and can’t promise a return on significant equity. The steady risk-mitigation of organic growth seems to be a necessary path.   Luni of the Fledge Accelerator refers to these as “earners” vs “burners”. Earners being the organic growth path, and burners being the quick equity and try to scale quickly path. A frustrating trend we’re starting to notice is that high-risk money is coming into the food/ag sector where the business models can’t justify it. In the 3-5 years it’s going to take to lose enough money that risk-takers stop flooding it in, those “burners” that get funded will distract partners and resources from the “earners” that could actually sustain and thereby starve them in the short term.   It’s yet another example of how our capital funding system is broken.

There’s a gag t-shirt that reads “There are 10 kinds of people in this world: those who understand binary, and those who don’t.” The gag being that if you understand binary numbering you immediately realize that “10” is written in binary numbering and therefore reads as “two” not “ten”. I feel a little that way talking about Piketty’s Capital. Since I work in finance, it sometimes seems like “everybody” will immediately recognize it as the most influential book on economics since Smith or Marx. But I’ve been spending time with folks outside of that community lately and running into more people who say “Eh?” Which stops me a little short.

SO, Le Capital au XXIe siècle, by French economist Thomas Piketty was published in August 2013 in France. The English translation by Arthur Goldhammer, Capital in the Twenty-First Century, came out in April of 2014. According to Wikipedia it’s the best selling book ever from Harvard University Press. It’s been #1 on both the New York Times nonfiction best seller list and the Wall Street Journal best seller list. I was gifted with my copy last year by Matt Talbot of Bristlecone Advisors. Seattle University just started a 6 week (spread out over 12) special seminar with talks from 6-9 on weekdays and it sold out, I couldn’t get in.
It’s a tome for sure – 577 pages, footnotes round it up to 655. In July of 2013 a math professor from the University of Wisconsin did an amusing analysis (published as a WSJ essay) of the distribution of reader highlights in Kindle editions of best-selling books. He used it as a metric for guesstimating whether or not people are finishing the books. If everyone is finishing the books, presumably there will be popular highlights throughout the book. At the time, all top 5 “popular highlights” of Kindle readers were in the first 26 pages of Piketty, earning it the label of the least-read best selling book. But hey, it had only been out 3 months and it’s over 600 pages! I don’t have it on Kindle so I can’t check but I bet it’s better now. There are also no end of derivative analytical summaries out there.
I’ve been listening to the audiobook, actually, and it’s great! Piketty refers to lots of charts and graphs so one might think I’d miss a lot, but actually I think I’m getting a much better “read” this way. For starters, I’m a fast reader so audiobooks really make me slow down and get everything. Piketty is also a good writer – he’s really good about telling you what he’s going to tell you, telling you, and then summarizing in conclusion. He explains all the charts and graphs so while I’m missing some, it’s not much. And this really is pretty interesting stuff to me so I’m good about skipping back and re-listening. The first couple chapters laying groundwork were a little dull but it’s been fascinating stuff since! The narration is excellent, L. J. Ganser- I’m your fan! The audiobook is 24 hours long and I’ve been getting in in 1 hour doses on a commute, so I end up really thinking about small sections at a time.
I want to blog about it, I’ve been daunted. But it’s time and it’s what will really help me process what I’ve been hearing. This book blows my mind – it really seems to me that the Occupy movement is based on it. Then the push to blow up individual political contribution limits in the US from like 30K to 300K is a countermove that Piketty practically suggests! As someone who has been a philanthropist working on issues of social and economic inequality for the last decade, Piketty is revolutionizing my thinking about how to measure it and how to address it.  I need to process and I need to write. You can help by bugging me to do it!

Imagining Inequality

Seattle Social Venture Partners did me the kindness of including a blog post by Jennie Locati in their recent newsletter. Jennie takes the interesting stance that one reason we as a country aren’t working harder on income inequality is because it’s so difficult to grasp just how unequal we are as we approach the top of the income and net worth spectrum. I think she’s makes a valid point. Check it out!

http://wyswords.com/2014/11/10/just-how-big-is-a-billion/

We are finally wrapping up a multi-month major remodel of a new home and will shortly be hosting an open house for the architecture firm and the general contractor. I have asked them to invite everyone who worked on the unit to come see the finished product. Several people have commented to me how generous this is. This is the kind of thanks I have difficulty accepting (but I’ll try as per Rick Hanson!) because to me it seems like it’s just the proper thing to do. After pondering why for a bit, I will assert that it’s an American value that one should get to enjoy or at least experience the fruits of one’s own labor.

