Archive for the ‘Capital Thoughts’ Category

It’s a common frustration for small business owners that banks seem only willing to finance companies that don’t need it. It’s pretty standard that to get a bank loan a business has to have multiple consecutive quarters of profitability. That seemed pretty conservative to me, but after a couple years of working with bootstrap small businesses I’m beginning to see why that might be necessary protection.
Bootstrapped startup and young businesses are wonderfully creative in their ability to make-do. As a business grows and generates more resources, it doesn’t become profitable right away. Those early years of business growth end up steadily funding capacity building. As a business has more resources, those resources go not only into growth through marketing, or asset building with equipment and facilities, but professionalization where previously there’s been make-do.
Obvious and common sources of “hidden funding” are underpayment or non-payment of founders or early staff. Understaffing and working folks long but unsustainable hours is common. Family members might work in the business for free. When building financial models, staffing is one category where educated guesses can be made about what it should be to support a target level of business, and so this one is less hidden, but still difficult to assess.
Making do with word-of-mouth advertising can work when a business is small, but to grow into a fundable company it will need to move beyond personal social networks and be able to develop a clientele based on its marketing & sales reach. That costs more money and changes margins on sales. Upgrades of equipment and facilities are likely in search of more efficient process, or lower risk.
Professionalization where there is currently make-do is a more subtle version that requires more attention. Bookkeeping needs to be done by a bookkeeper, not Aunt Jane. Software and technology needs to be legally purchased with regular investments for backups, replacements and upgrades. Office furniture and facilities, if cobbled together from craigslist, is a very likely expenditure as a company becomes able to afford it. Rent may be subsidized by a supportive launching business or relative.
How much growing funds are dedicated to upgrades and improvements before they’re ready to be peeled off to fund additional financing is going to vary a little bit from company to company. Does this CEO feel pinched by their 2nd hand desk or do they take pride in their own thriftiness? Is their affordable tech support person a local gem or are they having to wait for more profitability to afford better service? It does seem impossible as an outsider to assess what remains as not-yet-funded internal capacity in any given company. Instead, insisting that a company generate cashflow for a sustained period is a very tangible measure of its ability, and that CEO’s willingness, to operate at a given internal capacity level.

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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.

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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!

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The Value of Wall Street

A girlfriend sent me an article from last November’s New Yorker (Thanks jonathan for pointing out I mislabeled this as NYT initially) by John Cassidy that I’ve finally gotten around to reading, and as I ctrl+N my fourth email to tell someone about this article I realize it’s time to just blog.  It’s one of those articles that reinvigorates my desire to have a meaningful portion of my portfolio dis-intermediated – IE invested as directly as possible in entrepreneurs and enterprises that generate value and not in the markets.

The article is about capital market dysfunction and how the financial services industry has expanded to absorb more than a quarter of all U.S. profits.  Yeah, that’s pops my eyeballs a bit too.  The article then goes on a tour of how much of that is “rent-seeking” – the official economics term for capturing value rather than generating it.

One longtime financial industry insider is sufficiently concerned about the problem that he endowed the Paul Woolley Center for the Study of Capital Market Dysfunctionality at the London School of Economics in 2007.  The center publishes research like “Trading Frenzies and their Impact on Real Investment”.    The New Yorker article mentions a 10-point manifesto that Dr Woolley released in May of 2010. It is advice to giant pension funds designed to restore efficiency to the public markets and shift investment emphasis away from rent seeking.  Cassidy mentioned Wolley’s recommended cap on annual turnover, but my attention is drawn by his demands for total transparency of underlying investments and a commitment to only investing in publicly trading securities and refusing to make alternative investments.  To ask large funds to do this is essentially trying to drive the private capital markets public.  I think that would be a great thing and it seems likely to me that it would greatly improve market efficiency, but it’s hard to see how it can be a voluntary drive – it only works if a big enough segment of the market does it so it’s hard to be led by a few.   Like the accusation oft made of “socially responsible investing” its goals seem realistically implementable only by regulation.

Two parts of his “manifesto” leapt out at me because they’re points I’ve heard friends locally make:

  1. (Larina) that there’s a fundamental principal/agent problem where agents (the banks & investment agents) have better information than their customers and their interests are not sufficiently aligned.
  2. (Leslie – check this guy out!) “Understand that all tools now used to manage risk and return are based on the discredited theory of efficient markets”.

