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In investing, folks like to talk a great deal about “multiple”s.  IE I got a “1.5X return”. In my experience, professionals are pretty happy with the ones that are >1.0, and it’s common in a successful fund to fall between 0 and 2.5.  The ‘X’ is “times”, as in 1.5 times my return. Meaning that I put in 10,000 and I got back 15,000.  Depending on how long that takes, that can be pretty good money, or not much at all, as compared to earning interest in a bank.  This money invariably costs more in time and effort to make the investment and support it, that’s why it needs to earn a higher return than money in the bank. Otherwise, the only thing left for your investors to gain is ego points, and is that what you want to pay in?

A key tenant of what I’ll call “economic development investing” is finding ways to invest in early companies and get the investment back without requiring that the company be acquired by another company.  How do we invest in companies and leave them standing?  Methods that I have seen create ways for the company to buyback its shares at a later date, as a multiple of the original purchase price.  For a global worker-owned cooperative with >20M in annual revenue and a >10 year track record of paying an annual dividend? That multiple is One.  IE, if you sell your shares back to the company, you get back the price you paid for them, and you get to keep your dividends earned in the meantime.   For little startups with no operating history and track record? I’ve seen multiples of 2X and 2.5X.

Is that a bargain? Is that fair? Is that outrageous?  Well, if our theoretical alternative is buying a CD at the local bank, it depends on how much time goes by before that startup buys those shares back.  If I can buy a CD earning about 2.5%, and my startup will pay 10-12% in interest on a loan, there’s a nice window where it’s win-win for both of us, once I get compensated for my time/effort. That ignores the greater risk that some % of my investments will go to zero, which is highly unlikely for a CD. A fund needs returns that can absorb that risk.  True Angel investing is best budgeted as an expense that gets to revolve a few times before being totally spent.

To keep my head straight as I look at these investments, I made a handy reference table.  Here’s a copy for you!

QuickRef IRR vs multiples as PDF

QuickRef IRR vs multiples   as xlsx

 

 

The problem with Payroll

I’ve had the privilege of sitting in on a healthcare innovation class put together by the fabulous Emer Dooley for the University of Washington. The learnings from that class are a whole blog by itself. In talking about healthcare, a quick reference to its significance as an expense is that it’s the 2nd largest single expanse a company has, after payroll. The unpredictability & volatility of it as an expense for self-insured companies is a significant stress point for companies not used to being in the insurance business (The AOL “distressed baby” mishap being an extreme example) but the overall expense is so high that companies as small as 3,000 employees are going self-insured. Net, that means they keep the premiums, they take the risk on the expenses, and they pay an insurance company a small % to handle the administration & billing.

Now to that “single” biggest expense of payroll –if you look at a public financial statement it’s usually there as a lump sum. This is a great example of how financial statements are written for and by accountants. Payroll for small companies is often outsourced to a third party to make sure all the appropriate tax withholdings are done and passed on to the appropriate authorities at the right time. Larger companies may bring that back in as a department. For the company itself, it’s a big expense that happens on a single day, 2-3 times a month. Reconciliation of it is complex because employees can have all kinds of individual variations with deductions, vacations or leaves, new and departing employees. For the accounting department, payroll is a BIG deal. For managing cashflow, payroll is a BIG deal. It needs to be attended to as a thing.

But what a skilled executive/manager should know, is that payroll is not actually a thing in itself. If you’re looking at your expenses, it’s not helpful to look at “payroll”. It represents an agglomeration of many functions of a company – product creation, product validation, sales, distribution, marketing, customer relations. When you’re thinking about how your resources are currently allocated and might be better allocated, you want to think about those categories, and the people/energy going into them, and the effectiveness of those against expectations for their category. If you’re looking to invest more or make cuts, good management is to focus on those areas of company function, not just on “payroll”.

This is reinforced for me as I listen to Zeynep Ton’s The Good Jobs Strategy. She talks about her work with retail chains facing falling sales and deciding to cut payroll, without doing the analysis to discover that the falling sales were due to poor customer service. Instead of improving profitability, they got into a vicious circle that resulted in store closings. She worked with Borders for 5 years and was able to show that in many cases, increasing payroll actually increased sales. They key there is again, that payroll is not a thing – it’s a construct made for the accounting department to manage cashflow. What they were really tinkering with was customer service.