Most likely it simply never occurs to most people to hold such an open house. Doing significant construction is not without stresses, and often an official completion date is elusive. I think I was inspired to do this after our involuntary refinish due to flood in our previous home. We had an issue where some metalwork needed to be touched up and the craftsman in question offered to do it gratis in return for the opportunity to photograph the work in-place – he had never gotten to see the finished product on site. At the time I thought that was really unfortunate – I know that savoring a finished product is very important to me.

I am reminded of Mike Daisey and his “Agony and Ecstasy” character of the Chinese factory worker encountering a finished iPad for the first time and experiencing it as magic. That character turns out to be fictional, but the capturing power of that storytelling is undiminished. It was a tragedy that the worker could toil at their own physical expense and never know what for.

Karl Marx identified this as Entfremdung, explained by Wikipedia as “estrangement”, for his Theory of Alienation whereby capitalist production alienates people from their humanity. Admittedly, Marx’s Entfremdung applies much more to exploited factory workers than to the craftsmen and women (hmmm, were there women? I can think of one…) who get to contribute to a luxury remodel – merely not seeing the finished product in place is a long way from being unable to determine the means, location, goal or assigned value of production. Folks working at the top of their game are much less easily exploited. None the less, I’m glad to give them the opportunity to fully savor the results of their labors.

Money to the People!

I aspire to get back onto regular writing, so much comes by my mailbox these days it’s hard to keep up, not to mention the stack of books I’d like to be reading.  I’ve been gifted with a copy of Piketty’s Capital, but I’m quite excited about reporting back on a much less well known book that I think will yield great insights for impact investing. So stay tuned! More and more my focus is on finance closer to the grassroots and there’s great stuff going on.

First and foremost is the company where I’m privileged to spend two days a week: Community Sourced Capital.  My shorthand is “crowdfunding like kickstarter, but loans instead of donations”.   One of my favorite taglines from co-founder Casey Dilloway is “a community-based line of credit”.  Net: you, dear reader, as a non-accredited investor, can purchase an interest-free “square”, essentially contributing $50-$250 of your capital to support a local business.  Once enough squares are aggregated to cover the loan, the loan is made and the business makes repayments based on their revenue.  Instead of interest, they pay a monthly fee while the loan is outstanding.  Principal repayments go back into my “squareholder” account, and every month I get a chance to roll re-accumulated capital into a new small local business!  I’ve lent to a local small grocer, a vegan deli, a cupcake shop who wanted to purchase a refrigerated trailer for going to summer festivals, I helped Washington State’s first organic cranberry farm buy a juicing machine, and this month I rolled some of that repaid capital into a loan to a ceramicist who makes sauerkraut crocks! (You have until noon July 28th to join in!  Now I just need to go to the Columbia City farmers market to buy one for myself :-)  In less than a year, I’ve directly invested $1600, and I’ve already had $2100 of impact by re-investing $500 of already-repaid capital!

Able is another startup focused on using social capital to de-risk the small business capital space.  Their term of art is “collaborative underwriting”.  Their borrowers aggregate 25% of the target loan from 3-5 personal backers and then Able loans the rest.  One thing I’m curious about in a model like Able is: where’s the risk?  I notice they say that those backers are providing “the first 25%” of the loan – that ‘first’ is a key word.  Another key vocabulary word that catches my attention is “underwriting”.  That suggests to me that those personal backers are bearing most of the risk of the loan – that if there’s any under-repayment, the personal backers will lose all their money before Able loses any.  It’s common in banking to de-risk a loan by stacking capital:  a 10-20% down payment makes sure the borrower already has skin in the game; then a co-signer; then a “first-loss cushion” – basically a layer of capital that will eat losses before the commercial lender suffers any.  20% is a number I see commonly, so a 25% first-loss cushion seems pretty, well, cushy to me.

It’s interesting to me that in their blog they reference other “sharing economy” startups because just yesterday Kamal Patel of UbrLocal was talking to me about how folks are starting to wake up to the fact that the “sharing” economy is really just Peer-to-Peer (P2P) old-fashioned capitalism and isn’t actually about sharing at all.  I would say on my shallow read, Abel strikes me as a killer investment opportunity cloaked in social impact language.  Given they’ve got at least $5M in investor capital to generate a return on, it’s hard to see how they could be other.