There are lots of great quotes in Cassidy’s New Yorker article about the scourge of financial innovation: “’But these types of things don’t add to the pie. They redistribute it—often from taxpayers to banks and other financial institutions.’” attributed to Gerald Epstein at the University of Massachusetts.   Citigroup is described as making a shift from trading significantly on their own account to emphasizing relationships with their clients.  The fact that putting their client’s interest ahead of their own is a novel business strategy is a great illustration of how the financial industry has become a product industry instead of a service industry.  And yet, what exactly is the added value of what they make?

It also touches on the shocking quick return to profitability of the Wall Street Banks -something that resonates particularly today with the recent headlines about GM.  I almost need physical therapy for whiplash I feel on the short ride between the WSJ grousings about  oppressive government interference and the triumphant crowing over profits.  There’s also reinforcement for the argument that short-termism is a root problem – in this case because traders get compensated on short-term results despite the risk that the long-term results can destroy their employers. Heck, if the bonuses are big enough, even that’s not the trader’s problem.

Definitely a compelling read, too bad it seems to be cultural news more than policy. http://www.newyorker.com/reporting/2010/11/29/101129fa_fact_cassidy?currentPage=all

Rent-Seeking defined by Wikipedia: https://secure.wikimedia.org/wikipedia/en/wiki/Rent-seeking

The Woolley Center for the Study of Capital Market Dysfunctionality: http://www.lse.ac.uk/collections/paulWoolleyCentre/Paul%20Woolley%20Centre%20in%20the%20News/Default.htm

Paul Woolley’s Manifesto: http://www.lse.ac.uk/collections/paulWoolleyCentre/word/giantfunds.doc

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A frequent question in the arena of social enterprise is what legal structure to be:  for-profit, non-profit or hybrid?  The question is sufficiently confusing that Criterion Ventures has been successfully touring the country for over a year hosting day-long “Structure Lab”s to give folks some tools sort out the issues.  I took one and found it practical and helpful.  One of the issues to think about is fundraising – where will your funding come from and what are its constraints?  That may put constraints on your structure.  While folks in your lab may be helpful beyond that, note: they don’t give specific legal advice at the workshop. So let’s walk that through informally now: earned revenue can go either way;  any structure can take debt;  equity returns require a for-profit.  A tax-writeoff can be interesting – if there’s a non-profit intermediary willing to take expenditure responsibility (and your organization legitimately accomplishes a 501c3 compatible purpose) it could be possible to be a for-profit and get support from someone who wants to make a donation, definitely if that donation is to a community development loan fund who turns around and loans to the for-profit.

Perhaps you see how the hybrid model can get squishy, particularly when there’s a non-profit raising funds and contracting with a for-profit.  A dear reader got me started on this post (Thanks Tony!) with an article from today’s NYT “Hybrid Model for Nonprofits Hits Snags”.  That article talks about how GlobalGiving, a non-profit, had a for-profit subsidiary called ManyFutures Inc, that was trying to provide a technology platform to GlobalGiving and commercialize it.  In this instance, the founders (who founded both organizations) lost money on the for-profit. Since they didn’t benefit at all it’s difficult to suggest they benefited unfairly.  Still, close relationships raise the spectre of private inurement:  “providing excessive benefit to a person who is close to or has a controlling interest in a nonprofit — though tax law says nothing about how much is too much”, according to the NYT.  Periodically the media has raised the issue of “too much” – Minnesota Public Radio came under fire in the early ’90s because of high salaries at its for-profit subsidiary which handled the retail side of public radio.  Dan Palotta, created the for-profit Palotta TeamWorks, and raised millions for charity by organizing sporting events (and earning revenue for doing so) until he came under fire for personally profiting too much.  He’s written a book about how he believes the charitable model is broken, called “Uncharitable”.

So in the boom time, we got to see what happens when hybrids do well – we raise the issue of “how well is too well?”  Now in the bust the NYT questions if hybrids are particularly vulnerable to failure.  Are they?  Are social mission enterprises in general?    Getting away from hybrids, why choose for-profit vs non-profit for an earned revenue social mission?  The current wisdom seems to be that it’s easier to raise money for a for-profit than a non-profit, especially when you’re looking at big dollars.  People will commit more when they’re self-interested.  Kevin Doyle Jones (also quoted in the NYT article) used to talk about “two-pocket thinking”  -the investment pocket and the charitable pocket.  In my experience consistently the investment pocket is bigger.  The current economy raises another possible factor…