If you run one of the many small (and not so small) businesses managing on Quickbooks, congratulations to you if you’ve developed a habit of looking at your P&L on a monthly basis and comparing it to budget and re-projecting your cashflow. Most likely, you have a line item that’s “payroll”, or “wages”. You can start by at least breaking it into sub-categories: marketing, sales, production (hopefully you are already be breaking out your direct labor so you can correctly calculate fixed costs vs variable costs), administration, distribution. Things like IT and professional services if outsourced will show up somewhere else. Then go ahead and let all the payroll taxes sit as a lump sum because they’re not really discretionary anyway. The key here is to look at your relative investment in the various functions of your business.

If you really want to look at it that way, go ahead and move those payroll categories into the various sections of your P&L. Keep them as distinct line items so you can add them back together when you or your bookkeeper are doing bank reconciliation against that transfer to the payroll company. Again, you can leave payroll taxes as a line item under administration or general, though for finer grain detail on the total cost of in-house vs outsourcing you’ll need to consider the payroll taxes. Then a quick glance down your P&L will help you see where the resources of your company go at a high level. Are you investing enough in marketing? Whether it’s outsourced or in-house, whether it’s labor or google ads, how much is it as a % of sales? Are you spending a significant amount on production or service? If that’s the business you’re in, I hope so. If it’s not translating into sales, you can start asking why.

Fun with localism!

I recently had a fun experience doing some shopping in my local economy, which resulted in a blog that Ventures published on their site. Ventures is a training-led Community Development Finance Institution (CDFI), which means they do some small business lending but the preponderance of their work is in doing training and technical assistance. I was on the board back when they were known as Washington CASH (Community Alliance for Self Help). Read more about my adventure here!

The business of survival

I recently did a quick consultation with a friend of a friend who is an independent personal service provider. She has a reasonable hourly rate, though it’s not clear every client pays that. She’s independent because she likes the schedule flexibility, but it does mean her schedule is often not full. Looking at past taxes, her annual gross income has been 50-55K annually. It’s below the the median wage of 64K, but well above the living wage of $26,600. Or is it?

The two common challenges for small providers are 1) bookkeeping and 2) marketing. She knew her business worked on a cashflow basis but was talking to me because some months cash was feeling a little tight. After pulling some numbers together, it became apparent that her monthly expenses are almost $2000/month with rent, internet, phone, website, licensing, continuing ed, insurance, credit card processing and taxes. Lots of those are expenses that don’t come out every month, but add up. They’re also largely fixed expenses. So really, that gets her down to just above living wage as a take home.

We talked about a few marketing strategies – how she might get more referrals or remind existing customers about her service and maybe sprucing up her waiting lobby (though that’s a capital investment). It turns out it’s tricky to relocate or sublet her specific space so it’s difficult to chip away at those fixed costs. One solution she employs is some of her clients pay in cash. That contributes to difficulty in understanding her real profitability. I notice in my own efforts to hire a housekeeper that the first two have asked that I pay them in cash. Is this one of the signs the economy is not working for everyone? That those who can, go informal? Looking at risks – did I mention health insurance? She has to pay her own health insurance and that is a big chunk of those monthly expenses. It’s a significant risk to a small payer and there’s little help for her at a living wage.

Thinking about the risks of healthcare got me thinking about the risk of a major health disruption. Medical issues are the number one cause of bankruptcy in the US. It’s also another way the relatively rich stay richer – property protections in bankruptcy. If you are a property owner, you can protect some of your property in bankruptcy, and thus some of your assets. If you are a renter, and you don’t own tangible property, you’ve got nothing that you can protect, so it strikes me it’s much more likely you’ll be forced into homelessness. In fact, when I google for data to support this, what I learn is that a bankruptcy on your record is one of the things that can come up in a tenant screening and affect your ability to get a lease!

Net – there is no net, not of the safety kind. My provider just has to have faith in the continuity of her business (her track record to date is reassuring). A little effort in presentation or marketing might literally pay off. We also need to hope Obamacare and eventually medicare stay there for her, and that she doesn’t have a major health crisis that impacts her ability to work.

My takeaway for individual service providers is that it’s important to break the habit of letting personal & business expenses blur together – a habit that the tax reporting on Sole Proprietorships supports. You need to separate your business from your personal expenses, and track true monthly costs. You need to add up all those periodic one-time costs and figure out a monthly amount so you know your bottom line and not get lulled into complacency by your top line.

Modeling for Success

In my years of angel investing, many is the time I’ve been in due diligence groups looking at a projection and someone asks “so where is the marketing spend to support that growth?” Usually the answer is along the lines that folks will discover the product online, or refer their friends, that it will “go viral”, and that’s what we’re all investing for, because we believe that it’s that kind of product, right?  Another common answer is that one of the roles will really be spending 50% of their time on sales, or that sales will be part of everyone’s job.

