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MBA MondaysFred Wilson
This is a Leanpub book which is for sale at http://leanpub.com. Leanpubhelps you connect with readers and sell your ebook, while you’re writing itand after it’s done.
T A B L E O F C O N T E N T S
1Preface
3ROI and Net Present Value
3How to Calculate a Return on Investment
5The Present Value of Future Cash Flows
7The Time Value of Money
11Compounding Interest
15Corporate Entities
15Corporate Entities
19Piercing the Corporate Veil
21Accounting
21Accounting
24The Profit and Loss Statement
28The Balance Sheet
34Cash Flow
38Analyzing Financial Statements
43Business, Metrics and Pricing
43Key Business Metrics
45Price: Why Lower Isn't Always Better
47Projections, Budgeting and Forecasting
47Projections, Budgeting and Forecasting
49Scenarios
52Budgeting in a Small Early Stage Company
55Budgeting in a Growing Company
58Budgeting in a Large Company
60Forecasting
63Risk and Return
63Risk and Return
65Diversification
68Hedging
70Currency Risk in a Business
73Purchasing Power Parity
77Business Costs
77Opportunity Costs
78Sunk Costs
80Off Balance Sheet Liabilities
83Valuation
83Enterprise Value and Market Value
85Bookings Vs. Revenues Vs. Collections
87Commission Plans
87Commission Plans
91What a CEO Does
91What a CEO Does
92What a CEO Does, Continued
95Outsourcing
95Outsourcing
97Outsourcing Vs. Offshoring
101Employee Equity
101Employee Equity
103Employee Equity: Dilution
106Employee Equity: Appreciation
107Employee Equity: Options
111Employee Equity: The Liquidation Overhang
114Employee Equity: The Option Strike Price
117Employee Equity: Restricted Stock and RSUs
119Employee Equity: Vesting
122Employee Equity: How Much?
127Mergers and Acquisitions
127Acquisition Finance
128M&A Fundamentals
130Buying and Selling Assets
Pre face
MBA Mondays is written by Fred Wilson1, and licensed under the
Creative Commons Attribution 3.0 license. For details, see this post2.
1http://www.avc.com/a_vc/about.html2http://www.avc.com/a_vc/2011/02/mba-mondays-everywhere.html
ROI and Net P resentVa lue
How to Calculate a Return onInvestment
The Gotham Gal1 and I make a fair number of non-tech angel invest-
ments. Things like media, food products, restaurants, music, local realestate, local businesses. In these investments we are usually backingan entrepreneur we've gotten to know who delivers products to themarket that we use and love. The Gotham Gal runs this part of ourinvestment portfolio with some involvement by me.
As I look over the business plans and projections that these entrepren-eurs share with us, one thing I constantly see is a lack of sophisticationin calculating the investor's return.
Here's the typical presentation I see:
2
The entrepreneur needs $400k to start the business, believes he/shecan return to the investors $100k per year, and therefore will generatea 25% return on investment. That is correct if the business lasts foreverand produces $100k for the investors year after year after year.
1http://www.gothamgal.com/2http://www.avc.com/.a/6a00d83451b2c969e20120a80a233a970b-pi
But many businesses, probably most businesses, have a finite life. Arestaurant may have a few good years but then lose its clientele andgo out of business. A media product might do well for a decade butthen lose its way and fold.
And most businesses are unlikely to produce exactly $100k every yearto the investors. Some businesses will grow the profits year after year.Others might see the profits decline as the business matures and headsout of business.
So the proper way to calculate a return is using the "cash flow method".Here's how you do it.
1) Get a spreadsheet, excel will do, although increasingly I recommendgoogle docs spreadsheet
3 because it's simpler to share with others.
2) Lay out along a single row a number of years. I would suggest tenyears to start.
3) In the first year show the total investment required as a negativenumber (because the investors are sending their money to you).
4) In the first through tenth years, show the returns to the investors(after your share). This should be a positive number.
5) Then add those two rows together to get a "net cash flow" number.
6) Sum up the totals of all ten years to get total money in, total moneyback, and net profit.
7) Then calculate two numbers. The "multiple" is the total moneyback divided by the total money in. And then using the "IRR" function,calculate an annual return number.
Here's what it should look like:
3http://docs.google.com
4R O I a n d N e t P r e s e n tV a l u e
4
Here's a link to google docs where I've posted this example5. It is
public so everyone can play around with it and see how the formulaswork.
It's worth looking for a minute at the theoretical example. The in-vestors put in $400k, get $100k back for four years in a row (whichgets them their money back), but then the business declines andeventually goes out of business in its seventh year. The annual rateof return on the $400k turns out to be 14% and the total multiple is1.3x.
That's not a bad outcome for a personal investment in a local businessyou want to support. It sure beats the returns you'll get on a moneymarket fund. But it is not a 25% return and should not be marketedas such.
I hope this helps. You don't need to get a finance MBA to be able todo this kind of thing. It's actually not that hard once you do it a fewtimes.
The Present Value of Future CashFlowsMy friend Pravin
1 sent me an email last week after my "How To
Calculate A Return On Investment"2 post. He said:
4http://www.avc.com/.a/6a00d83451b2c969e20120a80a29da970b-pi5http://spreadsheets.google.com/ccc?key=0AvqoGGDowi93dGZmZUp3RVFrZGpxRHZfazJwZWhmRlE&hl=en1http://twitter.com/pravinsathe2http://www.avc.com/a_vc/2010/01/how-to-calculate-a-return-on-investment.html
R O I a n d N e t P r e s e n tV a l u e
5
I wish there was a class that I could take that would teachme how to properly research stocks/companies for invest-ment purposes and how that could be made into a privatetutoring business. It'd be for people like me, people whodidn't go to school for business but still are interested inunderstanding all the jargon, methods of investing, etcand how to apply it to a buy and hold strategy.
Pravin then went on to say that the post I wrote was exactly the kindof thing he was looking for and that he'd like to see me do more of it.So with that preface, I'd like to announce a new series here at AVC.I'm calling it "MBA Mondays". Every monday I'll write a post that isabout a topic I learned in business school. I'll keep it dead simple (manypeople thought my ROI post last week was too simple). And I'll tryto connect it to some real world experience.
I'll start with the topic Pravin wanted some help with: how to valuestocks, what they are worth today, and what they could be worth inthe future. This topic will take weeks of MBA Mondays to workthrough but we'll start with a fundamental concept, the present valueof future cash flows.
I was taught, and I believe with all my head and heart, that companiesare worth the "present value" of "future cash flows". What that meansis if you could know with certainty the exact amount of cash earningsthat the company will produce from now until eternity, you couldlay those cash flows out and then using some interest rate that reflectsthe time value of money, you could calculate what you'd pay todayfor those future cash flows.
Let's make it really simple. You want to buy the apartment next toyou for investment purposes. It rents for $1000/month. It costs$200/month to maintain. So it produces $800/month of "cash flow".Let's leave aside inflation, rent increases, cost increases, etc and assumefor this post that it will always produce $800/month of cash flow.
6R O I a n d N e t P r e s e n tV a l u e
And let's say that you will accept a 10% annual return on your invest-ment. There are a multitude of reasons why you'll accept differentinterest rates for different investments, but we'll just use 10% for thisone.
Once you know the cash flow ($800/month) and the interest rate (alsocalled the "discount rate"), you can calculate present value. And thisexample is as easy as it gets because the cash flow doesn't change andthe interest rate is 10%.
The annual cash flow is $9,600 (12 x $800) and if you want to earn 10%on your money every year, you can pay $96,000 for the apartment.In order to check the math, let's calculate 10% of $96,000. That's $9,600per year.
In practice, it is never this simple. Cash flows will vary year after year.You'll have to lay them out in a spreadsheet and do a present valueanalysis. We'll do that next week.
But it is the principle here that is important. Companies (and otherinvestments) are worth the "present value" of all the cash you'll earnfrom them in the future. You can't just add up all that cash because adollar tomorrow (or ten years from now) is worth less than a dollaryou have in your pocket. So you need to "discount" the future cashflows by an acceptable rate of interest.
That basic concept is the bedrock of all valuation concepts in finance.It can get incredibly complex, way beyond my ability to calculate oreven explain. But you have to understand this concept before you cango further. I hope you do. Next week we'll look at using spreadsheetsto calculate present values.
The Time Value of MoneyIt's Monday, time for MBA Mondays.
R O I a n d N e t P r e s e n tV a l u e
7
Last week, I posted about The Present Value Of Future CashFlows
1 and in the comments Pascal-Emmanuel Gobry
2 wrote
3:
That being said, before even covering NPV, I would have first talked aboutthe time value of money. To me, time value of money is one of the top 3concepts that blew my mind in business school and that should be commonknowledge. When you think about it, all of finance, but also much of business,is underpinned by that. Once you understand time value of money, you un-derstand opportunity costs, you understand sunk costs, you just view theworld in a whole different light.
PEG is right. We have to talk about the Time Value Of Money andit was a mistake to dive into concepts like Present Value and DiscountRates before doing that. So we'll hit the rewind button and go backto the start. Here it goes.
Money today is generally worth more than money tomorrow.As another commenter to last week's post put it "you can't buy beertonight with next year's earnings". Money in your pocket, cash inhand, is worth more than cash that you don't actually have in hand.If you think about it that simply, everyone can agree that they'd ratherhave the cash in hand than the promise of the same amount at somelater day.
And interest rates are used to calculate exactly how much more themoney is worth today than tomorrow. Let's say that you'd take $900today instead of $1000 exactly a year from now. That means you'daccept a 11.1% "discount rate" on that transaction. I calculated that asfollows:
1) I calculated how much of a "discount" you would take in order toget the money today versus next year. That is $1000 less $900, or $100
1http://www.avc.com/a_vc/2010/01/valuing-stocks-today-and-tomorrow.html2http://twitter.com/pegobry3http://www.avc.com/a_vc/2010/01/valuing-stocks-today-and-tomorrow.html#comment-32276641
8R O I a n d N e t P r e s e n tV a l u e
2) I then divided the discount by the amount you'd take today. Thatis $100/$900, which is 11.1%.
This transaction could be modeled out the other way. Let's say youare willing to loan a friend $900 and you agree that he'll pay you aninterest rate of 11.1%. You multiply $900 times 11.1%, you get $100 oftotal interest, and add that to the $900 and calculate that he'll pay youback $1000 a year from now.
As you can tell from the way I talked about them, interest rates anddiscount rates are generally the same thing. There are technical differ-ences, but both represent a rate of increase in the time value of money.
So if the interest rate describes the time value of money, then thehigher it is, the more valuable money is in your hands and the lessvaluable money is down the road.
There are multiple reasons that money can be more valuable todaythan tomorrow. Let's talk about two of them.
1) Inflation - This is a complicated topic that we are not going to getinto in detail here. But I need to at least mention it. When prices ofthings rise faster than they should, we call that inflation. It can becaused by a number of things, most often when the supply of moneyis rising faster than is sustainable. But the important thing to note isthat if a house that costs $100,000 today is going to cost $120,000 nextyear, that represents 20% inflation and you'd want to earn 20% onyour money every year to compensate you for that inflation. You'dwant a 20% interest rate on your cash to be compensated for that in-flation.
2) Risk - If your money is in a federally guaranteed bank deposit fora year, you might accept 2% interest on it. If it is invested in yourfriend's startup, you might want a double on your money in a year.Why the difference between a 2% interest rate and a 100% interestrate? Risk. You know you are getting the money in the bank back.You are pretty sure you aren't getting the money back that you inves-ted in your friend's startup and want to get a lot back if it works out.
R O I a n d N e t P r e s e n tV a l u e
9
So let's deconstruct interest rates a bit to parse these different reasonsout of them.
Let's say the current rate of interest on a one year treasury bill (a notesold by the US Gov't that is federally guaranteed) is paying a rate ofinterest of 3%. That is an important rate to pay attention to. Becauseit is a one year interest rate on a risk free instrument (assuming thatthe US Gov't is solvent and always will be). We will assume for nowthat is true. So the "risk free rate" is 3%. That is the rate that the"market" says we should be accepting for a one year instrument withno risk.
Now let's take inflation into account. If the Consumer Price Index(the CPI) says that costs are rising 2.5% year over year, then we cansay that the one year inflation rate is 2.5%. It can get a lot more com-plicated than this, but many real estate leases use the CPI so we canuse it too. If you subtract the inflation rate from the risk free rate, youget something called the "real interest rate". In our example, thatwould be 0.5% (3% minus 2.5%). And we call the 3% rate, the "nominalrate".
Now let's take risk into account. Let's say you can find a corporatebond in the bond market that is coming due next year and will pay$1000 and it is trading for $900 right now. We know from the examplethat we started with that it is "paying" a discount rate of 11.1% for thenext year. If we subtract the 3% risk free rate of interest from the11.1%, we can determine that market is demanding a "risk premium"of 8.1% over the risk free rate for this bond. That means that noteveryone thinks that this company is going to be able to pay back thebond in full, but most people do.
Ok, so hopefully you'll see that interest rates and discount rates havecomponents to them. In its simplest form, and interest rate is com-posed of the risk free rate plus an inflation premium plus a riskpremium. In our examples, the risk free "real" interest rate is 0.5%,the inflation premium is 2.5%, and the risk premium on the corporatebond is 8.1%. Add all of those together, and you get the 11.1% rate thatis the discount rate the corporate bond trades at in the markets.
10R O I a n d N e t P r e s e n tV a l u e
Which leads me to my final point. Markets set rates. Banks don't andgovernments don't. Banks and governments certainly impact ratesand governments can do a lot to impact rates and they do all the time.But at the end of the day it is you and me and it is the traders, bothspeculators and hedgers, who determine how much of a discount we'llaccept to get our money now and how much interest we'll want towait another year. It is the sum total of all of these transactions thatcreate the market and the market sets rates and they change everysecond and always will (at least in a capitalist system).
That was tough to do in a blog post. It's a very simple concept butvery powerful and as Pascal-Emmanuel said, it is fundamental to allof finance. I hope I explained it well. It's important to understand thisone.
Compounding Interest
It's time for MBA Mondays again. For the third week in a row, thetopic of the post has been suggested by a reader. Last week, EliaFreedman wrote:
"A suggestion for your next post. The logical follow-onis to explain the second half of the TVM (time value ofmoney), which is compounding interest."
Before I address the issue of compounding interest, I'd like to recognizetwo things about the MBA Monday series. The first is that each posthas a very rich comment thread attached to it. If you are seriouslyinterested in learning this stuff, you would be well served to take thetime to read the comments and the replies to them, including mine.The second is that the readers are building the curriculum for me.Each post has resulted in at least one suggestion for the next week's
R O I a n d N e t P r e s e n tV a l u e
11
post. I dove into MBA Mondays without thinking through the logicalprogression of topics. At this point, I'm just going to run withwhatever people suggest and try to assemble it on the fly. It's workingwell so far. So if you have a suggestion for next week's topic, or anytopic, please leave a comment.
Last week, I described interest as the rate of change in the time valueof money. And we broke interest rates down into the real rate, theinflation factor, and the risk factor. And we calculated that if you in-vested $900 today at an 11.1% rate of interest, you'd end up with $1000a year from now.
But what happens if you wait a few years to get your money back andreceive annual interest payments along the way? Let's say you investthe same $900, receive $100 each year for four years, and then in thelast year, you receive $1000 (your $900 back plus the final year's $100interest payment).
There are two scenarios here and they depend on what you do withthe annual interest payments.
In the first scenario, you pocket the cash and do something else withit. In that scenario, you will realize the 11.1% rate of interest that youwould have realized had you taken the $1000 one year later. It's basic-ally the same deal, just with a longer time horizon. And your totalproceeds on your $900 investment are $1400 (your $900 return of"principal" plus five $100 interest payments).
In the second scenario, you reinvest the interest payments at 11.1%each year and take a final payment in year five. If you reinvest eachinterest payment at 11.1% interest, at the end of year five, you willreceive $1524 as your final payment. Notice that the total proceedsin this scenario are $124 higher than in the other scenario. That isbecause you reinvested the interest payments instead of pocketingthem.
12R O I a n d N e t P r e s e n tV a l u e
Both scenarios produce a "rate of return" of 11.1%. If you look at thisgoogle spreadsheet
1, you can see how these two scenarios map out.
And you can see the calculation of total profit and "internal rate ofreturn".
The fact that you make a larger profit on one versus the other at thesame "rate of interest" shows the power of compounding interest. Itreally helps if you reinvest your interest payments instead of pocket-ing them. While $124 over five years doesn't seem like much, let'slook at the power of compounding interest over a longer horizon.
Let's say you inherit $100,000 around the time you graduate fromcollege. Instead of spending it on something, you decide to invest itfor your retirement 45 years later. If you invest it at the 11.1% rate ofinterest that we've been using, the differences between pocketing the$11,100 you'd get each year and reinvesting it are HUGE.
If you pocket the $11,000 of interest each year, you will receive$599,500 on your $100,000 investment over 45 years.
But if you reinvest the $11,000 of interest each year at 11.1% interest,you will receive $11.4 million dollars when you retire. That's right.$11.4 million dollars versus $599,500. That is the power of compound-ing interest over a long period of time.
You can see how this models out in this google spreadsheet (sheetstwo and three)
2.
Now let's tie this issue to startups and venture capital. Venture capitalinvestments are often held for a fairly long time. I am currentlyserving on several boards of companies that my prior firm, FlatironPartners, invested in during 1999 and 2000. Our hold periods for theseinvestments are into their second decade. Of course not every venturecapital investment lasts a decade or more. But the average hold periodfor a venture capital investment tends to be about seven or eight years.
1http://spreadsheets.google.com/ccc?key=0AvqoGGDowi93dDdFc0dCRGlBc0FFSV9zb3dYZllpSFE&hl=en2http://spreadsheets.google.com/ccc?key=0AvqoGGDowi93dDdFc0dCRGlBc0FFSV9zb3dYZllpSFE&hl=en
R O I a n d N e t P r e s e n tV a l u e
13
And during those seven to eight years, there are no annual interestpayments. So when you calculate the rate of return on the investment,the spreadsheet looks like this. It's a compound interest situation.