I’m feeling very aware  of how many for-profits (not necessarily mission-related) I’m invested in are themselves largely charitable enterprises right now- many companies are losing money in this economy and we investors are ponying up in the hope of making good on our existing investments.   Losing money and struggling to find traction for the business model like Many Futures, Inc doesn’t seem unique to hybrids or social enterprises to me.  Maybe the biggest difference between these social enterprise models and for-profits is that when we donate to a non-profit, or even invest but with low return expectations (and therefore somewhat charitably) in a for-profit, we “write it off” both mentally and literally at the time of the investment, so it doesn’t have the lure of… I’ll call it “Salvag-ation”.  In the for-profit investment where we hoped (or planned) to reap a reward, our difficulty in recognizing sunk costs and our hope of an eventual recovery perhaps keeps prior investors coming back to prop up a flagging enterprise through a couple extra difficult years.  Perhaps that commitment, intentional or not, is what gives for-profits an edge in building a sustainable revenue stream.  In fact, that reminds me of a quote I first heard during the Long Term Capital Management days though I see now it’s attributed to J. Paul Getty:  “If you owe the bank $100 that’s your problem, if you owe the bank $100 million, that’s the bank’s problem”.   In a for-profit,  financial self-interest binds us together.

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Regular readers may recall that one of my SRI investments is a deposit with ShoreBank.  Prudently kept below the FDIC limit, that deposit is now on a ride to a new bank, Urban Partnership Bank. As an electronic banking customer, it was fairly easy for the FDIC to just email me directly. How efficient.

Important Message from the FDIC – ShoreBank – August 20, 2010

On Friday, August 20, 2010, ShoreBank, Chicago, Illinois was closed by the Illinois Department of Financial and Professional Regulation, Division of Banking. The Federal Deposit Insurance Corporation (FDIC), as receiver, arranged for the Urban Partnership Bank, a newly chartered bank, to assume the banking operations of ShoreBank, including all of the deposits. There is no immediate impact for deposit customers. Depositors can continue to access their accounts as they normally would, including writing checks or using ATM or Debit cards.

There is no need for customers to come to the bank. All of the information customers should need is included in the referenced Question and Answer Guide <http://www.fdic.gov/bank/individual/failed/shorebank_q_and_a.html> . The FDIC encourages customers to read the Guide and contact the FDIC Call Center at 1-800-523-8503 with additional questions.

Bank activity will be business as usual. Deposit accounts remain insured up to $250,000. The FDIC encourages bank customers to use all traditional methods to conduct bank business.

Please be advised that you will not receive notification from the FDIC, the Receiver, or ShoreBank to claim/unlock/unsuspend your account or to provide any private information. Be wary of scams to obtain information by individuals or entities indicating they are acting on behalf of the FDIC or ShoreBank.

The new bank seems to have been formed primarily by the very investment group that was trying to invest in Shorebank to boost its assets.  I honestly have not followed the details of why Shorebank in particular was in trouble, given the number of bank failures it’s hard for me to single them out as particularly poorly managed or signifying something strongly unusual.  However their salvage plan included $75 million in TARP funds which became politicized and withheld.

The irony of this is that the seizure and transfer will cost the FDIC an estimated 367.7 million, as the new bank gets to purchase the old deposits at .50 on the dollar.  Ah politics.  The next question is… how does this impact our local affiliate, ShoreBank Pacific?  I found an interesting tidbit here:

ShoreBank Pacific, the separately chartered bank unit based in Washington state focused on lending to “green” businesses, won’t be included in the new operation. Its CEO, David Williams, said last spring that he was in talks with outside investors in the event that ShoreBank failed.

Unclear for now is what will happen to ShoreBank’s non-profit units and for-profit microlending operation in poor foreign countries. They aren’t expected to be part of the new unit.

I think I’ll check their website tomorrow.

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In 1989 Amory Lovins gave a keynote address at a green energy conference in Montreal.  In that address he talked about a brave new future where instead of investing in megawatts, we’d begin to invest in “Negawatts” – the avoided costs  created by implementing electrical efficiency measures.  Why does your utility give you free compact fluorescent lightbulbs like they were candy?  Because  already by 1989 it was found to be cheaper to give away energy efficient lightbulbs than to operate existing power stations.  Amory’s vision was that to solve our energy crisis we needed to work both the angle of supply AND the angle of demand.

Creating energy efficiency requires financing:  someone has to spend capital intitially to change some basic system – replace lightbulbs; add insulation; upgrade thermostats and circulation; and beyond.  Then they reap the benefits of that system.  At some point enough benefits accrue that you’ve paid back that original investment, but the longer it takes, the less motivated people are to make the initial investment.  Especially if it takes longer than you anticipate remaining in the property!  That initial capital investment might also cost more than you have handy to spend, so the next challenge is financing – a way for someone else to lend the capital up front and also reap a motivating reward for lending the money. Another challenge for financing property modifications is split-incentives – with rental properties, the owner usually pays for capital improvements, but the renter often pays the utilities, so who pays and who benefits are not the same.