Many years and a few hands-on lessons later, I have a more experiential awareness of what needs to underlie that answer.  Once you’re in a company, trying to manage to those numbers, it becomes clear that there’s no substance to it.  We modeled 10% month-over-month growth! Well, it didn’t happen this month so now what?  Without a plan of the measurable activities that were expected to generate that growth, there’s no way to look back and ask: did those activities happen? If yes, perhaps they’re not the right activities so let’s try some different ones. Perhaps we think they are the right activities but the sales cycle is turning out to be longer than we expected, let’s keep an eye on that and prepare to make some adjustments lest we run out of capital before we’ve figured out the true cost of a sale.  If those activities didn’t happen, why not?

Startups are fundamentally short-handed and the sales/marketing person is often not a specialist, and maybe they haven’t done sales/marketing before.  Likely they’re getting some uptake because it’s a new product or service and they get a little bit of earned media attention and they don’t know that the product won’t continue to sell itself. A few things do grow purely on word of mouth, or are fundamentally viral in that use of the product inevitable exposes new potential users to it. Even those things can be broken down into assumptions: each user uses the product x times per month and exposes Y other users to it, Z% of those decide to try it for themselves.

But sadly, the truth is things have to be sold, and over time I notice  how successful businesses build the cost of selling into the product – things like mutual funds having “12b-1 trails” that throw a small percentage to the platforms that carry them, or retail products having to build into their price assumptions about doing periodic discounting, offering coupons, paying cuts to distributors and brokers.

I felt validated to see in a recent business competition, Business Impact NW went beyond asking for a financial projection and also asked for a specific sales projection.  They work with small, local businesses, and apparently they’ve also decided it’s an important next step to making sure the business is actually successful.

So going forward, my experience is that a general question about “where’s your marketing spend?” isn’t really enlightening or helpful to the business.  A better question would be: where’s your sales plan – who will do what activities to promote the product/service and what’s your expected effort-to-reward ratio?  I have heard investors ask “how long is your sales cycle?” when looking at products that will be making dozens of large sales. Time is one measure of effort, and thinking about person-hours and intermediary fees and google ads needs to apply to the hundreds of small sales too. Helping an entrepreneur break that down ahead of time will help them figure out how to adapt as they gather more data, and set them up to start measuring/monitoring those assumptions from the start.

Who taxes you?

A good friend of mine has always refused to participate in loyalty programs. He figured, not unreasonably, that the company’s interest and his are not guaranteed to be aligned and the trouble of monitoring that was not worth whatever benefit might be gained.  So it’s only recently that I’ve considered getting a mileage credit card.  As part of a change in household, I signed up and began my new relationship with Bank of America.

Wait a second, Bank of America? A big corporate bank? I’m supposed to be an Impact Investor, a triple-bottom-line consumer. Why would I divert a significant percentage of my annual expenditure stream through their card, allowing them to pull a tithe from the business community via invisible-to-me credit card fees?  Because one thing I’m well aware of as a business consultant is that all those points and miles we earn are paid for by the businesses where we use our cards- through slightly higher credit card fees.  Businesses have no ability to sort cards, if they take one Visa they must take them all.

Of course the reason I would do this is simple: payola, in the form of airline miles.  I started asking around among friends and in Seattle, an Alaska Airlines hub, the Alaska Airlines card is everywhere. My friends fly with their miles. Some friends have an Amazon card, held by “Synchrony Bank”, which I know nothing about. Milage cards are not just about miles: Alaska charges bag-check fees, which they waive if I book my ticket using an Alaska credit card. Using the card saves me $50 per round trip when I need to take luggage. Add in a free annual companion ticket and it only takes one trip per year to more than pay pack the annual $75 fee.

Economy is based on the latin word for household.  If we want to change the priorities of our household, we need to think about who is in it, making decisions.  The small decisions we can make about which institutions we support through our incidental activity can add up to big decisions. This was the premise behind the “move your money” campaign that lead many people to move their money from banks to credit unions.  Who provides your access to credit is, if you have a decent credit rating and can make choices, the same decision.  I’m currently banking at a credit union, and their card would be the obvious choice. Certainly on an interest-rate and fee basis, it’s a much better choice than the loyalty card. It just doesn’t come with such powerful payola.