If you go back to the $100,000 over 45 years example, you'll see thata return of 114x your money over 45 years produces the same "return"as 6x your money with annual interest payments.
The differences are not as great over seven or eight years but they aremade greater by virtue of the fact that VCs seek to make 40-50% an-nual rates of return on their capital. If you read last week's post, you'llknow that comes from the risk factor involved. The more risk aninvestment has, the higher rate of return an investor will require ontheir money in a successful outcome.
If you want to generate a 50% rate of return compounded over eightyears on $100,000, you will need to return $2.562 million, or 25.6xyour investment. See this google spreadsheet (sheet 4)
3 for the details.
The good news is that most venture capital investments are madeover time, not all at once in the first year. So the "hold periods" on thelater rounds are not as long and make this math a bit easier oneveryone involved (maybe a topic for next week or some other time?).
But as you can see, compounding interest over any length of time in-creases significantly the amount of money you need to return in orderto pay the same rate of return as a security with annual interest pay-ments. There are two big takeaways here. The first is if you are aninvestor, you should reinvest your interest payments instead ofspending them. It makes a huge difference on the outcome of yourinvestment. The second is if you are an entrepreneur, you should takeas little money as you can at the start and always understand that yourinvestors are seeking a return and that the time value of moneycompounds and makes your job as the producer of that return partic-ularly hard.
3http://spreadsheets.google.com/ccc?key=0AvqoGGDowi93dDdFc0dCRGlBc0FFSV9zb3dYZllpSFE&hl=en
14R O I a n d N e t P r e s e n tV a l u e
Corpora te En t i t i e s
Corporate Entities
I'm taking a turn on MBA Mondays today. We are moving past theconcepts of interest and time value of money and moving into theworld of corporations. Today, I'd like to talk about what kinds ofentities you might encounter in the world of business.
First off, you don't have to incorporate to be in business. There aremany people who run a business and don't incorporate. A good ex-ample of this are many of the sellers on Etsy
1. They make things, sell
them, receive the income, and pay the taxes as part of their personalreturns.
But there are three big reasons you'll want to consider incorporating;liability, taxes, and investment. And the kind of corporate entity youcreate depends on where you want to come out on all three of thosefactors.
I'd like to say at this point that I am not a lawyer or a tax advisor andthat if you are planning on incorporating, I would recommend con-sulting both before making any decisions. I hope that we'll get bothlawyers and tax advisors commenting on this post and adding to thediscussion of these issues. I'll also say that this post is entirely basedon US law and that it does not attempt to discuss international law.
With that said, here goes.
When you start a business, it is important to recognize that it willeventually be something entirely different than you. You won't ownall of it. You won't want to be liable for everything that the companydoes. And you won't want to pay taxes on its profits.
1http://www.etsy.com/
Creating a company is implicitly recognizing those things. It is puttinga buffer between you and the business in some important ways.
Let's talk first about liability. When you create a company, you canlimit your liability for actions of the corporation. Those actions canbe for things like bills (called accounts payable in accounting parlance),promises made (like services to be rendered), and lawsuits. This is anincredibly important concept and the reason that most lawyers advisetheir clients to incorporate as soon as possible. You don't want to putyourself and your family at personal risk for the activities you under-take in your business. It's not prudent or expected in our society.
Taxes are the next thing most people think about when incorporating.There are two basic kinds of corporate entities for taxes; "flow throughentities" and "tax paying entities." Here is the difference. Flow throughcorporate entities don't pay taxes, they pass the income (and tax payingobligation) through to the owners of the business. Tax paying entitiespay the taxes at the corporate level and the owners have no obligationfor the taxes owed. Your neighborhood restaurant is probably a "flowthrough entity." Google is a tax paying entity. When you buy 100shares of Google, you are not going to get a tax bill for your share oftheir earnings at the end of the year.
And then there is investment/ownership. Even before we talk aboutinvestment, there is the issue of business partners. Let's say you wantto split the ownership of your business 50/50 with someone else. Youhave to incorporate to create the entity that you can co-own. Andwhen you want to take investment, you'll need to have a corporateentity that can issue shares or membership interests in return for thecapital that others invest in your business.
So now that we've talked about the three major considerations, let'stalk about the different kinds of entities you will come across.
For many new startups, the form of corporate entity they choose iscalled the LLC. It stands for Limited Liability Company
2. This form
of business has been around for a long time in some countries but be-
2http://en.wikipedia.org/wiki/Limited_liability_company
16C o r p o r a t e E n t i t i e s
came recognized and popular in the US sometime in the past 25 years.The key distinguishing characteristics of a LLC is that you get thelimitation of liability of a corporation, you can take investment cap-ital (with restrictions that we'll talk about next), but the taxes are"flow through". Most companies, including tech startups, start out asLLCs these days. Owners in LLC are most commonly called "members"and investments or ownership splits are structured in "membershipinterests."
As the business grows and takes on more sophisticated investors (likeventure funds), it will most often convert into something called a CCorporation
3. Most of the companies you would buy stock in on the
public markets (Google, Apple, GE, etc) are C Corporations. Mostventure backed companies are C Corporations. C Corporationsprovide the limitation of liability, provide even more sophisticatedways to split ownership and raise capital, and most importantly are"tax paying entities." Once you convert from a LLC to a C corporation,you as the founder or owner no longer are responsible for paying thetaxes on your share of the income. The company pays those taxes atthe corporate level.
There are many reasons why a venture fund or other "sophisticatedinvestors" prefer to invest in a C corporation over a LLC. Most ven-ture funds require conversion when they invest. The flow throughof taxes in the LLC can cause venture funds and their investors allsorts of tax issues. This is particularly true of venture funds withforeign investors. And the governance and ownership structures ofan LLC are not nearly as developed as a C corporation. This stuff canget really complicated quickly, but the important thing to know isthat when your business is small and "closely held" a LLC works well.When it gets bigger and the ownership gets more complicated, you'llwant to move to a C corporation.
A nice hybrid between the C corporation and the LLC is the S corpor-ation
4. It requires a simpler ownership structure, basically one class
of stock and less than 100 shareholders. It is a "flow through entity"
3http://en.wikipedia.org/wiki/C_corporation4http://en.wikipedia.org/wiki/S_corporation
C o r p o r a t e E n t i t i e s17
and is simple to set up. You cannot do as much with the ownershipstructure with an S corporation as you can with a LLC so if you planto stay a flow through entity for a long period of time and raise signi-ficant capital, an LLC is probably better.
Another entity you might come across is the Limited Partnership5.
The funds our firm manages are Limited Partnerships. And some bigcompanies, like Bloomberg LP, are limited partnerships. The keydifferences between a Limited Partnership and LLCs and C corpora-tions are around liabilities. In the limited partnership, the investorshave limited liability (like a LLC or C corporation) but the managers(called General Partners) do not. Limited Partnerships are set up totake in outside investment and split ownership. And they are flowthrough entities.
There are many other forms of corporate ownership but these threeare among the most common and show how the three big issues ofliability, ownership, and taxes are handled differently in each.
The important thing to remember about all of this is that if you arestarting a business, you should create a corporate entity to managethe risk and protect you and your family from it. You should startwith something simple and evolve it as the business needs grow anddevelop.
As an investor, you should make sure you know what kind of corpor-ation you are investing in, you should know what kind of liabilityyou are exposing yourself to, and what the tax obligations will be asa result.
And most of all, get a good lawyer and tax advisor. Though they areexpensive, over time the best ones are worth their weight in gold.
5http://en.wikipedia.org/wiki/Limited_partnership
18C o r p o r a t e E n t i t i e s
Piercing the Corporate Veil
Yet another MBA Monday topic comes from the comments of lastweek's post
1. This series is turning into a conversation which makes
me very pleased.
Mr Shawn Yeager said2:
As a recovering lawyer, and a serial entrepreneur, I con-stantly have associates, friends, and family coming tome for advice on formation issues (amongst other things).I think your high level overview leaves out something thatalways comes as a surprise to these people: the concept of"Piercing the Corporate Veil" of liability protection.
I said last week that forming a company is the best way to "putting abuffer between you and the business." But as Shawn and others pointout in last week's comment thread, you can't just pretend to be abusiness, you have to be a business.
"Being a business" means separating your personal and business re-cords, separating your personal and business bank accounts, treatingthe business as a real entity, having board meetings, taking boardminutes, doing major activities via board resolutions, following "dueprocess."
If you don't behave as a real business, you could find yourself in asituation where someone, most commonly someone who is suingyour business, can come after you (and your business partners) per-sonally. And then you are going to say "but what about the liabilitylimitation the business provides?" It may not be there for you.
1http://www.avc.com/a_vc/2010/02/corporate-entity.html2http://www.avc.com/a_vc/2010/02/corporate-entity.html#comment-36092343
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That's called "piercing the corporate veil". And you should take thatthreat seriously. So once you create a company, treat it seriously, fol-low the rules, and do it right. Once again, if you have a good lawyer,he or she will lay this all out for you and even give you many of thetools to do this stuff right.
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Account ing
Accounting
I'm making up the curriculum for MBA Mondays on the fly. The endgame is to lay out how to look a businesses, value it, and invest in it.We started with the time value of money and interest rates, we thentalked about the corporate entity. Now I want to talk about how tokeep track of the money in a company. That is called accounting. Thiswill be a multi-post effort and will include posts on cash flow, profitand loss, balance sheets, GAAP accounting, audits, and financialstatement analysis. But before we can get to those issues, we need tostart with the basics of accounting.
Accounting is keeping track of the money in a company. It's criticalto keep good books and records for a business, no matter how smallit is. I'm not going to lay out exactly how to do that, but I am goingto discuss a few important principals.
The first important principal is every financial transaction of acompany needs to be recorded. This process has been made mucheasier with the advent of accounting software. For most startups,Quickbooks
1 will do in the beginning. As the company grows, the
choice of accounting software will become more complicated, but bythen you will have hired a financial team that can make those choices.
The recording of financial transactions is not an art. It is a science anda well understood science. It revolves around the twin concepts of a"chart of accounts" and "double entry accounting." Let's start with thechart of accounts.
The accounting books of a company start with a chart of accounts.There are two kinds of accounts; income/expense accounts and as-
1http://quickbooks.intuit.com/
set/liability accounts. The chart of accounts includes all of them. In-come and expense accounts represent money coming into and out ofa business. Asset and liability accounts represent money that is con-tained in the business or owed by the business.
Advertising revenue that you receive from Google Adsense would bean income account. The salary expense of a developer you hire wouldbe an expense account. Your cash in your bank account would be anasset account. The money you owe on your company credit cardwould be called "accounts payable" and would be a liability.
When you initially set up your chart of accounts, the balance in eachand every account is zero. As you start entering financial transactionsin your accounting software, the balances of the accounts goes up orpossibly down.
The concept of double entry accounting is important to understand.Each financial transaction has two sides to it and you need both ofthem to record the transaction. Let's go back to that Adsense revenueexample. You receive a check in the mail from Google. You depositthe check at the bank. The accounting double entry is you record anincrease in the cash asset account on the balance sheet and a corres-ponding equal increase in the advertising revenue account. Whenyou pay the credit card bill, you would record a decrease in the cashasset account on the balance sheet and a decrease in the "accountspayable" account on the balance sheet.
These accounting entries can get very complicated with many ac-counts involved in a single recorded transaction, but no matter howcomplicated the entries get the two sides of the financial transactionalways have to add up to the same amount. The entry must balanceout. That is the science of accounting.
Since the objective of MBA Mondays is not to turn you all into ac-countants, I'll stop there, but I hope everyone understands what achart of accounts and an accounting entry is now.
Once you have a chart of accounts and have recorded financialtransactions in it, you can produce reports. These reports are simply
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the balances in various accounts or alternatively the changes in thebalances over a period of time.
The next three posts are going to be about the three most commonreports;
• the profit and loss statement which is a report of the changes inthe income and expense accounts over a certain period of time(month and year being the most common)
• the balance sheet which is a report of the balances all all asset andliability accounts at a certain point in time
• the cash flow statement which is report of the changes in all of theaccounts (income/expense and asset/liability) in order to determinehow much cash the business is producing or consuming over acertain period of time (month and year being the most common)
If you have a company, you must have financial records for it. Andthey must be accurate and up to date. I do not recommend doing thisyourself. I recommend hiring a part-time bookkeeper to maintainyour financial records at the start. A good one will save you all sortsof headaches. As your company grows, eventually you will need a fulltime accounting person, then several, and at some point your financeorganization could be quite large.
There is always a temptation to skimp on this part of the business.It's not a core part of most businesses and is often not valued by techentrepreneurs. But please don't skimp on this. Do it right and well.And hire good people to do the accounting work for your company.It will pay huge dividends in the long run.
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The Profit and Loss Statement
Today on MBA Mondays we are going to talk about one of the mostimportant things in business, the profit and loss statement (also knownas the P&L).
Picking up from the accounting post1 last week, there are two kinds
of accounting entries; those that describe money coming into and outof your business, and money that is contained in your business. TheP&L deals with the first category.
A profit and loss statement is a report of the changes in the incomeand expense accounts over a set period of time. The most commonperiods of time are months, quarters, and years, although you canproduce a P&L report for any period.
Here is a profit and loss statement for the past four years for Google2.
I got it from their annual report (10k).3 I know it is too small on this
page to read, but if you click on the image, it will load much larger ina new tab.
4
1http://www.avc.com/a_vc/2010/03/accounting.html2http://www.tracked.com/company/google/3http://sec.gov/Archives/edgar/data/1288776/000119312510030774/d10k.htm4http://www.avc.com/.a/6a00d83451b2c969e201310fa0e6cd970c-pi
24A c c o u n t i n g
The top line of profit and loss statements is revenue (that's why you'lloften hear revenue referred to as "the top line"). Revenue is the totalamount of money you've earned coming into your business over a setperiod of time. It is NOT the total amount of cash coming into yourbusiness. Cash can come into your business for a variety of reasons,like financings, advance payments for services to be rendered in thefuture, payments of invoices sent months ago.
There is a very important, but highly technical, concept called revenuerecognition. Revenue recognition determines how much revenueyou will put on your accounting statements in a specific time period.For a startup company, revenue recognition is not normally difficult.If you sell something, your revenue is the price at which you sold theitem and it is recognized in the period in which the item was sold. Ifyou sell advertising, revenue is the price at which you sold the advert-ising and it is recognized in the period in which the advertising actu-ally ran on your media property. If you provide a subscription service,your revenue in any period will be the amount of the subscriptionthat was provided in that period.
This leads to another important concept called "accrual accounting."When many people start keeping books, they simply record cash re-ceived for services rendered as revenue. And they record the bills theypay as expenses. This is called "cash accounting" and is the way mostof us keep our personal books and records. But a business is not sup-posed to keep books this way. It is supposed to use the concept of ac-crual accounting.
Let's say you hire a contract developer to build your iPhone app. Andyour deal with him is you'll pay him $30,000 to deliver it to you. Andlet's say it takes him three months to build it. At the end of the threemonths you pay him the $30,000. In cash accounting, in month threeyou would record an expense of $30,000. But in accrual accounting,each month you'd record an expense of $10,000 and because you aren'tactually paying the developer the cash yet, you charge the $10,000each month to a balance sheet account called Accrued Expenses. Thenwhen you pay the bill, you don't touch the P&L, its simply a balance
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sheet entry that reduces Cash and reduces Accrued Expenses by$30,000.
The point of accrual accounting is to perfectly match the revenuesand expenses to the time period in which they actually happen, notwhen the payments are made or received.
With that in mind, let's look at the second part of the P&L, the expensesection. In the Google P&L above, expenses are broken out into severalcategories; cost of revenues, R&D, sales and marketing, and generaland administration. You'll note that in 2005, there was also a contri-bution to the Google Foundation, but that only happened once, in2005.
The presentation Google uses is quite common. One difference youwill often see is the cost of revenues applied directly against the rev-enues and a calculation of a net amount of revenues minus cost ofrevenues, which is called gross margin. I prefer that gross margin bebroken out as it is a really important number. Some businesses havevery high costs of revenue and very low gross margins. And examplewould be a retailer, particularly a low price retailer. The gross marginsof a discount retailer could be as low as 25%.
Google's gross margin in 2009 was roughly $14.9bn (revenue of $23.7bnminus cost of revenues of $8.8bn). The way gross margin is most oftenshown is as a percent of revenues so in 2009 Google's gross marginwas 63% (14.9bn divided by 23.7). I prefer to invest in high gross marginbusinesses because they have a lot of money left after making a saleto pay for the other costs of the business, thereby providing resourcesto grow the business without needing more financing. It is also mucheasier to get a high gross margin business profitable.
The other reason to break out "cost of revenues" is that it will mostlikely increase with revenues whereas the other expenses may not.The non cost of revenues expenses are sometimes referred to as"overhead". They are the costs of operating the business even if youhave no revenue. They are also sometimes referred to as the "fixedcosts" of the business. But in a startup, they are hardly fixed. Theseexpenses, in Google's categorization scheme, are R&D, sales and
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marketing, and general/admin. In layman's terms, they are the costsof making the product, the costs of selling the product, and the costof running the business.
The most interesting line in the P&L to me is the next one, "IncomeFrom Operations" also known as "Operating Income." Income FromOperations is equal to revenue minus expenses. If "Income From Op-erations" is a positive number, then your base business is profitable.If it is a negative number, you are losing money. This is a criticalnumber because if you are making money, you can grow your businesswithout needing help from anyone else. Your business is sustainable.If you are not making money, you will need to finance your businessin some way to keep it going. Your business is unsustainable on itsown.