In 2009 the California Institute for Energy and the Environment published an excellent roundup of various efforts to-date to create financing initiatives for residential clean energy. The paper reviews 18 residential efficiency financing programs with a focus on On-Bill Financing programs.  “This research revealed several limitations of these programs including: limited applicability of the programs to households most in need, low participation rates, difficulty assuring that savings will exceed payments, limited support for comprehensive energy retrofits, the inability of most programs to cover their costs, and issues particular to OBF programs.” (Fuller, 2009)

One of the programs covered in the paper was the Berkeley FIRST program: Financing Initative for Renewable and Solar Technology. It was a pilot project designed to finance residential solar upgrades and repay them over 20 years through a special tax added to the property bill.  This addresses the challenge of having the capital up front to pay for the system, as well as a way to pay it back over a long time so it’s less expensive than the savings.  A key innovation here is that tying the payback to the property instead of the person keeps the payback tied to the savings – so that if the house sells to a new owner the original owner isn’t still stuck with the payments.

According to the evaluation on the Berkeley website, the city of Berkeley allocated bond funding to finance up to 40 installations.  Of the 40 original applicants only 13 were actually financed.  Many of the remainder discovered they were able to get home equity loans instead (the bond interest rate was twice that of the home equity loans) and did ultimately install solar.  One owner cited as a barrier “…ridiculous prepayment penalties, I am very exposed if I attempt to sell or refinance the house, and the new lender demands that I pay off BerkeleyFirst.”  (Berkeley First Initial Evaluation)  I’ve been hearing about PACE for nearly a year so I’m surprised to find that the Berkeley pilot only concluded last year.  It was discontinued because of high costs relative to small scale according to a very nice case study at the Home Performance Resource Center.

To handle the administration of the program, Berkeley partnered with Renewable Funding, LLC, which took the responsibility of marketing the bonds.  By June of 2009, Palm Desert, California and Boulder, Colorado were working on their own programs.  The program began spreading faster than hot celebrity gossip: more than 200 cities are reported to be considering the program.  However it seems the buzz has preceeded the reality (not unlike celebrity gossip, I imagine).  According to PACE Now, 30 legislative bodies (city/county/state) have passed legislation to-date enabling such programs.  A Dow Jones report notes that Boulder and Sonoma County California had made hundreds of loans, yet interestingly the city of San Francisco is reported to have suspended their program before it started.

The objectors went national on July 6, 2010 when the Federal Housing Finance Agency determined that “certain energy retrofit lending programs present significant safety and soundness concerns that must be addressed by Fannie Mae, Freddie Mac and the Federal Home loan Banks…. Under most of these programs, such loans acquire a priority lien over existing mortgages, though certain states have chosen not to adopt such priority positions for their loans.”   Essentially, the government agencies who buy mortgages are dismayed that that cities are lending (by issuing bonds) money to homeowners  (for clean energy upgrades) and then inserting themselves with first right to repayment (because often tax obligations come ahead of mortgage obligations).  So it’s pushback because of the credit crisis.

A week later the State of California filed suit in federal court arguing that the FHFA is misrepresenting the nature of PACE programs.  A big motivation for states and municipalities is the anticipated economic stimulus and creation of green jobs that could come from a flurry of home energy upgrades.   The lobbying battle has begun.  You can get involved in your local advocacy efforts via the Pace Now website.

On the commercial side, cutting edge innovation involves the creation of Managed Energy Service Agreements (MESA) where a third party inserts between the property owner and the utilities, finances energy efficiency upgrades and then harvests the savings for return.  But that will have to be another blog.

Lovins, Amory, 1989. “The Negawatt Revolution”.   http://www.ccnr.org/amory.html

Fuller, Merrian, 2009.  “Enabling Investments in Energy Efficiency.”  http://uc-ciee.org/energyeff/documents/resfinancing.pdf

The Setup and Evaluation of the Berkeley FIRST pilot program:   http://www.ci.berkeley.ca.us/ContentDisplay.aspx?id=26580

Home Performance Resource Center, 2010. “Case Study: Berkeley FIRST”. http://www.hprcenter.org/publications/best_practices_case_study_berkeley.pdf

Renewable Funding, LLC, PACE central:  http://www.renewfund.com/

PACE Now, get involved in advocacy:  http://www.pacenow.org/

The Dow Jones report on the California lawsuit: http://tinyurl.com/26wwky5

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