Making that moral choice costs me real airline dollars! With an opposite-coast family, I will fly annually. I was feeling ready to make that stand anyway when my voice of envy took a new turn and made a case not about gain but about loss: successful businesses who take credit cards recognize the fees as the cost of doing business and price accordingly. For example, Square charges small businesses a flat processing fee of 2.75%, which greatly exceeds the fees paid to Visa, so Square is collecting credit card premiums from businesses regardless of whether or not they pass them on to the full consortium of Visa, BOA and Alaska Air. A pessimistic view might be that those of us not using loyalty cards are left subsidizing those who do, or just padding the pockets of the card processors.  Ooo, that argument was more difficult for me.  Fine, I thought.  Surely there was some compromise between selling my economic allegiance and leaving money on the table.

The answer I came to is a loyalty card with a values-based bank that I am proud to direct a revenue stream through, to a cause I believed in.  I remembered a friend who had a “Salmon Nation” card that supported an environmental organization in Portland.  It was issued by Beneficial State Bank.  I went to their website to survey their options and was immediately drawn to the B-Corporation visa (I get no referral if you click that link :).  A chance to support a cause I passionately believe in – an organization doing third-party certification of good internal corporate management in the 5 areas of Governance, Community, Environment, Employees and Customers. I applied and awaited my card.

In the intervening duration I thought again about the free trip I could probably earn every year if I instead selected a mileage card, or about how much stuff I still end up buying on Amazon despite my commitment to purchase locally as much as I can. Or the marginally higher fees I would have with this card than a vanilla credit union card (but still lower than a BOA card).  Was I being silly?  The card answered the question. I’m so pleased to pull out this card, and the opportunities it provides to talk about B Corporation and why I think it’s something more people should know about, I don’t for a second regret it.

I was also feeling less impressed with Alaska’s milage program; having just come off a binge of using up old United miles to travel to DC, Alaska required 30% more miles for the same trip.  Looking harder though, with the companion ticket, plus the free checked bags each way, using the Alaska card to book my annual opposite coast family trip produced a 400% return on my $75 annual fee.   So in the end I got the Alaska card, too, which I only use for booking Alaska travel.

The deep issue here that merits attention is how incredibly embedded in our everyday financial transactions there are invisible corporations that effectively tax us, and how little we know about those taxes or what they pay for.  It’s an interesting systems issue. Change does happen, Square is new on the scene and has bred a host of competitors, but it seems likely they’re yet another layer of technical middleman, taking another cut out of the value exchange between consumer and business.

Merchant Maverick was my go-to resource when I set up billing for a new business a couple years ago, they have a great writup on the credit card processing fee stack here.

Cash for Growth

I recently got to work with a small manufacturer who had a multi-week work-in-progress period.  This small business was using quickbooks but growing quickly and so often managing more by the level of cash in the bank account than by budget.  While I was working with them, the business got the hang of looking at their COGS and their variable costs vs fixed costs and more of an accrual style of reporting.  They also shifted to more of a product distribution model which meant longer receivable delays and more planning. I realized that with that supposed “improvement” of business maturity there was a possible loss: that of deliberately funding the increase of inventory to support sales growth.

When operating on more of a cash basis, this business had to use current sales to cover the cost of future growth, because they had to buy inventory this month, and do labor this month, for product that would not be ready until next month (or later). They had started out with a direct-to-consumer model and so sales were entirely cash in the beginning.  Since anticipated future sales were higher, they had to figure out how to create that product with the cash they had on hand, because inventory providers were unwilling to provide credit for such a small startup.  As they grew as a business and we focused on looking at accrual accounting, it becomes apparent why separately tracking cashflow is so important – because in an accrual presentation, the cash needed to fund the higher investment for higher future sales becomes invisible, each month looks like it can cover itself.

I once had an angel fund investment go south and what we heard back was that somehow in the transition from cash to accrual accounting they had come up a significant amount of money short (maybe 1/3 of the round they had just raised).  A funder stepped in a provided it, but at sufficiently punitive terms that our investment became pretty insignificant. The CEO and CFO were replaced, of course, but I had always wondered how that could possibly happen.  Now it makes sense to me, that if they had done their financial modeling on an accrual basis and not attended to cashflow, they could have raised a bunch of money for growth and missed how much inventory they’d have to build to support that growth and how far ahead of sales they’d need the cash.  It’s also possible that they underestimated how long their cash-conversion-cycle would be:  that route from dollar invested in inputs, created into goods, shipped to distributors, sold to customer, and then easily 90 days from shipped-to-distributor until finally returned-to-company.

Another angel I know invested in a homey wood-toy company who got caught by that: the homey wood toys were manufactured in China and required a 6 week boat ride to get to US distribution.  Growing sales required also growing an even bigger cycle of toys in the manufacturing/distribution pipeline.

Net: although accrual style accounting is standard for a mature company, you lose important information if you don’t still also do a cash accounting.