The line items after "Income From Operations" are the additionalexpenses that aren't directly related to your core business. They in-clude interest income (from your cash balances), interest expense(from any debt the business has), and taxes owed (federal, state, local,and possibly international). These expenses are important becausethey are real costs of the business. But I don't pay as much attentionto them because interest income and expense can be changed bymaking changes to the balance sheet and taxes are generally only paidwhen a business is profitable. When you deduct the interest and taxesfrom Income From Operations, you get to the final number on theP&L, called Net Income.
I started this post off by saying that the P&L is "one of the most im-portant things in business." I am serious about that. Every businessneeds to look at its P&L regularly and I am a big fan of sharing theP&L with the entire company. It is a simple snapshot of the health ofa business.
I like to look at a "trended P&L" most of all. The Google P&L that Ishowed above is a "trended P&L" in that it shows the trends in reven-ues, expenses, and profits over five years. For startup companies, Iprefer to look at a trended P&L of monthly statements, usually overa twelve month period. That presentation shows how revenues are
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increasing (hopefully) and how expenses are increasing (hopefullyless than revenues). The trended monthly P&L is a great way to lookat a business and see what is going on financially.
I'll end this post with a nod to everyone who commented last weekthat numbers don't tell you everything about a business. That is verytrue. A P&L can only tell you so much about a business. It won't tellyou if the product is good and getting better. It won't tell you howthe morale of the company is. It won't tell you if the managementteam is executing well. And it won't tell you if the company has theright long term strategy. Actually it will tell you all of that but afterit is too late to do anything about it. So as important as the P&L is, itis only one data point you can use in analyzing a business. It's a goodplace to start. But you have to get beyond the numbers if you reallywant to know what is going on.
The Balance Sheet
Today on MBA Mondays we are going to talk about the Balance Sheet.
The Balance Sheet shows how much capital you have built up in yourbusiness.
If you go back to my post on Accounting1, you will recall that there
are two kinds of accounts in a company's chart of accounts; revenueand expense accounts and asset and liability accounts.
Last week we talked about the Profit and Loss statement2 which is a
report of the revenue and expense accounts.
The Balance Sheet is a report of the asset and liability accounts. Assetsare things you own in your business, like cash, capital equipment, andmoney that is owed to you for products and services you have de-
1http://www.avc.com/a_vc/2010/03/accounting.html2http://www.avc.com/a_vc/2010/03/the-profit-and-loss-statement.html
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livered to customers. Liabilities are obligations of the business, likebills you have yet to pay, money you have borrowed from a bank orinvestors.
Here is Google's balance sheet as of 12/31/2009:
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3
Let's start from the top and work our way down.
3http://www.avc.com/.a/6a00d83451b2c969e201310fc99f39970c-pi
30A c c o u n t i n g
The top line, cash, is the single most important item on the balancesheet. Cash is the fuel of a business. If you run out of cash, you are inbig trouble unless there is a "filling station" nearby that is willing tofund your business. Alan Shugart, founder of Seagate and a few otherdisk drive companies, famously said "cash is more important thanyour mother." That's how important cash is and you never want toget into a situation where you run out of it.
The second line, short term investments, is basically additional cash.Most startups won't have this line item on their balance sheet. Butwhen you are Google and are sitting on $24bn of cash and short terminvestments, it makes sense to invest some of your cash in "short terminstruments". Hopefully for Google and its shareholders, these invest-ments are safe, liquid, and are at very minimal risk of loss.
The next line is "accounts receivable". Google calls it "net receivables'because they are netting out money some of their partners owe them.I don't really know why they are doing it that way. But for mostcompanies, this line item is called Accounts Receivable and it is thetotal amount of money owed to the business for products and servicesthat have been delivered but have not been collected. It's the moneyyour customers owe your business. If this number gets really big rel-ative to revenues (for example if it represents more than three monthsof revenues) then you know something is wrong with the business.We'll talk more about that in an upcoming post about financialstatement analysis.
I'm only going to cover the big line items in this balance sheet. So thenext line item to look at is called Total Current Assets. That's theamount of assets that you can turn into cash fairly quickly. It is oftenconsidered a measure of the "liquidity of the business."
The next set of assets are "long term assets" that cannot be turned intocash easily. I'll mention three of them. Long Term Investments areprobably Google's minority investments in venture stage companiesand other such things. The most important long term asset is "PropertyPlant and Equipment" which is the cost of your capital equipment.For the companies we typically invest in, this number is not large
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unless they rack their own servers. Google of course does just thatand has spent $4.8bn to date (net of depreciation) on its "factory". De-preciation is the annual cost of writing down the value of yourproperty plant and equipment. It appears as a line in the profit andloss statement. The final long term asset I'll mention is Goodwill. Thisis a hard one to explain. But I'll try. When you purchase a business,like YouTube, for more than it's "book value" you must record thedifference as Goodwill. Google has paid up for a bunch of businesses,like YouTube and Doubleclick, and it's Goodwill is a large number,currently $4.9bn. If you think that the value of any of the businessesyou have acquired has gone down, you can write off some or all ofthat Goodwill. That will create a large one time expense on yourprofit and loss statement.
After cash, I believe the liability section of the balance sheet is themost important section. It shows the businesses' debts. And the otherthing that can put you out of business aside from running out of cashis inability to pay your debts. That is called bankruptcy. Of course,running out of cash is one reason you may not be able to pay yourdebts. But many companies go bankrupt with huge amounts of cashon their books. So it is critical to understand a company's debts.
The main current liabilities are accounts payable and accrued expenses.Since we don't see any accrued expenses on Google's balance sheet Iassume they are lumping the two together under accounts payable.They are closely related. Both represent expenses of the business thathave yet to be paid. The difference is that accounts payable are forbills the company receives from other businesses. And accrued ex-penses are accounting entries a company makes in anticipation ofbeing billed. A good example of an accounts payable is a legal bill youhave not paid. A good example of an accrued expense is employeebenefits that you have not yet been billed for that you accrue for eachmonth.
If you compare Current Liabilities to Current Assets, you'll get a senseof how tight a company is operating. Google's current assets are $29bnand its current liabilities are $2.7bn. It's good to be Google, they are
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not sweating it. Many of our portfolio companies operate with thesenumbers close to equal. They are sweating it.
Non current liabilities are mostly long term debt of the business. Theamount of debt is interesting for sure. If it is very large compared tothe total assets of the business its a reason to be concerned. But itseven more important to dig into the term of the long term debt andfind out when it is coming due and other important factors. You won'tfind that on the balance sheet. You'll need to get the footnotes of thefinancial statements to do that. Again, we'll talk more about that in afuture post on financial statement analysis.
The next section of the balance sheet is called Stockholders Equity.This includes two categories of "equity". The first is the amount thatequity investors, from VCs to public shareholders, have invested inthe business. The second is the amount of earnings that have beenretained in the business over the years. I'm not entirely sure howGoogle breaks out the two on it's balance sheet so we'll just talk aboutthe total for now. Google's total stockholders equity is $36bn. That isalso called the "book value" of the business.
The cool thing about a balance sheet is it has to balance out. TotalAssets must equal Total Liabilities plus Stockholders Equity. InGoogle's case, total assets are $40.5bn. Total Liabilities are $4.5bn. Ifyou subtract the liabilities from the assets, you get $36bn, which isthe amount of stockholders equity.
We'll talk about cash flow statements next week and the fact that abalance sheet has to balance can be very helpful in analyzing andprojecting out the cash flow of a business.
In summary, the Balance Sheet shows the value of all the capital thata business has built up over the years. The most important numbersin it are cash and liabilities. Always pay attention to those numbers.I almost never look at a profit and loss statement without also lookingat a balance sheet. They really should be considered together as theyare two sides of the same coin.
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Cash Flow
This week on MBA Mondays1 we are going to talk about cash flow.
A few weeks ago, in my post on Accounting2, I said there were three
major accounting statements. We’ve talked about the Income State-ment
3 and the Balance Sheet
4. The third is the Cash Flow Statement.
I’ve never been that interested in the Cash Flow Statement per se. Thestandard form of a cash flow statement is a bit hard to comprehendin my opinion and I don’t think it does a very good job of describingthe various aspects of cash flow in a business.
That said, let’s start with the concept of cash flow and we’ll come backto the accounting treatment.
Cash flow is the amount of cash your business either produces orconsumes in a given period, typically a month, quarter, or year. Youmight think that is the same as the profit of the business, but that isnot correct for a bunch of reasons.
The profit of a business is the difference between revenues and ex-penses. If revenues are greater than expenses, your business is produ-cing a profit. If expenses are greater than revenues, your business isproducing a loss.
But there are many examples of profitable businesses that consumecash. And there are also examples of unprofitable businesses thatproduce cash, at least for a period of time.
Here’s why.
As I explained in the Income Statement post5, revenues are recognized
as they are earned, not necessarily when they are collected. And ex-
1http://www.avc.com/a_vc/mba-mondays/2http://www.avc.com/a_vc/2010/03/accounting.html3http://www.avc.com/a_vc/2010/03/the-profit-and-loss-statement.html4http://www.avc.com/a_vc/2010/03/the-balance-sheet.html5http://www.avc.com/a_vc/2010/03/the-profit-and-loss-statement.html
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penses are recognized as they are incurred, not necessarily when theyare paid for. Also, some things you might think of as expenses of abusiness, like buying servers, are actually posted to the Balance Sheetas property of the business and then depreciated (ie expensed) overtime.
So if you have a business with significant hardware requirements,like a hosting business for example, you might be generating a profiton paper but the cash outlays you are making to buy servers maymean your business is cash flow negative.
Another example in the opposite direction would be a software as aservice business where your company gets paid a year in advance foryour software subscription revenues. You collect the revenue upfrontbut recognize it over the course of the year. So in the month you col-lect the revenue from a big customer, you might be cash flow positive,but your Income Statement would show the business operating at aloss.
Cash flow is really easy to calculate. It’s the difference between yourcash balance at the start of whatever period you are measuring andthe end of that period. Let’s say you start the year with $1mm in cashand end the year with $2mm in cash. Your cash flow for the year ispositive by $1mm. If you start the year with $1mm in cash and endthe year with no cash, your cash flow for the year is negative by $1mm.
But as you might imagine the accounting version of the cash flowstatement is not that simple. Instead of getting into the standard form,which as I said I don’t really like, let’s talk about a simpler form thatgets you to mostly the same place.
Let’s say you want to do a cash flow statement for the past year. Youstart with your Net Income number from your Income Statement forthe year. Let’s say that number is $1mm of positive net income.
Then you look at your Balance Sheet from the prior year and thecurrent year. Look at the Current Assets (less cash) at the start of theyear and the Current Assets (less cash) at the end of the year. If theyhave gone up, let’s say by $500,000, then you subtract that number
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from your Net Income. The reason you subtract the number is yourbusiness used some of your cash to increase its current assets. Onetypical reason for that is your Accounts Receivable went up becauseyour customers are taking longer to pay you.
Then look at your Non-Current Assets at the start of the year and theend of the year. If they have gone up, let’s say by $500k, then you alsosubtract that number from your Net Income. The reason is yourbusiness used some of your cash to increase its Non-Current Assets,most likely Property, Plant, and Equipment (like servers).
At this point, halfway through this simplified cash flow statement,your business that had a Net Income of $1mm produced no cash be-cause $500k of it went to current assets and $500k of it went to non-current assets.
Liabilities work the other way. If they go up, you add the number toNet Income. Let’s start with Current Liabilities such as AccountsPayable (money you owe your suppliers, etc). If that number goes upby $250k over the course of the year, you are effectively using yoursuppliers to finance your business. Another reason current liabilitiescould go up is Deferred Revenue went up. That would mean you areeffectively using your customers to finance your business (like thatsoftware as a service example earlier on in this post).
Then look at Long Term Liabilities. Let’s say they went up by $500kbecause you borrowed $500k from the bank to purchase the serversthat caused your Non-Current Assets to go up by $500k. So add that$500k to Net Income as well.
Now, the simplified cash flow statement is showing $750k of positivecash flow. But we have one more section of the Balance Sheet to dealwith, Stockholders Equity. For Stockholders Equity, you need to backout the current year’s net income because we started with that. Onceyou do that, the main reason Stockholders Equity would go up wouldbe an equity raise. Let’s say you raised $1mm of venture capital duringthe year and so Stockholder’s Equity went up by $1mm. You’d addthat $1mm to Net Income as well.
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So, that’s basically it. You start with $1mm of Net Income, subtract$500k of increased current assets, subtract $500k of increased non-current assets, add $250k of increased current liabilities, add $500k ofincreased long-term liabilities, and add $1mm of increased stockhold-ers equity, and you get positive cash flow of $1.75mm.
Of course, you’ll want to check this against the cash balance at thestart of the year and the end of the year to make sure that in fact cashdid go up by $1.75mm. If it didn’t, then you have to go back and checkyour math.
So why would anyone want to do the cash flow statement the longway if you can simply compare cash at the start of the year and theend of the year? The answer is that doing a full-blown cash flowstatement tells you a lot about where you are consuming or producingcash. And you can use that information to do something about it.
Let’s say that your cash flow is weak because your accounts receivableare way too high. You can hire a dedicated collections person. Youcan start cutting off customers who are paying you too late. Or youcan do a combination of both. Bringing down accounts receivable isa great way to improve a business’ cash flow.
Let’s say you are spending a boatload on hardware to ramp up yourweb service’s capacity. And it is bringing your cash flow down. If youare profitable or have good financial backers, you can go to a bankand borrow against those servers. You can match non-current assetsto long-term liabilities so that together they don’t impact the cashflow of your business.
Let’s say your current liabilities went down over the past year by$500k. That’s a $500k reduction in your cash flow. Maybe you arepaying your bills much more quickly than you did when you startedthe business and had no cash. You might instruct your accountingteam to slow down bill payment a bit and bring it back in line withprior practices. That could help produce better cash flow.
These are but a few examples of the kinds of things you can learn bydoing a cash flow statement. It’s simply not enough to look at the In-
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come Statement and the Balance Sheet. You need to understand thethird piece of the puzzle to see the business in its entirety.
One last point and I am done with this week’s post. When you aredoing projections for future years, I encourage management teamsto project the income statement first, then the cash flow statement,and then end up with the balance sheet. You can make assumptionsabout how the line items in the Income Statement will cause thevarious Balance Sheet items to change (like Accounts Receivableshould be equal to the past three months of revenue) and then lay allthat out as a cash flow statement and then take the changes in thevarious items in the cash flow statement to build the Balance Sheet.I like to do that in monthly form. We’ll talk more about projectionsnext week because I think this is a very important subject for startupsand entrepreneurial management teams to wrap their heads around.
Analyzing Financial Statements
This topic could be and is a full semester course at some businessschools. It is a deep and rich topic that I can’t cover in one single blogpost. But it is also a relatively narrow skill set at its most developedlevels. If you are going to be a public equity analyst, you need to un-derstand this stuff cold and this post will not get you there.
But if you are an entrepreneur being handed financial statementsfrom your bookkeeper or accountant or controller, then you need tobe able to understand them and I’d like this post to help you do that.I’d also like this post help those of you who want to be more confidentbuying, holding, and selling public stocks. So that’s the perspective Iwill bring to this topic.
In the past three weeks, we talked about the three main financialstatements, the Income Statement
1, the Balance Sheet
2, and the Cash
1http://www.avc.com/a_vc/2010/03/the-profit-and-loss-statement.html2http://www.avc.com/a_vc/2010/03/the-balance-sheet.html
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Flow Statement3. This post is going to attempt to help you figure out
how to analyze them, at least at a cursory level.
In general, I like to start with cash. It’s the first line item on the BalanceSheet (it could be the first several lines if you want to combine it withshort term investments). Note how much cash you have or how muchcash the company you are analyzing has. Remember that number. Ifsomeone asks you how much cash you have in your business, or abusiness you are analyzing, and you can’t answer that to the last ac-counting period (at least), then you failed. There is no middle ground.Cash is that important.
Then look at how much cash the business had in a prior period. Lastmonth is a good place to start but don’t end there. Look at how muchcash went up or down in the past month. Then look much fartherback, at least a quarter, and ideally six months and/or a year. Calculatehow much cash went up or down over the period and then divide bythe number of months in the period. That’s the average cash flow (orcash burn) per month. Remember that number.
But that number can be misleading, particularly if you did any debtor equity financings during that period (or if you paid off any debtfacilities during that period). Back out the debt and equity financingsand do the same calculations of average cash flow per month. Hope-fully the monthly number, the quarterly average, the six-month av-erage, and the annual average are in the same ballpark. If they are not,something is changing in the business, either for the good or the badand you need to dig deeper to find out what. We’ll get to that.
If cash flow is positive for all periods, then you are done with cash. Ifit is negative, do one more thing. Divide your cash balance by the av-erage monthly burn rate and figure out how many months of cashyou have left. If you are burning cash, you need to know this numberby heart as well. It is the length of your runway. For all you entrepren-eurs out there, the three cash related numbers you need to be on topof are current cash balance, cash burn rate, and months of runway.
3http://www.avc.com/a_vc/2010/03/cash-flow.html
A c c o u n t i n g39
I generally like to go to the income statement next. And I like to layout a few periods next to each other, ideally chronologically fromoldest on the left to the newest on the right. For startups and earlystage companies, a 12 month trended monthly presentation of theincome statement is ideal. For more mature companies, includingpublic companies, the current quarter and the four previous quartersare best.Some people like to graph the key line items in the income statement(revenue, gross margin, operating costs, operating income) over time. That’s good if you are a visual person. I find looking at the hardnumbers works better for me. Note how things are moving in thebusiness. In a perfect world, revenues and gross margins are growingfaster than operating costs, and operating income (or losses) are in-creasing (or decreasing) faster than both of them. That is a demonstra-tion of the operating leverage in the business.
But some early stage companies either have no revenue or are invest-ing in the business faster than they are growing revenue. That is asound strategy if the investments they are making are solid ones andif they have a timeline laid out during which they’ll do this. You can’tdo that forever. You’ll run out of cash and go out of business.