Angel Investing is growing in Seattle, and in many ways it’s a good thing. More capital to test more ideas is what will build our economy in the long term. My concern lies with the model of investing that is becoming encoded and passed on to new investors. It’s very much driven by the economics of technology companies: lots of front-loaded investment leading to a payoff or a total loss. The risk of the total loss is pretty high, so for the model to work at a portfolio level the potential payoff also needs to be high. It’s pretty straightforward math: if your investments have a 1 in 10 chance of getting to payoff, then the one that pays off needs to pay 10x or you don’t even break even! It’s not realistic to believe you can guess which ones will payoff, so you need a portfolio approach. When I took the “Power of Angel Investing” class around 2007 they suggested you needed at least 10 companies in your portfolio. In David Rose’s book on Angel Investing that just came out he’s now saying 20. Fundamentally, this is a kind of gambling.
For some angels, it kindof works, but it only works if you stick to the formula: your companies need to have the possibility of paying back 10x. Now maybe one will, and not all will go bust, some will return 1-2.5x and that’s how it makes money. The problem is that possibility of paying back 10x – it only makes sense for high margin businesses like software or healthcare technology (and why margins are so high in healthcare is another interesting systems discussion we could have about why we have all the hottest innovations in the US and broad lack of access or affordability and is that really what we want?). Further, once a business pursues this fundraising path, it’s now under pressure to “swing for the fences” and continue to make high-risk choices as it learns from the marketplace and pivots its business model. A more conservative path that would mean slower growth is no longer acceptable. I believe it becomes self-fulfilling prophecy – that by taking high-risk investor money, the business is driven to become a high-risk business, and may forgo opportunities that would be less lucrative but more likely to generate stable employment or a reliable long-term service to customers. This extends down into business schools and incubators – we are all coached to focus on rapid scale. The primary thing I see driving that is the pressure of the capital providers, and it saddens me to watch angel groups form to reproduce this capital market view unexamined for its larger effects.
Exits often destroy value – acquiring companies are often not thoughtful about who and what they acquire, they instead have money to burn, or are acquiring the people. Larger companies might have higher return goals than a group of small investors might be satisfied with, and they’ll meet those goals by “streamlining operations” – laying off the local accountant, the local support people, discontinuing the local rent and relocating people into their offices.
For many kinds of businesses this kind of high-risk/high reward front-loaded investment with an eventual payoff is not the economics of the business. What then? They need equity too. For me the pinnacle of angel groups over-driving the Capital conversation was when a local farm made the rounds. We need to have much more creative conversations about how to fund business. Hopefully the Element 8 event about Investing Without Exits was a start. We need to think about loans, about patient returns, about lowering risk for ourselves as investors AND for the entrepreneurs, and seeking more reasonable returns. We also need to think hard about what we’re taking risk for and how much we can take– and then apply that budget consciously to buy the kinds of communities we want to live in. You can’t eat software, and I hope it will be many more years before my date nights are the waiting room at Drs office.

Traditionally lenders and insurers mitigate risk by screening borrowers and charging higher-risk borrowers higher rates.  This is done across all types of borrowing and insuring – home, auto, life, business, personal credit. This has always bothered me because it strikes me as self-fulfilling prophecy. Charging higher rates can only increase the risk of default. It’s also penalizing the people who need help the most. This is the opposite of the kind of system Americans like to see; we prefer one that reinforces opportunity for those who work hard, rather than just raising the bar for those who start closer to the bottom.

Recently a friend sent me an NYT article about Bruce Marks and the Neighborhood Assistance Program of America.  NACA focuses on the subprime market and has found a new way to mitigate risk. They mitigate the risk for the borrower rather than mitigating the risk purely for the lender. They do this by working with borrowers to create financial plans as part of the lending process. Instead of making borrowers with low down payments buy mortgage insurance, those borrowers pay into a neighborhood Membership Assistance Program.  Membership in the MAP gives them access to free financial and credit counseling. Further, the MAP can provide up to three months of mortgage payment assistance.  All assistance that protects the mortgage – by protecting the borrower.  Further, they engage the homeowners by creating Peer Lending Committees to review requests for assistance.

This is the kind of risk mitigation thinking we can use more of – ways of working together instead of against each other.  Reading the articles below it seems this hasn’t spread further because the founder is still very much in the culture of working against, he’s just redefined who he works against as other lenders.  Still, the ideas are good ones and remind me very much of grameen bank and their lending circles.

A Nonprofit Lender Revives the Hopes of Subprime Borrowers – NYTimes.com.

https://www.naca.com/nacaWeb/program/assistanceProgram.aspx

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