From this analysis, you may see why the business is burning cash orburning cash more quickly or less quickly. You may see why thebusiness is growing its cash flow rapidly. I am most comfortable whenthe monthly operating income (or losses) of a business are roughlyequal to its cash flow (or cash burn). This does not have to be the casefor the business to be healthy but it means the business has a relativelysimple economic architecture, which is always comforting. FromEnron to Lehman Brothers, we’ve learned that complex business ar-chitectures are hard to analyze and easy to manipulate.
One thing that bears mentioning here are “one time items” on the In-come Statement. They make your life harder. If you go back to theIncome Statement post
4 and look at Google’s statement, you’ll see that
in the first year of their presentation Google made a one-time contri-bution to the Google Foundation. That depressed earnings in that
4http://www.avc.com/a_vc/2010/03/the-profit-and-loss-statement.html
40A c c o u n t i n g
period. You need to back that one time charge out for a consistentpresentation, but you also need to be somewhat suspicious of one-time charges. Companies can try to bury ongoing expenses in one-time charges and inflate their earnings. You don’t see that much instartups but you do in public companies and it’s a “red flag” if a com-pany does it too often.
If the monthly operating income (after backing out one-time charges)doesn’t come close to the monthly cash burn rates, then something isgoing on with the balance sheet of the business. Many of these differ-ences are normal for certain businesses. My friend Ron Schreiber toldme about a software distribution business he and his partner JordanLevy ran in the mid 80s. They would buy software from Microsoft,Lotus, and others in bulk and sell it in small quantities to mom andpop businesses. Microsoft and Lotus wanted to be paid upfront whenthe shipped the software but the mom and pop businesses were run-ning on fumes and could not pay until they sold the software. So Ron’sbusiness, called Software Distribution Services (of course), was alwaysout of cash. In Ron’s words, they were a bank and a distributioncompany and weren’t getting paid for the banking part of their busi-ness. All during this time the revenue line and the operating incomeline was growing fast and furious as desktop software went from aniche business to a mainstream business. Eventually Ron and Jordanhad to sell their business to Ingram, a large book distributor who hadthe financial resources to provide the “banking services”. They madea nice hit on that company, but not anything like what Microsoft andLotus did even though they grew their topline just as fast as theirsuppliers.Ron and Jordan’s business was “working capital intensive.” Workingcapital is the non cash current assets and liabilities of the business.When they grow rapidly in relation to revenues, it means you arefinancing other parts of the food chain in your industry and that’s agreat way to run out of cash.
So if monthly income and monthly cash flow aren’t in the same ball-park, look at the changes in working capital month over month. Wewent over this a bit last week in preparing the cash flow statement.
A c c o u n t i n g41
If working capital is the culprit soaking up the cash, you need to lookat two things.The first is if the revenues are real. A great way to inflate revenues isto “ship product” to people who aren’t going to pay you. A companythat is doing that is operating fraudently so you don’t see it very often.But if someone is doing this, cash will be going down while profitsare steady and accounts receivable are growing rapidly. I always lookfor that in a company that is supposed to be profitable but is suckingcash.
The second is the availability of working capital financing. If a busi-ness can finance its working capital needs inexpensively, then it canoperate successfully with this business model. In times when debt isflowing freely, these can be good businesses to operate. When cash istight, they are not.
The final thing to look for on the balance sheet is capex. If a businessis operating profitably, and growing profits, but its capex line isgrowing faster than profits, it’s got the potential for problems. Hostingcompanies are an example of a set of companies that might be in thissituation. Again, the availability of financing is the key. Local cableoperators operated profitably for years with big negative cash flowsbecause of capex. The fiancial markets like the monopolies thesebusineses were granted and consistently provided them with financingto buy more capex. But if that party ends, it can be painful.This post is three pages long in my editor so it’s time to stop. Thereis more to discuss on this topic so I’d like to know if I did this topicjustice for most of you or if you’d like another post that digs a littledeeper. My preference is to move on because I’m getting a bit tired ofwriting about accounting every Monday, but most of all I want tocover the stuff you want to learn or freshen up on. So let me know.
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Bus ines s , Met r i c s andPr i c ing
Key Business MetricsThe past five MBA Mondays posts have been about accounting con-cepts, financial statements, and related issues. I don't know about allof you, but I'm a bit tired of that stuff. So I'm moving on to somethinga bit different.
Every business should have a set of metrics that it tracks on a regularbasis. These metrics could include some of the accounting stuff we'vebeen talking about like cash, revenues, profits, etc but it should notbe limited to those kinds of metrics.
Early on when the company is developing its first product or service,those metrics might be related to product development like develop-ment resources, features completed, known bugs, etc. Once the productor service is launched, the metrics might shift to include customers,daily active users, churn, conversions from free trial to paid customer,etc.
As the business grows and develops, the amount of data you can collectand publish to your team grows. If you aren't careful, you can over-whelm your team with data.
It becomes very important to distill the business down to a handfulof key business metrics. There are usually four to six metrics that willbe sufficient to determine the overall health and growth trajectoryof the business and it is best to focus the team on them.
Our portfolio company Meetup 1has learned to focus on successful
Meetup groups. Those are Meetup groups that are active, meetingregularly, have growing memberships, and are paying fees to Meetup.Meetup could focus on other data sets like monthly unique visitors,new Meetup groups, total registered users, revenues, profits, cash.They collect that data and share it with the team. But the number onething they look at it successful Meetup groups and that has workedwell for them. It is their key business metric.
Sometimes the most important data on your business is the hardestto collect. Twitter
2 knows that the total number of times all tweets
have been viewed each day, month, or year is a critical measure of theoverall reach of the network. But because so many of those tweets areviewed on third party services, web pages, apps, etc, it is very hard tocollect that data. The Company is only now starting to measure them.
Most key business metrics will be drivers of revenues and growthbut not all of them. Etsy
3 is focusing a lot of effort on its customer
service metrics, which are a cost center not a revenue driver. But theCompany knows that customer service is critical to the health of themarketplace, so customer service metrics are key business metricsfor them.
The management team should spend time talking about and selectingthe key business metrics to focus on. They should collect the data ona regular basis, the more real-time the better in my opinion, and theyshould publish the key business metrics to the entire team.
I do not believe it makes any sense to segment who gets to see whatbusiness metrics in a company. Sales metrics should be shared withdevelopment. Customer service metrics should be shared with finance.And so on and so forth.
Some companies buy big screens and mount them on the walls aroundthe office and publish the key business metrics on them so everyonecan see them. I like that approach. But I also like sending out a regular
1http://www.meetup.com/2http://twitter.com/3http://www.etsy.com
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email to the entire company with the key business metrics and howthey are trending. And of course, I think these metrics should be sharedwith the Board and key investors.
When you publish financial projections (a topic for the coming weeks),you should include your projections or assumptions for key businessmetrics in the periods for which you are projection financial perform-ance. Many of these metrics will be drivers of your projections butthey are also helpful to establish the overall progress of the businessover time.
It is a good idea to evaluate what your company's key business metricsshould be from time to time. I like to suggest at least once a year,probably around the annual budgeting exercise (another topic for thecoming week). It is expected that you will change some of these metricsevery year as the business grows and develops. Don't just keep addingnew ones, you should also subtract old ones that don't seem as usefulanymore. Keep the total number of key business metrics you aretracking to a small enough number that most people on the teamcould recite them from memory. Less is more when it comes to keybusiness metrics.
Tracking key business metrics is important for a bunch of reasons,but probably the most important reason is cultural. It helps to keepeveryone on the same page, aligns people across the different partsof the business, and leads to a culture of success when you see the keybusiness metrics moving in the right direction. It's critical to celebratewhen a key business metrics reaches a new and important milestone.These kinds of things seem silly to some but are incredibly importantto building a strong company culture that can work together andgrow rapidly.
Price: Why Lower Isn't Always Better
I want to tackle the issue of forecasting and projections next in theMBA Mondays series but I don't yet have an outline in my head of
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how I am going to approach this critical subject. So I am taking abreather this week and instead will tell a story I heard from a market-ing professor in business school.
This professor did a lot of consulting on the side. He was known as ahighly analytic marketing expert. He was asked to take on a frenchproducer of champagne as a client. This champagne producer wastrying to enter the US market but was not selling very much of theirproduct in the US.
The professor did an analysis of the "five Ps"; product, price, people,promotion, and place. He determined that the champagne was of veryhigh quality, it was being distributed in the right places, and that themarketing investment behind it was substantial. And yet it wasn'tselling very well.
He did an analysis of comparable quality champagnes and determinedthat this particular producer was pricing his product at the very lowend of the range of comparable product.
So the professor's recommendation was to increase the wholesaleprice such that the retail price would double. The client was verynervous about the professor's recommendation but in the end did it.And the champagne started selling like crazy. They couldn't keep itin stock.
The morale of this story is that price is often used as a proxy forquality by customers, particularly when the product is a luxury item.By pricing the champagne at the very low end of the range of compar-able product, the producer was signaling that its product was of lowerquality than the competition. And by raising the price, they signaledit was of higher quality.
So when you are selling something, be it advertising, software, orsomething else, think carefully about how you are signaling themarket with your pricing. Having the lowest price among yourcompetition might be the right strategy but it might also be the wrongone.
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Pro jec t i ons , Budge t ingand Forecas t ing
Projections, Budgeting andForecasting
MBA Mondays is starting a new topic this week. It's a big one and Ithink we'll end up doing at least four and maybe even five posts onthis topic in the coming weeks.
I said the following in one of my first MBA Mondays posts1:
companies are worth the "present value" of "future cashflows"
The point being that the past doesn't matter too much when it comesto valuing companies. It's all about what is going to happen in thefuture. And that requires projecting the future.
There is another big reason why projections matter. They are usedfor goal and expectation setting. Generally speaking goal setting isused to manage the team and expectation setting is used to managethe board, investors, and other important stakeholders.
And finally, projections matter because they tell you what your fin-ancing needs are. It is critical to know when you will need additionalfinancing so you can start planning and executing the process wellin advance of running out of cash (I like 6 months).
There are three important kinds of projections. I'll outline each ofthem.
1http://www.avc.com/a_vc/2010/01/valuing-stocks-today-and-tomorrow.html
1) Projections - These are a set of numbers, both financial and opera-tional, that you make about your business for various purposes, in-cluding raising capital. They are aspirational and are often done witha "what could be" perspective.
2) Budgets - These are a set of numbers, both financial and operational,that the management team prepares each year, usually in the fall, thatoutline what the company plans to achieve in the coming year. Theyare presented and approved by the board and the management team'scompensation is often driven by them.
3) Forecasts - These are iterations of the budget that are done intra-year by the management team to indicate what is likely to occur. Theyreflect the fact that the actual performance is going to vary frombudget (in both positive and negative ways) and it is important toknow where the numbers will actually end up.
Over the coming weeks, I will go through the processes companiesuse to project, budget, and forecast. Because I do not do this workmyself, I've enlisted one of our portfolio companies to help me withthese posts.
I've been working with Return Path2 for ten years now. Matt Blum-
berg3, CEO, and Jack Sinclair
4, CFO and sometimes COO, have done
over ten sets of projections, budgets, and forecasts for me and otherinvestors, board members, and team members. In the process theyhave evolved from a raw startup to a well oiled machine. With theirhelp, I will talk about the how three "model companies" go aboutprojecting, budgeting, and forecasting. These companies will be 10person, 75 person, and 150 person. These are the typical sizes ofcompanies that I work with and are probably also the sizes of compan-ies that most of the readers of this blog are dealing with.
I'll end this post with a picture that Matt sent me last week. This isten years worth of board books that include Return Path's projections,budgets, and forecasts. The goal of MBA Mondays in the coming
2http://www.returnpath.net/3http://twitter.com/mattblumberg4http://twitter.com/JSinclair
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weeks will be to get all of you to a place where you can create some-thing similar.
5
Scenarios
In last week's MBA Mondays1, I introduced the topic that we'll be
focused on for the next month or so; projections, budgeting, andforecasting. In that post, I described projecting as a "what if" exercisethat is done at a higher level of abstraction than the budgeting andforecasting exercises. I said this about projections:
These are a set of numbers, both financial and operation-al, that you make about your business for various pur-poses, including raising capital. They are aspirationaland are often done with a "what could be" perspective.
Since projections are not budgets and are much more "big picture"exercises, it is important to use a scenario driven approach to them.I generally like three scenarios; best case, base case, and worst case.But you could do as many scenarios as you like. It's not the results thatmatter so much, it's the process and the learning that comes from theprojections exercise.
5http://www.avc.com/.a/6a00d83451b2c969e20133ecf5a9ae970b-pi1http://www.avc.com/a_vc/2010/04/projections-budgeting-and-forecasting.html
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If you build your projections with a detailed set of assumptions andif you can assign probabilities to each assumption, you could easilydo a monte carlo simulation in which literally thousands, or tens ofthousands, of scenarios are run and the outcomes are charted on a bellcurve. I don't recommend doing projections this way, but my pointis simply that the number of scenarios is not important, it's the processby which you determine the key drivers of the business, the assump-tions about them, and the probabilities associated with them.
A few weeks ago on MBA Mondays we talked about key businessmetrics
2. It is very important to identify your key business metrics
before you do projections. These key business metrics will drive yourprojections and your assumptions about how these metrics will devel-op over time will determine how your scenarios play out.
Let's get specific here. I'll assume we are operating a software businessand we are selling the software as a service over the internet using afreemium model. Everyone can use a lightweight version of the soft-ware for free, but to get the fully featured version the user must pay$9.95 per month. So here are some of the key business metrics youmight use in projecting the business; productivity of the engineeringteam, feature release cycle, current outstanding known software bugs,total users, new free users per month, conversion rate from free topaid, marketing dollars invested per new free user, marketing dollarsinvested per new paid user; customer support incidents per day; costto close a customer support incident. These are just examples of keybusiness metrics you can use. Every business will have a different set.
The next step is to lay all of these metrics out in a spreadsheet andmake assumptions about them. As I said, I like three assumptions, bestcase, base case, and worst case. Best case is not the best it could everbe but best you think it will ever be. Base case is what you genuinelyexpect it to be. And worst case should be the worst it could ever be.Worst case is really important. This is your nightmare scenario.
You then calculate your costs and revenues as a function of thesemetrics. There are some expenses that will not vary bases on the as-
2http://www.avc.com/a_vc/2010/04/key-business-metrics.html
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sumptions. Rent is a good example of that in the short term. But overtime, rent will move up if you need to hire like crazy. I would go outat least three years in a projections exercise. Some people like to goout five years. I've even seen ten year projections. I don't think anytechnology driven business can project out ten years. I am not evensure about five years. I believe three years is ideal.
Getting the assumptions right and building up to a full blown projec-ted profit and loss statement
3 is an iterative process. You will not get
it right the first time. But if you build the spreadsheet correctly theiterating process is not too painful. Do not do this exercise all byyourself. It should be done by a team of people. If you are a one personcompany right now, then show the results to friends, advisors, poten-tial investors. Get feedback on your key business metrics, assumptions,and results. Think about the results. Do they make sense? Are theyachievable?
In last week's comment thread we got into a conversation about "topdown" vs "bottom up" analysis. Top down is when you say "the marketsize is $1bn, we can get 10% of it, so we'll be a $100mm business." Ithink top driven analysis is not very rigorous and likely to producebad answers .The kind of projection work I've been talking about inthis post is "bottom up" and is based on what can actually be achieved.However, it is often best to take the results of a bottom up analysisand do a reality check using a top down analysis.
So when your best case scenario has your business at $100mm inrevenues in year three, do yourself a favor and do a top down realitycheck on that. No matter how rigorous the projections process is, ifthe results are not believable then the whole exercise will have beenwasted.
Most entrepreneurs do projections as part of a financing process. Andit is a good idea to have projections for your business when you goout to raise money. But I would advise entrepreneurs to do projectionsfor themselves too. It is a good idea to have some idea of what you are
3http://www.avc.com/a_vc/2010/03/the-profit-and-loss-statement.html
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building to. Make sure it is not a waste of time for you and the teamyour recruit to join you.
It is true that most great tech businesses, possibly all businesses, areinitially built to "scratch an itch."
4 But once you get past the "I built
this because I wanted it" and when you find yourself hiring people,raising capital, renting space, it's time to think about what you aredoing as a business and having solid projections and a few scenariosis a really good way to do that.
Budgeting in a Small Early StageCompany
Today and for the next two weeks, we are going to talk aboutbudgeting on MBA Mondays. Since the budgeting process works dif-ferently in companies of various sizes, we are going to focus on threecompany sizes; 10 people, 75 people, and 150 people. Today we willtalk about the 10 person company scenario.
As I said in a previous post1, I have been working with Matt Blumberg
and Jack Sinclair, CEO and COO/CFO of our portfolio company Re-turn Path
2 on these budgeting posts. I have been involved with Return
Path for ten years now and I've watched Matt and Jack run excellentbudgeting processes and so we are getting the benefit of their workand learning in these posts.
Last week we talked about projections3. It is important to run a pro-
jections process before you turn to budgeting. Think of budgeting asa refinement of the projections process where the goal is to predictwhat is going to happen in a particular calendar year.
4http://www.paulgraham.com/organic.html1http://www.avc.com/a_vc/2010/04/projections-budgeting-and-forecasting.html2http://www.returnpath.net/3http://www.avc.com/a_vc/2010/05/scenarios.html
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I believe that budgeting should be done on a yearly basis. If you wantto start budgeting and you are in the middle of the year, that is fine.Just budget for the rest of the year and then do your first full yearbudget in the late fall.
The late fall is budgeting time. October and November are the bestmonths to do it. If you have a board, you should be able to presentyour budget for the next year to the full board in December so theycan approve it before the year starts. If you don't have a board, thenyou should be able to lock into a budget with your team in December.
The budgeting process starts with a financial model. If you have doneprojections, then you should have a financial model already built. Ifhaven't done projections, then go back to the projections post
4, follow
the directions, and do some projections. Then come back and readthis post.
The first step in budgeting is to review the key business metrics andlock them down based on what is realistic for the next year. Be veryrealistic. A good budget is a conservative budget. In a ten personcompany, the budgeting process can be done by a couple of the seniormanagers, typically the CEO and the most financially savvy of theother team members. These two people can run the process all bythemselves without any input from the rest of the team. That willchange quickly as the company grows, but in a very small companyyou do not need to involve the entire team in budgeting.
If the company is pre-revenue as many 10 person companies are, thenthe focus will be on hiring and people costs. And the budgeting processwill largely be about spending and how many people the companycan hire and how much money the company can spend and how longits cash will last before needing another round of funding.
If the company has revenues, they will not likely be large yet at 10people, so the revenue forecast will be a bit tricky. In the first fewyears of revenue generation, the revenue model changes a lot and thedrivers of it change too. I would encourage everyone to be conservat-
4http://www.avc.com/a_vc/2010/05/scenarios.html
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ive about revenue budgeting early in a company's life. Most budgetsare missed because revenue does not come in as planned.
Make sure to include a cash line item in your budget. Most budgetsare done as profit and loss statements which is how they should bedone. But you should back into a cash projection based on the profitand loss numbers and include that line item in your budget. If this isnew material to you, go back to my posts on profit and loss
5, balance
sheet6, and cash flow
7 to see how these three statements work together.
Once the budget has been locked down and approved by the boardand/or by the senior team, you should share the budget with yourentire company. Some executives don't like to share the entire lineby line budget with the team and I can understand that. Some execut-ives don't like to show a cash line that runs out with the team and Ialso understand that. But you should at least show the key businessmetrics and some of the most important line items in the budget withthe entire company. This will be their roadmap for the next year andit is important that they understand it if they are going to be expectedto help you deliver it.
All that said, I favor being as transparent as you can possibly be withyour company. It is hard to hide information from the company. Theimportant information leaks out eventually and if and when it does,you won't be there to provide context. So the more information youprovide, the better off you will be.
Once you have a budget, you need to measure yourself against it. Eachmonth report the actual numbers versus the budget and track howyou are doing against each key business metric and line item in thebudget. At some point during the year, you may want to do a refore-cast. We will talk about that exercise in a few weeks.
Next week we will talk about how this process changes as you growto 75 people. It a very different process at that point.
5http://www.avc.com/a_vc/2010/03/the-profit-and-loss-statement.html6http://www.avc.com/a_vc/2010/03/the-balance-sheet.html7http://www.avc.com/a_vc/2010/03/cash-flow.html
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Budgeting in a Growing Company
I failed to post a MBA Mondays post last monday. Sorry about that.I had something else on my mind when I woke up, wrote about that,and didn't realize that it was monday and I was supposed to do anMBA Mondays post until late in the afternoon.
So we are now picking up from where we left off two weeks ago.Which is in the middle of a four to six post series on projections,budgeting, and forecasting. We covered budgeting in a small company
1
two weeks ago. We are now going to talk about what happens to thebudgeting process once revenues start coming in, headcount gets tobetween 50 and 100 employees, and you are now a full fledged highgrowth business.
Once you have real revenues, 50+ employees, and a real business, youshould have a full time finance person on your team. It could be a CFOor it could be a VP Finance. There are tradeoffs between the two. Ifyou think you are going to be an independent company for a longtime that will go public or do a large number of private financingsand M&A transactions, then you will want a CFO. If you plan to keepthe business simple and head for the exits within a few years, a VPFinance should be fine. I should do a post on the difference betweena CFO and a VP Finance and I will, but this is not the time for it.
So your budgeting process should start with your lead finance person.He or she should run the process with you as their partner. Yourbudgeting team should also include the leader of your sales or revenueoperation and your head of engineering or tech ops if you have one.The way I like to think of these two people is the person who "owns"revenues and the person who "owns" capex. This group is sufficientto run a budgeting process in a 50 to 100 employee company.
1http://www.avc.com/a_vc/2010/05/budgeting-in-a-small-early-stage-company.html
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There are three inputs to the budgeting process in a company of thissize; a detailed revenue plan/model, a comprehensive cost model in-cluding headcount, and a set of key performance indicators (KPIs).
Start with the revenue plan/model and do it bottoms up (meaningidentify where the revenue is going to come from and how much ofit you are going to be able to pull in during the year). The sales leaderwill give you a plan that he or she thinks they can hit. Dial it back. Asmuch as I love sales leaders, they are optimists. Very few of them canproperly estimate revenue in a high growth relatively early stagecompany. I believe they generally do a good job of identifying wherethe revenue will come from but a poor job of estimating how muchof it will come in during your time frame. Things always take longer.So dial the sales leader's numbers back.
Then once you have a set of revenue numbers, lay out all the KPIsthat it will take to hit them. What is needed from the product team?What is needed from the engineering team? What is needed from thebus dev team? What is needed from marketing, customer service, HR,etc? The KPIs are the glue between the top line model and the costmodel. Spend a lot of time on this part of the process.
Going from KPIs to a comprehensive cost model is not that hard, es-pecially for a seasoned finance person. The key is being comprehens-ive. If you are growing headcount aggressively, will your currentspace be sufficient? If not, you'll need numbers for more space. Thingslike legal and recruiting costs really start to pile up at this stage. Theymay not be very large in your historical financials. Plan for them andbudge them.
And make sure to budget for capex costs. Some companies rent theircapex via leases or managed hosting. If you do this, your capex willshow up in your operating costs. Some companies acquire their capexwith cash. If you do this, your capex will show up on your balancesheet. Either way, capex can eat up a lot of cash. So budget for it cor-rectly and make sure your engineering or tech ops leader is held ac-countable to the capex budget.
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In my last post on this topic, I said that budgeting time is October andNovember so that the board can approve it in December. That isgenerally true for a 10 person company but not for a 50 to 100 personcompany. I like to see budgeting start in September for a company ofthis size and I like to see the Board look at the budget in November.That way if there is a disconnect between management and the Board,another revision to the process can occur before the year starts onJan 1st.
The budget is not just for the Board. It is first and foremost for theteam. So make sure to share the budget with the team and make surethey are all bought into it. If they are uneasy about it, listen to themand don't force a plan on the team that they do not think they can hit.
A company at this stage will have a senior team and they should beaccountable to the budget. They may even have incentive comp asso-ciated with the budget goals. I like to see the entire senior team parti-cipate in the budget presentation to the Board. I like all of them totalk to their parts of the budget. That shows they understand it, theyhave bought into it, and they are behind it.
To be brutally honest, very few budgets are met in companies of thissize. These businesses are still very much in flux and things change alot during a year. But I still believe in the value of doing budgets. Theprocess is incredibly helpful in establishing what can be done andwhat can't be done. It focuses the mind and the company. And if yourealize half way through the year that you are not going to meet yourbudget, you can and should do a forecast. We'll talk about that in afew weeks.
Next up is budgeting in a 150+ person company. We'll do that nextMonday assuming I don't have another brain fade.
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Budgeting in a Large Company
Last week we talked about budgeting in a growing company1. I defined
that as a company between 50 and 100 employees. Today we are goingto wrap up the budgeting series by talking about what happens to theprocess when you get to be a "big company." The context for the wholeof this MBA Mondays series of posts is the world of entrepreneurialstartups so "big company" means 150 employees or more to me. Thebiggest companies that I actively work with are between 150 employ-ees and 1000 employees. Once they get bigger than that, they arebeyond my ability to comprehend them and help them.
The process of budgeting in a large company doesn't differ that muchfrom a growing company. If you haven't read that post, please go backand read it
2.
The budgeting process is still led by the financial leader of the com-pany (VP Finance or CFO but by this stage you are likely to have aCFO) and the CEO. But the team that runs the budgeting process nowincludes the entire senior team. That is because each senior teammember has control over a meaningful team and piece of the business.So you have to get them all involved in the budgeting process.
It's also increasingly likely that your revenues are coming from anumber of lines of business so you will want to do a more detailedrevenue forecast with attention to each segment of revenue. Yoursales leader will still be responsible for the revenue forecast, but heor she will need help from the finance leader and often from othersenior team members to put the revenue forecast together.
You will continue to use KPIs as a bridge between the revenue budgetand the cost budget, but the creation of the KPIs and the forecast ofthem is now driven by the entire senior team. As I said in last week's
1http://www.avc.com/a_vc/2010/05/budgeting-in-a-growing-company.html2http://www.avc.com/a_vc/2010/05/budgeting-in-a-growing-company.html
58P r o j e c t i o n s , B u d g e t i n ga n d F o r e c a s t i n g
post, this is the most important part of the budgeting process so makesure to give the senior team ample time to get the KPIs right.
Cost budgeting in a large company is a much more exhaustive process.The cost budget has a lot more detail and input into it. It is an iterativeprocess where each senior team member brings a cost budget fromhis or her team and the finance leader integrates it all together andthen negotiates with the senior team members to get the numberswhere they need to be. This is where entrepreneurial budgeting startsto feel like big company budgeting.
One thing that many companies start doing at this stage is benchmark-ing their budget numbers versus others in their industry sector. Thisis mostly done with public company numbers since getting detailedfinancials on privately held companies is difficult. It is helpful to lookat what your competitors or similar companies are spending as apercent of revenues on the various parts of the business. And it ishelpful to look at how profitable their businesses are versus yours.
As you can see, the primary difference between the budgeting processin a growing company and a large company is the amount of involve-ment, interaction, and iteration among the senior team. This all takestime. So start the budgeting process by labor day, if not a bit sooner.It will take three months to do this right. You'll want your budgetready for a board review in mid to late November so there is time todo one more iteration before year end if that is necessary.
The budgeting process is really critical in a large company. It forcesthe company to make highly informed decisions about investmentsand resource allocation and it creates company wide discipline aroundhitting goals. I have never seen a company of 150 employees or moreoperate functionally without a strong budget process.
I'd like to again thank Matt Blumberg3 and Jack Sinclair
4 of our
portfolio company Return Path5 for their help with these budgeting
posts. I have watched them go through all of the various stages over
3http://twitter.com/mattblumberg4http://twitter.com/jsinclair5http://returnpath.net/
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the years and their planning and budgeting has been stellar. Theirinsights were invaluable to me in putting the "how to" parts of theseposts together.
Next week we'll talk about what happens when the reality starts di-verging from the budget - forecasting.
Forecasting
This is the final post in a long MBA Mondays1 series on projections,
budgets, and forecasts. Today we will talk about what happens whenreality starts to differ from what you've budgeted - you re-forecast.
Let's go back to the framework I laid out at the start of this series.Projections are long-term high level efforts to establish the scope ofthe opportunity. Budgets are an effort to establish an operatingframework for the coming year. And forecasts are done intra-year toestablish what is likely to happen. As someone said in the comments,it's "long term, short term, and real-time."
Forecasts are typically done mid-year but they can and should be donewhenever the actual performance differs significantly from what wasbudgeted. Forecasts are not an attempt to throw out the budget. Thecompany should continue to measure itself and report against thebudget. The forecast should exist beside the budget and show whatmanagement thinks is likely to happen.
Forecasts are important for a variety of reasons but first and foremostyou want to know where your cash balances will actually be. Andyou'll want to know where you will be on your revenue growth tra-jectory. If you are planning on doing a financing, forecasts are import-ant because they will give you an indication of what the metrics in-vestors will be using when they offer you terms for a financing.
1http://www.avc.com/a_vc/mba-mondays/
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The process of doing a forecast is not very hard. You simply take themodel you used for budgeting and put new numbers in for revenuesand costs. The way most forecasts go down is the revenues are takendown to reflect slower sales growth. Then management looks at thecosts in the budget. In some cases, costs are not adjusted becausemanagement feels that they need to continue to invest in the business.But in many cases, costs are adjusted down somewhat to reflect a desireto conserve cash. Either way, you'll have a new set of numbers for themonths ahead.
You combine these new sets of numbers for the coming months withthe actual results for the months that have already happened and youhave your forecast.
Once you do a forecast, it is a good idea to keep updating it as the yeardevelops. If you do a forecast at mid-year and by the fall that forecastis off, do another forecast. The forecast is not another budget youhave to try to meet. It is an attempt to estimate actual results. So keepadjusting the forecast in an attempt to nail it.
As you get into the fall, you will start budgeting for the next year.Use the learning that came from the forecasting exercise to make nextyear's budget better. Think of budgets and forecasts as agile financialmanagement. The budget is the annual release and the forecasts arethe iterations based on feedback.
So that's it. We are now done with projections, budgeting, and fore-casting. Next week we'll tackle a new topic.
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R i sk and Return
Risk and Return
One of the most fundamental concepts in finance is that risk and re-turn are correlated. We touched on this a tiny bit in one of the earlyMBA Mondays posts
1. But I'd like to dig a bit deeper on this concept
today.
Here's a chart I found on the Internet2 (where else?) that shows a bunch
of portfolios of financial assets plotted on chart.
3
As you can see portfolio 4 has the lowest risk and the lowest return.Portfolio 10 has the highest risk and the highest return. While youcan't draw a straight line between all of them, meaning that risk and
1http://www.avc.com/a_vc/2010/02/the-time-value-of-money.html2http://bogltd.com/BOG_OPTIMALPORTS.html3http://www.avc.com/.a/6a00d83451b2c969e20133f0ec969e970b-pi
return aren't always perfectly correlated, you can see that there is adirect relationship between risk and return.
This makes sense if you think about it. We don't expect to make muchinterest on bank deposits that are guaranteed by the federal govern-ment (although maybe we should). But we do expect to make a bigreturn on an investment in a startup company.
There is a formula well known to finance students called the CapitalAsset Pricing Model
4 which describes the relationship between risk
and return. This model says that:
Expected Return On An Asset = Risk Free Rate + Beta (Expect MarketReturn - Risk Free Rate)
I don't want to dig too deeply into this model, click on the link on themodel above to go to WIkipedia for a deeper dive. But I do want totalk a bit about the formula to extract the notion of risk and return.
The formula says your expected return on an asset (bank account,bond, stock, venture deal, real estate deal) is equal to the risk free rate(treasury bills or an insured bank account) plus a coefficient (calledBeta) times the "market premium." Basically the formula says themore risk you take (Beta) the more return you will get.
You may have heard this term Beta in popular speak. "That's a highbeta stock" is a common refrain. It means that it is a risky asset.Beta
5 (another Wikipedia link) is a quantitative measure of risk. It's
formula is:
Covariance (asset, portfolio)/Variance (portfolio)
I've probably lost most everyone who isn't a math/stats geek by now.In an attempt to get you all back, Beta is a measure of volatility. Themore an asset's returns move around in ways that are driven by theunderlying market (the covariance), the higher the Beta and the riskwill be.
4http://en.wikipedia.org/wiki/Capital_asset_pricing_model5http://en.wikipedia.org/wiki/Beta_coefficient
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So, when you think about returns, think about them in the contextof risk. You can get to higher returns by taking on higher risk. Andto some degree we should. It doesn't make sense for a young personto put all of their savings in a bank account unless they will need themsoon. Because they can make a greater return by putting them intosomething where there is more risk. But we must also understandthat risk means risk of loss, either partial or in some cases total loss.
Markets get out of whack sometimes. The tech stock market got outof whack in the late 90s. The subprime mortgage market got out ofwhack in the middle of the last decade. When you invest in thosekinds of markets, you are taking on a lot of risk. Markets that go upwill at some point come down. So if you go out on the risk/rewardcurve in search of higher returns, understand that you are taking onmore risk. That means risk of loss.
Next week we will talk about diversification. One of my favorite riskmitigation strategies.
Diversification
I was talking to a friend over the weekend and he told me a storyabout a person he knows who made hundreds of millions of dollarsof net worth in his career and then lost it all. I asked my friend howthat could happen. He said "he made a lot of risky bets and none ofthem worked out."
I don't get how anyone could do that to be honest. I don't understandhow someone gives Madoff all of their money to manage for them.When someone has very little to lose, I totally get betting it all andgoing for it. But when you have accumulated a nest egg or more, youmust be diversified in your investments and assets. You cannot putall of your eggs in one basket.
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Last week on MBA Mondays, we talked about Risk and Return1. I
made the point that risk and return are correlated. If you want tomake higher returns, you must take on higher risk. But you can mit-igate that risk by diversification. And this post is about that strategy.
One of the things most everyone learns in business school is portfoliotheory
2 (that's a wikipedia link if you want to learn more). Portfolio
theory says that you can maximize return and minimize risk bybuilding a portfolio of assets whose returns are not correlated witheach other.
Let's use some real life examples. Let's say you have a portfolio ofstocks and all of them are tech companies. To some degree, they areall correlated. When the tech bubble blew up in March of 2000, everytech stock went down. So if you had that portfolio, your portfoliowent down big. Let's say you have a portfolio that has some techstocks, some oil stocks, some packaged goods stocks, some real estate,some bonds, and some cash in it. When the tech bubble bursts, youget hit, but your portfolio does not "blow up." That is the power ofdiversification at work.
I have my own tech bubble story that is similar to that example. Whenthe Gotham Gal and I moved back to NYC in the late 90s, we boughta large piece of real estate in lower manhattan from NYU. We sold abig slug of Yahoo stock that we got in the sale of Geocities to fund thepurchase. And then we sold another big slug of Yahoo stock to funda complete renovation of that real estate. Beyond those two sales, wedid not get liquid on most of our internet and tech stocks because ourfunds were locked up on almost everything else.
When the bubble burst, our net worth dropped 80% to 90%. But itcould have dropped 100%. That real estate did not drop in price. Itactually increased by 2.5x over the eight years we owned it. That isthe power of diversification at work.
Of course, we learned our lesson from that experience. We now havea fairly diversified portfolio of assets that includes venture capital
1http://www.avc.com/a_vc/2010/06/risk-and-return.html2http://en.wikipedia.org/wiki/Modern_portfolio_theory
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investments, real estate investments, hedge funds, and municipalbonds. I am not suggesting that our mix is a good mix. I suspect wecould be much more conservative and more "efficient" with our assetallocation if we hired a professional financial planner to do this workfor us.
But this post is not really about our portfolio construction or evenabout asset allocation. It is about the power of diversification as a riskmitigator.
Let's talk about diversification in venture capital funds. Making "oneoff" early stage venture capital investments is a bad idea. The chancethat you will pick a winner in early stage venture capital is about onein three. I've said many times on this blog that one third of our invest-ments will not work out at all, one third will work but will not beinteresting investments. And all of our returns will come from theone third that actually work out. If you are making "one off" earlystage investments and make five or six investments over the courseof a few years, you do not have enough diversification. You couldeasily pick five or six investments and not once get to the one thirdthat work.
We put 21 investments into our 2004 fund and I believe we will putbetween 20 and 25 investments into our 2008 fund. With that numberof investments, we have a good chance of finding one investment thatwill be good enough to return the entire fund. And we have a goodchance of finding another four or five investments that will returnthe fund again. We can handle a complete wipe out on between fiveand ten investments and still produce excellent returns. That is howdiversification helps to manage risk in an early stage venture portfolio.
So if you are building a portfolio of anything, be it financial assets oranything, make sure to fill it with things that are not too similar andnot too correlated with each other. To do otherwise is not prudent.
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Hedging
This is the third in a series of MBA Mondays1 posts about risk and
return. Last week we talked about diversification, my favorite formof risk mitigation. This week we are going to talk about another fa-vorite risk mitigation method of mine - hedging.
There are different types of investors in any highly developed andliquid market. There are speculators who are looking to make riskybets and you can use them to reduce your risk by taking the oppositeside of those bets. Doing this is called hedging.
Let's go through some real world examples. The simplest one isshorting a stock that you own. Let's say you own 1,000 shares of Applethat you bought during the 2008 market break at $75/share. The Appleshares are now at $267/share and you are worried that the iPhone 4reception problems are going to hurt the stock in the short term. Youcould sell the stock, but you really don't want to. So you can short1,000 shares of Apple for as long as you are nervous.
The way shorting a stock works is someone who also owns the stockloans you the shares and you sell them. You promise to give themback the stock at some future date. You pocket the $267,000 you getfrom selling the Apple stock but you have a liability which is youhave to give the stock back to the person or institution who loanedit to you. Fortunately, you still own the stock you originally purchasedso you can always pay back the loan in the stock you own. If the stockgoes down, you can use some of the $267,000 you got in the sale ofstock to buy back the Apple stock at a lower price and use that to repaythe loan. If the stock goes up, you are losing money on your short,but making exactly the same amount on the stock you originallybought.
1http://www.avc.com/a_vc/mba-mondays/
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In this scenario, you have hedged your risk of the stock going down,but you are also not going to make any money if the stock goes up. Itis like you sold the stock except that you still have your original stockin your possession. You are perfectly hedged except for counterpartyrisk, which are risks brought on by the other party to your hedgingtransaction. In this case, counterparty risk is pretty low.
Another form of hedging involves options. There are two primaryforms of options, puts and calls. A put option gives you the option of"putting" your stock to someone else at a specific price. A call optiongives you the option of "calling" a stock from someone else at a specificprice.
Let's continue this example of Apple stock at $267/share. Instead ofshorting the stock you can use options to hedge your position. Thesimplest form of a hedge is to buy a put to protect your downside.Let's say you want to make sure you get $250/share for your Applestock no matter what. You can buy a put that allows you to "put" yourApple stock for $250/share until August 10th (a little more than 5weeks) for $27. If that happens, you actually are getting $223/sharebecause you'll get $250/share but you had to pay $27 for the call. Thatis the purest form of downside protection. It is expensive, but you getto keep all of the upside on the stock. And there is counterparty riskbecause if the person selling you the put goes out of business, theywon't be there to honor the call.
If you are willing to give up some upside, then a better approach isthe "collar". In this trade you buy a put and sell a call. The August 10thApple put at $250 is trading at $27 right now. To finance that cost,you can sell an Aug 10th Apple $280 call for $24. You are still out$3/share but it is must less expensive insurance. However, if the stockgoes up to $280, it can get called from you.
I got all these option prices from the CBOE's website2. These are the
current prices as of Monday morning before the markets open. Theseprices will move around a lot, reflecting both the price of Apple stock,
2http://www.cboe.com/delayedquote/quotetable.aspx
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the remaining time until expiration of the option, and the volatilityof the stock.
If you think about the collar, it is a lot like shorting a stock you alreadyown. You are protected if the stock goes down but you aren't goingto make much if the stock goes up.
When our venture capital firm finds itself with a lot of public stockthat we cannot sell for one or more reasons and we want to protectourself from downside risk, we like to use a collar. You can use tradedoptions, like the ones I am quoting from the CBOE. Or you can get atrading desk at a major brokerage firm to create synthetic options foryou. No matter what you do with collars, it is going to cost something.You are purchasing insurance and insurance has a cost.
It is important to remember the counterparty risk when you arehedging. No hedge is any good if the other party to the transaction isnot there to settle up. It is like buying insurance. You want to buyinsurance from a highly rated carrier and you want to do hedgingtransactions with financially secure and stable counterparties. Whatconstitutes that these days is another issue.
In summary, when you have a large gain on your hands, think abouttaking some of that gain off the table by selling it and diversifying. Ifyou can't do that for one reason or another (taxes is a common one),think about a hedging transaction.
Currency Risk in a Business
I'm in europe this week, using euros for everything instead of dollars.So I thought it would be an appropriate time to talk about currencyrisk in a business.
When you have a business that only generates revenues in your localcurrency, you don't have to concern yourself with the fluctuationsof one currency versus another. But if you start generating revenues
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in other currencies, or if you open an office outside of your countryand start generating expenses in other currencies, you will have tostart thinking about currency risk.
First, let's talk a little about currencies and how they fluctuate againsteach other. Since I'm spending euros this week, let's look at the past120 days of price action in dollar/euro:
1
So let's say that 20% of your company's revenues are euro denominated.And let's say that your business is doing $10mm a year in revenues.So about $2mm in US dollars of your revenue is in euros. And let'ssay that was the case at the beginning of the year. At that time, theexchange rate was about .7 euros to 1 dollar. So your business wasgenerating 1.4mm euros in revenues. Since the start of the year, theeuro has dropped and now you get .8 euros for every dollar. So if yourbusiness is still generating 1.4mm euros in revenues, that is now only$1.75mm dollars of revenue per year. You are still selling just as muchin euros, but your annual revenues in dollars has dropped $250,000in six months. That is how currency fluctuations can impact a business.
Let's do the same analysis, but this time with expenses. If at the startof the year, you had $2mm in annual expenses in a euros because youhave an office in europe with employees, rent, etc, then you had 1.4mmeuros in annual expenses. By June of this year, those expenses have
1http://www.avc.com/.a/6a00d83451b2c969e2013485372d3a970c-pi
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dropped to $1.75mm, saving your company $250,000 in annual ex-penses.
What this example shows is the primary lesson of currency risk inbusiness. It is ideal to have your foreign currency denominated ex-penses and revenues be as close to each other as possible. Because ifyou can do that, they are a natural hedge. If our examples are com-bined, and you have $2mm of revenues and $2mm of expenses in euros(a breakeven business in euros), then your profits will not be impactedby currency fluctuations. Your revenues might go up or down, butyour profits will be immune.
If you cannot match foreign currency denominated revenues andexpenses, then you will have risk to your business. If the foreigncurrency revenues and/or expenses are small (measured in the millionsor less), then you should not do anything about this risk. Just under-stand that you have the risk and live with it.
But if your unmatched foreign currency denominated revenues and/orexpenses are in the tens of millions of dollars or more, then you canhedge the risk. As I explained in last week's post
2, there are a number
of hedging strategies that you can put in place to manage this risk.There are currency desks at the major money center banks and globalbrokerage firms that specialize in hedging currency risk for companiesand they will be happy to put in place currency hedges for you.Hedging currency risk can get expensive, which is why I don't recom-mend it for small companies, but for large companies with significantcurrency risk, it is standard business practice and it is very common.
For many entrepreneurs, currency risks are not going to be somethingto worry at the start of the business. But we see most of our portfoliocompanies start thinking about international expansion about fiveyears into the development of their business. They open an officeoutside the US and start generating non dollar denominated expenses.In time, they start generating non dollar denominated revenues. Atsome point, these amounts become significant and the CFO has tostart thinking about currency risk. If you get to that point in your
2http://www.avc.com/a_vc/2010/06/hedging.html
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business, think of it as a good sign. Something to manage for sure, buta sign that the business is on the right trajectory.
Purchasing Power Parity
Continuing the international theme, we are going to talk about Pur-chasing Power Parity
1 today on MBA Mondays
2. I learned about
purchasing power parity in business school and it has always helpedthink about international exchange rates. The theory is far fromperfect and fails miserably in many situations, but I still think thebasic construct of purchasing power parity is something everyone inbusiness should understand.
The basic concept is this: a basket of goods that are traded betweenmarkets should cost the same in different markets. My favorite ex-ample is the "Big Mac Index
3" which is calculated and published annu-
ally by The Economist4. If a Big Mac costs $4 in the US and 3 pounds
in the UK, then the proper exchange rate between the two currenciesshould be four dollars to three pounds which works out to be 1.33dollars per pound.
The reason I like the Big Mac index is it is simple to understand. ABig Mac is not a "basket of goods" however and a more comprehensivebasket of goods is normally used to calculate purchasing power parityof different countries.
That said, I will use the Big Mac index one more time to explain howpurchasing power parity can be used to determine of a currency isovervalued or undervalued. This example comes from wikipedia:
1http://en.wikipedia.org/wiki/Purchasing_power_parity2http://www.avc.com/a_vc/mba-mondays/3http://en.wikipedia.org/wiki/Big_Mac_Index4http://www.economist.com/markets/bigmac/
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Using figures in July 2008:
• the price of a Big Mac was $3.57 in the US
• the price of a Big Mac was £2.29 in the United Kingdom (Britain)(Varies by region)
• the implied purchasing power parity was $1.56 to £1, that is$3.57/£2.29 = 1.56
• this compares with an actual exchange rate of $2.00 to £1 at thetime
• [(1.56-2.00)/2.00]*100= -22%
• the pound was thus overvalued against the dollar by 22%
This is important to understand. If two baskets of goods should costthe same in different markets and they don't, then the implication isthat one currency is overvalued relative to another and that differencewill eventually unwind itself.
Let's look at China versus the US. The International Monetary Fund(IMF) estimated in 2008 that one US dollar was worth 3.8 yuan usingpurchasing power parity. And yet the official exchange rate at thattime was one dollar for 7 yuan. That situation has not changed much.The yuan dollar exchange rate is now one dollar of 6.8 yuan.
What this means is that US made goods are more expensive in Chinathan they should be using purchasing power parity as a guide. AndChinese goods are less expensive in the US than they should be usingpurchasing power parity as a guide. If the dollar yuan exchange ratewas allowed to move entirely with market forces, the theory of pur-chasing power parity says that the exchange rate should move toaround 4 yuan to the dollar. Until that happens, this price discrepancywill remain.
There are all sorts of problems with purchasing power parity but Iwill not go into them here. The basic concept makes sense to me and
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is used widely in international economics. It is worth understandingas it provides a basic framework for how currencies can and shouldmove relatively to each other.
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Bus ines s Cos t s
Opportunity Costs
We are going to turn our attention on MBA Mondays1 to some costs
that are important to recognize in business. First up is OpportunityCost.
Opportunity Cost is the cost of not being able to do something becauseyou are doing something else. These costs don’t end up on your incomestatement but they are expensive, particularly in a small businesswhere you have very few resources.
Let’s use an example. Assume you have three software engineers onyour team and you commit to building a new product that ties allthree of them up completely for six months. Not only do you committo build that product, but you sell it in advance and take a depositfrom your customer to fund the development. And then an evenbigger opportunity comes your way. You have been invited to builda version of your product that will ship in a hot new device that amajor computer company is making a big bet on. But you can’t takeon that project because your team is tied up on the first project.
So the cost of the first project is not only the time and salaries of thethree software engineers who are working on it. It is also the lostrevenues and market share you might have gotten if you had beenable to work on the partnership on the new device. That is your op-portunity cost.
The problem with opportunity costs is that you can’t predict ormeasure them very well. They become painfully obvious in hindsightbut not at the decision point when you need to know their magnitude.
1http://www.avc.com/a_vc/mba-mondays/
So what do you do about opportunity costs that are out there but youcan't see or measure? That's a tough one. I like what my friendGretchen Rubin
2 said on the subject
3:
I also try to ignore opportunity costs. I can become para-lyzed if I think that way too much. Someone once told me,of my alma mater, “The curse of Yale Law School is todie with your options open” – meaning, if you try topreserve every opportunity, you can’t move forward.
So my advice is to understand the concept of opportunity costs, buildthem into you mental map, but don't focus too much on them. If youcan, try to build some flexibility into your organization so you aren'tcompletely resource constrained. That will reduce opportunity costs.But at the end of the day, you need to "move forward" in Gretchen'swords and that is first and foremost what all great entrepreneurs do.
Sunk Costs
Today on MBA Mondays1 we are going to talk about another form
of costs; Sunk Costs.
Sunk Costs are time and money (and other resources) you have alreadyspent on a project, investment, or some other effort. They have beensunk into the effort and most likely you cannot get them back.
The important thing about sunk costs is when it comes time to makea decision about the project or investment, you should NOT factorin the sunk costs in that decision. You should treat them as gonealready and make the decision based on what is in front of you interms of costs and opportunities.
2http://twitter.com/gretchenrubin3http://www.psychologytoday.com/blog/the-happiness-project/201006/what-is-opportunity-cost-does-it-matter-happiness-yes
1http://www.avc.com/a_vc/mba-mondays/
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Let's make this a bit more tangible. Let's say you have been fundinga new product effort at your company. To date, you've spent sixmonths of effort, the full-time costs of three software developers, oneproduct manager, and much of your time and your senior team's time.Let's say all-in, you've spent $300,000 on this new product. Those costsare sunk. You've spent them and there is no easy way to get that cashback in your bank account.
Now let's say this product effort is troubled. You aren't happy withthe product in its current incarnation. You don't think it will workas currently constructed and envisioned. You think you can fix it, butthat will take another six months with the same team and same effortof the senior team. In making the decision about going forward orkilling this effort, you should not consider the $300,000 you havealready sunk into the project. You should only consider the additional$300,000 you are thinking about spending going forward. The reasonis that first $300,000 has been spent whether or not you kill the project.It is immaterial to the going forward decision.
This is a hard thing to do. It is human nature to want to recover thesunk costs. We face this all the time in our business. When we haveinvested $500,000 or $5mm into a company, it is really easy to get intothe mindset that we need to stick with the investment so we can getour money back. If we stop funding, then we write off the investmentalmost all of the time. If we keep putting money in, there is a chancethe investment will work out and we'll get our money back or evena return on it.
Even though I was taught about sunk costs in business school twenty-five years ago, I have had to learn this lesson the hard way. Most ofthe time that we make a follow-on investment defensively, to protectthe capital we have already invested, that follow-on investment ismarginal or outright bad. I have seen this again and again. And so wetry really hard to look at every investment based on the return onthe new money and not include the capital we have already investedin the decision.
B u s i n e s s C o s t s79
This ties back to the discussion about seed investing and treating seedinvestments as "options." Every investor, if they are rational, willlook at the follow-on round on its own merits and not based on thecapital they already have invested. But the venture capital businessis a relatively small world and reputation matters as well. Those in-vestors who make one follow-on for every ten seeds they make willget a reputation and may not see many high quality seed opportunitiesgoing forward. Our firm has followed every single seed investmentwe have made with another round. In most cases, those investmentshave been good ones. But we have made a few marginal or outrightbad follow-ons. We do that for reputation value as much as anythingelse. We measure that value and understand that is what we are doingand we keep those reputation driven follow-ons small on purpose.
When it is time to commit additional capital to an ongoing projector investment, you need to isolate the incremental investment andassess the return on that capital investment. You should not includethe costs you have already sunk into the project in your math. Whenyou do that, you make bad investment decisions.
Off Balance Sheet Liabilities
In the past couple weeks we’ve talked about some costs that don’t al-ways appear on the income statement; opportunity costs
1 and sunk
costs2. Today, I’d like to talk about some liabilities that don’t appear
on the balance sheet. The technical term for them is “off balance sheetliabilities” and they are something to be very wary of as an investor.
When you think about investing in a business, whether it is a publicstock you can buy via Schwab, or a mature business you are acquiringwith debt financing in a leveraged purchase transaction, or a growthcompany you are investing in, or even a young startup, you shouldtake a close look at the balance sheet. You should see what obligations
1http://www.avc.com/a_vc/2010/07/opportunity-costs.html2http://www.avc.com/a_vc/2010/07/sunk-costs.html
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that company has built up over the years and how they compare tothe company’s assets. When the liabilities are large and the assets arenot and if the cash flow is weak or non-existent, then you should beextremely cautious because those liabilities can sink the company.We talked a bit about this in the post I did on financial statementanalysis
3 and the balance sheet
4.
But sometimes companies don’t put all of their obligations on thebalance sheet. There are at times valid reasons for this, but there aretimes when the company is just trying to pull a fast one on the investorcommunity. Enron is a classic business case story about this. WhatEnron did was create investment partnerships where they transferredassets and liabilities. But those partnerships had close ties back toEnron and at the end of the day, they did not eliminate the liabilities,they just took them off their reported balance sheet. When thosepartnerships blew up, Enron came crashing down. Billions were lostand executives went to jail.
Even if the company you are looking to invest in is totally clean andhonest, there will be likely be liabilities that are not on the balancesheet. Let’s say you are looking at investing in a company that doesmobile software development for big media companies. Let’s say theyhave just signed a three-year contract to develop mobile apps for oneof the largest media companies in the world. Let’s say they got paidupfront $1mm to do this work. That $1mm will appear on the balancesheet as deferred revenue and that is a liability. But what if the com-pany misjudged the amount of work it will take and they will ulti-mately lose money on the deal? What if it will actually take them$1.5mm in costs to do this work? The $500k of losses is an additionalliability but it doesn’t appear on the balance sheet anywhere. But thoselosses could sink the company if it is thinly capitalized.
Real estate liabilities are a particularly thorny issue. Back in the earlypart of the last decade, right after the Internet bubble burst, I spentalmost all of 2001 trying to negotiate a bunch of companies out of realestate liabilities. These companies were all growing like crazy in 1999and 2000 and they signed five and ten year leases on big spaces (like
3http://www.avc.com/a_vc/2010/04/analyzing-financial-statements.html4http://www.avc.com/a_vc/2010/03/the-balance-sheet.html
B u s i n e s s C o s t s81
10,000 square feet or more) with big landlords. Many of these leaseshad rent concessions in the first year or 18 months and when thoseconcessions came off, the companies instantly faced the dual realitythat they could not afford the leases and that they were not going toraise more money with these huge lease obligations in place. But thoselease obligations were not on the balance sheets. The annual rent ex-penses were on the income statement, but the future lease obligationsthat ultimately sunk a few of these companies were only disclosed inthe back of the footnotes.
The footnotes are where you have to go to see these off balance sheetliabilities. If the Company is audited, then their annual financialstatements will have footnotes and this kind of stuff is likely to be inthere. If the company is publicly traded, it will be audited, and thefootnotes will be in the 10Ks and 10Qs that the company files withthe SEC. But many privately held companies, particularly early stageprivately held companies, are not audited. So if you are going to investin a company that is not audited, you need to diligence these unrepor-ted liabilities yourself. You should ask about lease obligations and anyother contractual obligations the company has. Read the leases andthe contracts. Understand what the company is obligated to do andhow much money it will cost. Make sure those funds are in the pro-jected cash flows.Balance sheets and income statements are important to understandinga company. But they do not tell the entire picture. They don’t tell youif the team is solid. They don’t tell you if the product is any good. Theydon’t tell you if the market is big. And they don’t even tell you aboutall the costs and they don’t tell you about all the liabilities. So you haveto dig deeper and understand what is really going on before puttingyour capital at risk. That is called due diligence and it is critical toinvesting. And looking out for liabilities that aren’t reported on thefinancial statements is an important part of that.
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Va lua t i on
Enterprise Value and Market Value
Last week I mentioned that sometimes I am at a loss for somethingto post about on MBA Mondays
1. Andrew Parker
2, who got his MBA
at Union Square Ventures (largely self taught) from 2006 to 2010,suggested in the comments
3 that I post about the differences between
Enterprise Value and Market Value. It was a good suggestion and sohere goes.
The Equity Market Value (which I will refer to as Market Value forthe rest of this post) is the total number of shares outstanding timesthe current market price for a share of stock. To make this post simple,we will focus only on public companies with one class of stock. TheMarket Value is the price you are paying for the entire companywhen you buy a stock.
Let's use Open Table4, a recent public company as our real world ex-
ample in this post. Open Table (ticker OPEN) closed on Friday at$48.19 and has a "market value" of $1.1bn according to this page onTracked.com
5. According to Google Finance
6, Open Table has 22.77
million shares outstanding. So to check the market value calculationon Tracked.com, let's multiply the market price of $48.19 by the sharesoutstanding of 22.75 million. My desktop calculator tells me that is$1.096 billion.
So if you purchase Open Table stock today, you are effectively paying$1.1bn for the company. But Open Table has $70 million of cash andhas $11.6 million of short term debt outstanding. So if you paid $1.1bn
1http://www.avc.com/a_vc/mba-mondays/2http://twitter.com/andrewparker3http://www.avc.com/a_vc/2010/08/the.html#comment-658425454http://www.tracked.com/company/open-table/5http://www.tracked.com/company/open-table/6http://www.google.com/finance?q=NASDAQ%3AOPEN
for the company (as would be the case if your company purchasedOpen Table), then you would be getting $70 million of cash and a debtobligation of $11.6 million.
So the Enterprise Value of Open Table, meaning the value of thebusiness without any cash or debt, is a bit less than $1.1bn. To get theEnterprise Value, you calculate the Market Value and then subtractcash and add debt. When we do that, we find that Open Table cur-rently has an Enterprise Value of $1.038bn. Not much difference inpercentage, but almost $60mm in difference in dollars.
There are some companies that have a lot of cash or a lot of debt rel-ative to their Market Values and in those cases it is really importantto do this calculation to get to Enterprise Value.
We do a lot of valuation analysis on our portfolio companies, partic-ularly the ones with a lot of revenues and profits. We do them mostlyfor our accountants as part of something called FAS 157 or "mark tomarket accounting". I am not a fan of FAS 157 and I've blogged aboutit here before
7. But regardless of whether or not I think "mark to
market" is the right way to value a venture portfolio (I do not), it isthe current practice and we need to do it.
When we do valuations, we often use public market comps to get"market revenue and profit multiples" and then we apply them to ourportfolio companies. When you do this work, it is critical to use theEnterprise Values to get the multiples. Then when you apply themultiples to the target company, again you need to get an EnterpriseValue and then work back to get Market Values.
If you use Market Values to calculate multiples, you may end up withsome really screwy numbers for businesses with a lot of cash or a lotof debt. So use Enterprise Values when you are doing valuations andcalculating multiples.
7http://www.avc.com/a_vc/2009/01/the-valuation-b.html
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Bookings Vs. Revenues Vs. Collections
A reader suggested this topic for MBA Mondays1. It is a good one.
When a customer commits to spend money with your company, thatis a “booking”. A booking is often tied to some form of contractbetween your company and the customer. The contract can be simpleor very complicated. And some bookings do happen without a con-tract. Examples of these contracts with customers include an insertionorder in advertising, a license agreement in enterprise software, anda subscription agreement in “software as a service” businesses.
Revenue happens when the service is actually provided. In the caseof advertising, the revenue is recognized as the ads are run. In the caseof licensed software, the revenue is recognized when the software isdelivered and accepted by the customer. In the case of a subscriptionagreement, the revenue is most often recognized ratably over the lifeof the subscription.
The customer’s cash shows up in your company’s bank account whenit is collected. That can happen at the time of booking the business(as is typical in subscription businesses), or it can happen at the timeof revenue recognition (as it typical in ecommerce), or it can happena long time after revenue recognition (as it typical in advertising).
It is important to track all three of these metrics very closely. Youwant to know how much revenue your company has booked, youwant to know what your monthly revenues are, and you want toknow how much revenue you have collected, and most importantly,how much you have not yet collected (that is called Accounts Receiv-able).
It is also possible to collect cash at the time of booking in advance ofwhen the revenues will be realized. That is called deferred revenueand it is a liability because delivery of the revenue is an obligation of
1http://www.avc.com/a_vc/mba-mondays/
V a l u a t i o n85
the company. Many companies have four revenue oriented items theytrack; bookings, deferred revenues, revenues, and collections.
An interesting metric that many analysts and financial managerstrack is the book to bill ratio. You get that by dividing monthly (orweekly or quarterly) bookings by the revenues in the same period. Ifbookings are lower than revenues, that can be a negative sign. Ifbookings are a lot higher than revenues, that can be a positive sign.But it can also mean that your company is having a hard time gettingrevenue realized.
In some industries, not all bookings turn into revenues. In the advert-ising business, for example, it is often the case that not all the bookedbusiness can be delivered (and thus recognized as revenue). This is abig issue in highly targeted advertising businesses. If you have such abusiness, it is important to track your yield which is the percentageof booked revenue that you actually deliver in a given period.I like to think of the bookings to billings to collections as the wayrevenues “flow” through the business. And since revenues are the lifeblood of any business, it is important to understand your company’sspecific flow and measure it along the way.
86V a l u a t i o n
Commiss ion P lans
Commission Plans
Last week's MBA Mondays1 post about Bookings, Revenues, and
Collections2 generated a number of comments and questions about
sales commission plans. So I decided to ask my friend and AVC com-munity member Jim Keenan
3 to write a guest post on the topic. Jim's
blog, A Sales Guy4, is a great read for those who want to get into the
mind of a sales leader. So with that intro, here are Jim's high levelthoughts on setting up commission plans. I know the discussion onthis post is going to be a good one. So make sure to click on the com-ments link and if you are so inclined, please let us know what youthink on this topic.
-----
I get asked a lot how to build a good commission plan. I give the sameanswer every time. Keep it simple and align it with company goals.
It amazes me how often companies screw this up.
Sales people are coin operated. Tell them they get a buck if they goget a rock, you'll get a rock, a whole lot of rocks. Tell them they gettwo bucks for red rocks, you'll get a lot of red rocks, but fewer rocksin general.
1http://www.avc.com/a_vc/mba-mondays/2http://www.avc.com/a_vc/2010/08/bookings-vs-revenues-vs-collections.html3http://twitter.com/keenan4http://asalesguy.com/
Sales people don't hear what you say; they hear what you pay! Com-mission plans need to do two things; motivate sales people and sellproduct. They should align what you say, with what you pay.
The killer commission plan starts with two critical questions; 1) Whatdo you want to sell? 2) How do you want the sales team to behave?
Commission plans drive behavior, get it wrong or don't align commis-sion incentives with the company’s goals you’ll get everything youdon’t want and little of what you do want.
What do you want to sell? Do you want to sell your existing productsor your new products? Do you want to sell your services or yoursoftware? Do you want more revenue or higher margin? Answeringthese questions up front matters. Whatever you put in your commis-sion plan you WILL get. Build your plan for what you want to sell.
How do you want the team to behave? Do you want new accountsand new business or more business from existing accounts? If youwant new accounts pay for hunting, if you want them to work theaccounts you already have, then pay for farming. What ever you payfor you WILL get. Build your plan for how you want the team to act.
The key is to sit down with finance, product and marketing with thebudget
5 in hand and ask the questions; what do we need to sell by the
end of the year? Where do we need the business to be? How muchrevenue do we need? How much margin do we want? How manynew customers do we need? How much growth are we looking for? How do we define success at the end of the year? Once these questionsare answered, incent the sales team to do exactly that. What ever youpay for you will get.
5http://www.avc.com/a_vc/2010/04/projections-budgeting-and-forecasting.html
88C o m m i s s i o n P l a n s
Once the incentives have been nailed and properly aligned, make theplan dead, stupid, simple. Don’t overcomplicate it. Don’t try to besophisticated, creating fancy algorithms and fancy spreadsheets filledwith if/thens. Make the plan "simple stupid."
A plan is simple stupid if a sales person knows exactly what they willbe paid on a deal without looking it up. Simple plans motivate salesteams. They know what their deals are worth and chase them accord-ingly.
Complicated plans de-motivate. When sales doesn’t know how muchthey will get paid on a deal, motivation is nipped. Make sure it’s easyfor sales to figure out what they get paid on a deal by deal basis.
In addition to being dead, stupid, simple, all plans must have acceler-ators. Don’t be greedy. Don’t look to cap sales earnings. If they areselling more, pay them more. Accelerators are when more commis-sion is paid for a deal after a certain threshold is met, usually quota.
Finally, AND most important, once the plan is done DON'T MESSWITH IT. Nothing is more detrimental to a sales environment thanchanging the commission plan on the fly. You have to live with whatyou have. Commission plans are the lifeblood of a sales team. Getthem right; start counting the money. Get them wrong; it’ll be a longyear.
Remember; Sales people don’t hear what you say, they hear what youpay . . . so pay right.
C o m m i s s i o n P l a n s89
What a CEO Does
What a CEO Does
I am posting this as a MBA Mondays1 post. But I did not learn this
little lesson at business school. I learned it from a very experiencedventure capitalist early in my post-MBA career.
I was working on a CEO search for one of our struggling portfoliocomapnies. We had a bunch of them. I started in the venture capitalbusiness just as the PC hardware bubble of the early 80s was busting.Our portfolio was a mess. It was a great time to enter the business. Icleaned up messes for my first few years. I learned a lot.
Anyway back to the CEO search. One of the board members was avery experienced VC who had been in the business around 25 yearsby then. I asked him "what exactly does a CEO do?"
He answered without thinking:
A CEO does only three things. Sets the overall vision andstrategy of the company and communicates it to allstakeholders. Recruits, hires, and retains the very besttalent for the company. Makes sure there is alwaysenough cash in the bank.
I asked, "Is that it?"
He replied that the CEO should delegate all other tasks to his or herteam.
1http://www.avc.com/a_vc/mba-mondays/
I've thought about that advice so often over the years. I evaluate CEOson these three metrics all the time. I've learned that great CEOs canand often will do a lot more than these three things. And that is OK.
But I have also learned that if you cannot do these three things well,you will not be a great CEO.
It is almost 25 years since I got this advice. And now I am passing iton. It has served me very well over the years.
What a CEO Does, Continued
Last week's MBA Mondays1 post on What A CEO Does
2 was a huge
hit. Matt Blumberg3, who is one of the finest CEOs I've had the
pleasure of working with, wrote a follow-up post4 on the topic for
his blog5. I asked him if I could run it as a guest post here on MBA
Mondays and he agreed.
So, here's a bit more on What A CEO Does:
----
What Does a CEO Do, Anyway?
Fred has a great post up last week in his MBA Mondays series caled“What a CEO Does.“ His three things are set vision/strategy andcommunicate broadly, recruit/hire/retain top talent, and make surethere’s enough cash in the bank.
It’s great advice. These three are core job responsibilities of any CEO,probably of any company, any size. I’d like to build on that premiseby adding two other dimensions to the list.
1http://www.avc.com/a_vc/mba-mondays/2http://www.avc.com/a_vc/2010/08/what-a-ceo-does.html3http://twitter.com/mattblumberg4http://www.onlyonceblog.com/2010/09/what-does-a-ceo-do-anyway5http://onlyonce.blogs.com/
92W h a t a C E O D o e s
First, three corollaries – one for each of the three responsibilities Fredoutlines.
• Setting vision and strategy are key…but in order to do that, theCEO must remember the principle of NIHITO (Nothing InterestingHappens in the Office) and must spend time in-market. Get to knowcompetitors well. Spend time with customers and channel partners. Actively work industry associations. Walk the floor at conferences. Understand what the substitute products are (not just direct compet-ition).
• Recruiting and retaining top talent are pay-to-play…but youhave to go well beyond the standards and basics here. You have to bepersonally involved in as much of the process as you can – it’s notabout delegating it to HR. I find that fostering all-hands engagementis a CEO-led initiative. Regularly conduct random roundtables of 6-10 employees. Send your Board reports to ALL (redact what you must)and make your all-hands meetings Q&A instead of status updates. Hold a CEO Council every time you have a tough decision to makeand want a cross-section of opinions.
• Making sure there’s enough cash in the bank keeps the lightson…but managing a handful of financial metrics in concert with eachother is what really makes the engine hum. A lot of cash with a lotof debt is a poor position to be in. Looking at recognized revenuewhen you really need to focus on bookings is shortsighted. Managingoperating losses as your burn/runway proxy when you have hugelooming CapEx needs is a problem.
Second, three behaviors a CEO has to embody in order to be successful– this goes beyond the job description into key competencies.
• Don’t be a bottleneck. You don’t have to be an Inbox-Zero nut,but you do need to make sure you don’t have people in the companychronically waiting on you before they can take their next actionson projects. Otherwise, you lose all the leverage you have in hiringa team.
W h a t a C E O D o e s93
• Run great meetings. Meetings are a company’s most expensiveendeavors. 10 people around a table for an hour is a lot of salary ex-pense! Make sure your meetings are as short as possible, as actionableas possible, and as interesting as possible. Don’t hold a meeting whenan email or 5-minute recorded message will suffice. Don’t hold aweekly standing meeting when it can be biweekly. Vary the tempoof your meetings to match their purpose – the same staff group canhave a weekly with one agenda, a monthly with a different agenda,and a quarterly with a different agenda.
• Keep yourself fresh…Join a CEO peer group. Work with an ex-ecutive coach. Read business literature (blogs, books, magazines) likemad and apply your learnings. Exercise regularly. Don’t neglect yourfamily or your hobbies. Keep the bulk of your weekends, and at leastone two-week vacation each year, sacrosanct and unplugged.
There are a million other things to do, or that you need to do well…butthis is a good starting point for success.
94W h a t a C E O D o e s
Outsourc ing
Outsourcing
This MBA Mondays topic was suggested by Aviah Laor, a regularmember of this community.
I'll start this post by describing outsourcing and explain why compan-ies do it. Then I'll talk about outsourcing in the context of startups.
Outsourcing is when a company hires another company to performcertain functions. Wikipedia defines it
1 as "contracting to third
parties." The term has become synonomous with the transfer oflabor/work overseas, but outsourcing is not geographically defined.You can outsource work to the company across the hall.
The two primary reasons one company will outsource work to anoth-er company are cost and skill set. The third party outsourcing com-pany can provide the required work at either lower cost or higherquality or possibly both. Sometimes time is also a factor. It is oftenthe case than an outsourcing company can get the job done faster.
All kinds of business functions can be outsourced. I have seen almostevery part of a business outsourced at one time or another. But themost common things that companies outsource are software engin-eering, data entry/data hygiene, customer service, tech support, andfinancial record keeping/reporting.
Startups are among the most active outsourcers. It makes sense.Typically the founding team has skills in one or two areas and doesn'thave the entire set of skills to launch a business. So they outsourcethe tasks they don't have the expertise in. This can be a good thingbut can also be a bad thing.
1http://en.wikipedia.org/wiki/Outsourcing
Specifically, I think it is always a bad thing for the founding team ofa software company to outsource software development. We see thisa lot. A team will come into our office and pitch us. When I ask howmany people they have, they say "this is all of us". Then I say, "who iswriting code?" And they say, "we've hired a company to do that forus." That is a very disappointing moment for me because it means wealmost certainly won't invest in that team. We believe that softwarecompanies must own their most important capability themselves andthat is the ability to produce their product in house.
The founding team of a software company should have a strongproduct manager on it (often that is the founder) and should have atleast several strong software developers on it who can write most ofthe code. It does make sense to outsource some parts of software en-gineering from time to time. A common thing we've been seeing re-cently is outsourcing the development of a blackbbery app or someother kind of mobile app. Right now, that is still a fairly nascent skillset but we are also advising most of our portfolio companies to bringindividuals in house to do that work because it appears that mobileapp development will be a key skill set for our portfolio companiesfor some time to come.
It is tempting for startups to want to outsource customer service andtech support because these are labor intensive activities that can befairly easily outsourced to a call center, either in the US or even outsidethe US. At some point, most companies will outsource some of all ofthis work. But we do not believe startups should outsource this workuntil they are "all grown up" (whatever that means). Customer serviceand tech support are the best way for startups to talk to their custom-ers. Sometimes it is the only way startups get to talk to their customers.And customer feedback is so very important to startups so it is criticalfor them to do this work in house.
Data input and data hygiene is one area that we do think startups canand should outsource. This is not strategic for most startups and isoften costly and time consuming work that can be easily outsourced.
96O u t s o u r c i n g
The function that most startups outsource in the beginning is financialrecord keeping and reporting. And that makes sense. Accounting andbookkeeping is a specific skill that most founders don't have. By out-sourcing it, you make sure your books and records are kept accuratelyand up to date.
I am a fan of outsourcing in general. I believe companies should devel-op those skills and functions that are their core competency and out-source the skills and functions that are not. I believe that the US shouldinvest in outsourcing instead of demonizing it. I believe there is a lotof opportunity for economically weak regions of the US to use out-sourcing to build their economies and grow.
But for startups, outsourcing is a tricky issue. You should not out-source those things that are core competencies or critical feedbackpoints. If you don't have the skills on your founding team to do thatwork, go find people who do and either hire them or bring them ontothe founding team.
Outsourcing Vs. Offshoring
A lot of the discussion about last week’s MBA Mondays1 post on
Outsourcing2 was about the differences between outsourcing locally
and outsourcing outside your home country. A popular term for thelatter approach is offshoring.
The advent of modern electronic communications has allowed com-panies to efficiently source and manage labor all around the globe.This is one of the megatrends, if not the megatrend, of the currenteconomic period we are living in.
1http://www.avc.com/a_vc/mba-mondays/2http://www.avc.com/a_vc/2010/09/outsourcing-vs-offshoring.html
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But just because you can use labor halfway around the world doesn’tmean you should. This post is about the pros and cons of offshoringfrom my perspective.
On the plus side, offshoring often offers considerable cost savings.Labor costs in emerging markets are often a fraction of the labor costsin the developed world. And you can often tap into highly educatedand skilled labor pools. We have companies in our portfolio that havebuilt world class engineering teams in places like Belarus, Solvenia,and India. These teams cost less and often produce amazing work.AVC community member Ken Berger has been involved in buildinga strong team of ruby engineers in Vietnam
3. I have no doubt that
team can do excellent work at a fraction of the cost of a team of rubyengineers in San Francisco or New York.
On the negative side, there are significant communication and man-agement issues that arise when you have a team working half wayaround the world for you. Yes, you can Skype, IRC, Twitter, and IMall day long with your remote team. But often they want to be asleepwhen you want to be awake. Israeli tech teams are well known fortheir participation in critical product/tech meetings with their UScounterparts in the wee hours of the morning. They might be in themeetings, but you have to wonder if they are at their best.
But as problematic as the communications issues are, the managementissues are even harder. You can outsource the management issues byhiring a firm to do your work for you. I am not a big fan of that ap-proach, particularly for startups. As I outlined in my post last week
4,
I believe startups need to directly employ the people doing the mostcritical tasks. And for a startup, that includes things that are commonlyoffshored like software engineering and customer support. And evenif you outsource the management to an offshore firm, you will haveto manage that firm. And managing vendors is often harder thanmanaging employees.
3http://eastagile.com4http://www.avc.com/a_vc/2010/09/outsourcing-vs-offshoring.html
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I have observed that hiring a local manager for a remote team is oftenthe hardest thing to do. And you need a strong manager in place inyour remote location if you are going to be successful. A weak managerof a remote team is almost always a disaster for your company. Itcauses delays and management messes that you will have to clean up.
The most reliable technique I have observed is to ask a trusted andexperienced team member to go overseas and launch/manage the re-mote team. That is a big ask and often is not possible. But if you canmake that work, it has the highest probability of success.
The companies in our portfolio that have done the best job with teamslocated in other parts of the world have had founders who came fromthose places or founders who spent significant time in those locations.They are able to source high quality talent and manage them, some-times even remotely due to their familiarity with the people, place,and culture.
Speaking of culture, you can’t overemphasize what a big deal it ishaving multiple cultures in your company. Some cultures take it easyin the summer and work hard in the winter. Some cultures have dif-ferent approaches to gender in the workplace. Some cultures valuerespect more than money. Some cultures value money more than re-spect. Multiple cultures can often create tensions between offices andteams. Managing all of this is hard and I have not seen many do itexceptionally well. But I have also observed that as this kind of organ-ization structure gets more common, entrepreneurs and managersare getting better at handling cultural complexity.
The single most important thing you can do is get everyone, at leastall the senior team members of the company, across all geographies,together on a regular basis. And I think it is not a good idea to alwayshave the remote offices come to the home office. The home officeneeds to travel to the remote offices too.
As I said at the start of this post, being able to source and manage talentall across the globe may be the signature megatrend of the currenteconomic period. It has far reaching consequences for companies ofall shapes and sizes. For startups, it offers lower costs and at times ac-
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cess to excellent skills and talent. But it comes with great challengesand you should not undertake an offshoring exercise lightly.
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Emp loyee Equ i t y
Employee Equity
One of the topics I get asked about most on MBA Mondays is "options."But options are only one form of employee equity. I am going to doa series of posts on this topic over the next month of MBA Mondays.I will start by laying out the logic for employee equity, going oversome target ownership levels, and describing the various securitiesyou can use to issue employee equity.
One of the defining characteristics of startup culture is employeeownership. Many large companies provide employee ownership sothis is not unique to startup culture. But when you join a startup, youhave the expectation of getting some ownership in the company andif the company is successful and is sold or taken public, that you willshare in the gains that result.
Employee ownership is such an important part of startup culture. Itreinforces that everyone is on the team, everyone is sharing in thegains, and everyone is a shareholder. I can't think of a company thathas come to pitch us that has not had an employee equity plan. And Ican't think of a term sheet that we have issued that didn't have a spe-cific provision for employee equity. It is simply a fundamental partof the startup game.
While employee equity is "standard" in the startup business, the levelsof employee ownership vary quite a bit from company to company.There are a variety of reasons. Geography matters. Employee owner-ship levels are higher in well developed startup cultures like the bayarea, boston, and NYC. They are lower in less developed startupcommunities. Engineering heavy startups will tend to have higherlevels of employee ownership than services and media companies. Iam not suggesting that is right or fair, but it is what I have seen. And
if the founders are the top managers in a company, the level of "nonfounder employee ownership" will be lower. If the founders are largelygone from a company, the levels of "non founder employee ownership"will be higher.
If the founders are the top managers in the company, then the typical"non founder employee ownership" will tend to be between 10% and20%. If the founders have largely left the company, then "non founderemployee ownership" will be closer to 20% and could be a bit higher.I like the 20% number as a target if for no other reason than it mapswell to the VC business. The people providing the "sweat equity"typcally get 20% of the gains in our business (at USV we get 20%) andthey should get at least that in the companies we back. I say "at least"because the founders are often still providing "sweat equity" and theycan own much more than 20%.
There are four primary ways to issue employee equity in startups:
- Founder stock. This is the stock that founders issue to themselveswhen they form the company. It can also include stock issued to earlyteam members. Founder stock has special vesting provisions amongthe founders so that one or more of them doesn't leave early and keepall of their stock. Those vesting provisions are extended to the in-vestors once capital is invested in the business. Founder stock willtypically be common stock and it will be owned by the founderssubject to vesting provisions.
- Restricted stock. This is common stock that is issued to either earlyemployees or top executives that are hired into the company fairlyearly in a company's life. Restricted stock will have vesting provisionsthat are identical to standard employee option plans (typcially fouryears but sometimes three years). The difference between restrictedstock and options is that the employee owns the shares from the dayof issuance and can get capital gains treatment on the sale of the stockif it is held for one year or more. But issuing restricted stock to anemployee triggers immediate taxable income to the recipient so it canbe very expensive to the recipient and therefore it is only done very
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early when the stock is not worth much or when a senior executiveis hired who can handle the tax issues.
- Options. This is by far the most common form of employee equityissued in startup companies. The stock option is a right issued to anemployee to purchase common stock at some point in the future at aset price. The "set price" is called the "strike price." I am going to doat least one and probably several ful MBA Mondays posts on optionsso I am not going to say much more now.
- Restricted Stock Units. Knows as RSUs, these securities are relativelynew in the startup business. They were created to fix issues with op-tions and restricted stock and have characteristics of both. A RSU isa promise to issue common stock once the vesting provisions havebeen satisfied. The vesting provisions can include a liquidity event.So when you are getting an RSU, you are getting something that feelslike an option but there is no strike price. When you get the shares,you will own them outright. But you might not get them for a while.
I will end this post by imploring all of you entrepreneurs to hire anexperienced startup lawyer. Employee equity issues are tricky. Youcan and will make a bunch of expensive mistakes with employeeequity unless you have the right counsel. There are plenty of law firmsand lawyers who specialize in startups and you should have one ofthem at your side when you are setting up your company andthroughout its life. That is true for a lot of reasons, but employeeequity is one of the most important ones.
Employee Equity: Dilution
Last week I kicked off my MBA Mondays1 series on Employee Equity
2.
Today I am going to talk about one of the most important things you
1http://www.avc.com/a_vc/mba-mondays/2http://www.avc.com/a_vc/2010/09/employee-equity.html
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need to understand about employee equity; it is likely to be dilutedover time.
When you start a company, you and your founders own 100% of thecompany. That is usually in the form of founders stock. If you neverraise any outside capital and you never give any stock away to em-ployees or others, then you can keep all of that equity for yourself. Ithappens a lot in small businesses. But in high growth tech companieslike the kind I work with, it is very rare to see the founders keep 100%of the business.
The typical dilution path for founders and other holders of employeeequity goes like this:
1) Founders start company and own 100% of the business in foundersstock
2) Founders issue 5-10% of the company to the early employees theyhire. This can be done in options but is often done in the form of re-stricted stock. Sometimes they even use "founders stock" for thesehires. Let's use 7.5% for our rolling dilution calculation. At this pointthe founders own 92.5% of the company and the employees own 7.5%.
3) A seed/angel round is done. These early investors acquire 5-20% ofthe business in return for supplying seed capital. Let' use 10% for ourrolling dilution calcuation. Now the founders own 83.25% of thecompany (92.5% times 90%), the employees own 6.75% (7.5% times90%), and the investors own 10%.
4) A venture round is done. The VCs negotiate for 20% of the companyand require an option pool of 10% after the investment be establishedand put into the "pre money valuation". That means the dilution fromthe option pool is taken before the VC investment. There are twodiluting events going on here. Let's walk through them both.
When the 10% option pool is set up, everyone is diluted 12.5% becausethe option pool has to be 10% after the investment so it is 12.5% beforethe investment. So the founders now own 72.8% (83.25% times 87.5%),
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the seed investors own 8.75% (10% times 87.5%), and the employeesnow own 18.4% (6.8% times 87.5% plus 12.5%).
When the VC investment closes, everyone is diluted 20%. So thefounders now own 58.3% (72.8% times 80%), the seed investors own7% (8.75% times 80%), the VCs own 20%, and the employees own 14.7%(18.4% times 80%). Of that 14.7%, the new pool represents 10%.
5) Another venture round is done with an option pool refresh to keepthe option pool at 10%. See the spreadsheet below to see how the dilu-tion works in this round (and all previous rounds). By the time thatthe second VC round is done, the founders have been diluted from100% to 42.1%, the early employees have been diluted from 7.5% to3.4%, and the seed investors have been diluted from 10% to 5.1%.
3
I've uploaded this spreadsheet to google docs4 so all of you can look
at it and play with it. If anyone finds any errors in it, please let meknow and I'll fix them.
This rolling dilution calculation is just an example. If you have dilutedmore than that, don't get upset. Most founders end up with less than42% after rounds of financing and employee grants. The point of thisexercise is not to lock down onto some magic formula. Every companywill be different. It is simply to lay out how dilution works foreveryone in the cap table.
Here is the bottom line. If you are the first shareholder, you will takethe most dilution. The earlier you join and invest in the company,
3http://www.avc.com/.a/6a00d83451b2c969e2013487f4abe4970c-pi4https://spreadsheets.google.com/ccc?key=0AvqoGGDowi93dHdOWG5aMDNNVDJ4d2FqeXlFcWJCUFE&hl=en
E m p l o y e e E q u i t y105
the more you will be diluted. Dilution is a fact of life as a shareholderin a startup. Even after the company becomes profitable and there isno more financing related dilution, you will get diluted by ongoingoption pool refreshes and M&A activity.
When you are issued employee equity, be prepared for dilution. It isnot a bad thing. It is a normal part of the value creation exercise thata startup is. But you need to understand it and be comfortable withit. I hope this post has helped with that.
Employee Equity: Appreciation
This is the third post in an MBA Mondays series on Employee Equity.Last week I talked about Dilution. This week I am going to talk aboutthe antidote to Dilution which is Appreciation, specifically stock priceappreciation.
When you start a company, on day one the stock is basically worthless.There are some exceptions to this rule such as a spinoff companywhere Newco is getting some valuable assets day one. However in thevast majority of cases, the value of a startup on day one is zero.
One of the objectives of an entrepreneur is to steadily increase thevalue of the business and the stock price.
At some point, the Company will generate revenues and earnings andcan be valued using traditional valuation metrics like discounted cashflow and earnings multiples. But early on in the life of a startup it istrickier to value the stock.
Fortunately we have a marketplace for startup equity. It is called theventure capital business. Every time a startup raises capital, there isa competition between investors and a negotiation beetween theCompany and the investors. Those two processes provide a mechanismto determine stock price.
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There is a growing trend to finance the 'seed stage' of a startup's lifewith debt, specifically convertible debt. One of the reasons I am notfond of convertible debt is that it obfuscates the equity pricing process.But that's a digression.
So between the formation time when the stock price is most likely$0.01 per share (ie zero) and the time of exit at hopefully $100/shareor more, there is a progression of price appreciation along the waymarked by the progress of the business, financing events, and eventu-ally revenues and earnings which lead to financial analysis.
If you are an entrepreneur or an employee in a startup who has equityas part of your compensation, it behooves you to understand the ap-preciation in the value if your equity.
One thing that you need to know is that the price doesn't always rise.There can be setbacks in the business that lead to price declines. Therecan be setbacks in the capital markets that make all businesses lessvaluable including startups.
And if course your Company could fail in which case all of the em-ployee equity will be worthless.
In the case of a startup that becomes a successful business, the pricewill appreciate over time. There can be price declines or long periodsof price stagnation, but if you are patient and the business succeeds,the employee equity will appreciate over the long run.
There are some specific issues that require a deeper dive, includingthe impact of liquidation preferences and the role of a 409a valuation.I will tackle those issues in the comings weeks.
Employee Equity: Options
A stock option is a security which gives the holder the right to pur-chase stock (usually common stock) at a set price (called the strike
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price) for a fixed period of time. Stock options are the most commonform of employee equity and are used as part of employee compensa-tion packages in most technology startups.
If you are a founder, you are most likely going to use stock optionsto attract and retain your employees. If you are joining a startup, youare most likely going to receive stock options as part of your compens-ation. This post is an attempt to explain how options work and makethem a bit easier to understand.
Stock has a value. Last week we talked about how the value is usuallyzero at the start of a company and how the value appreciates over thelife of the company. If your company is giving out stock as part of thecompensation plan, you’d be delivering something of value to youremployees and they would have to pay taxes on it just like they paytaxes on the cash compensation you pay them. Let’s run through anexample to make this clear. Let’s say that the common stock in yourcompany is worth $1/share. And let’s say you give 10,000 shares toevery software engineer you hire. Then each software engineer wouldbe getting $10,000 of compensation and they would have to pay taxeson it. But if this is stock in an early stage company, the stock is notliquid, it can’t be sold right now. So your employees are gettingsomething they can’t turn into cash right away but they have to payroughly $4,000 in taxes as a result of getting it. That’s not good andthat’s why options are the preferred compensation method.
If your common stock is worth $1/share and you issue someone anoption to purchase your common stock with a strike price of $1/share,then at that very moment in time, that option has no exercise value.It is “at the money” as they say on Wall Street. The tax laws are writtenin the US to provide that if an employee gets an “at the money” optionas part of their compensation, they do not have to pay taxes on it. Thelaws have gotten stricter in recent years and now most companies dosomething called a 409a valuation of their common stock to insurethat the stock options are being struck at fair market value. I will doa separate post on 409a valuations because this is a big and importantissue. But for now, I think it is best to simply say that companies issue
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options “at the money” to avoid generating income to their employeesthat would require them to pay taxes on the grant.
Those of you who understand option theory and even those of youwho understand probabilities surely realize that an “at the money”option actually has real value. There is a very big business on WallStreet valuing these options and trading them. If you go look at theprices of publicly traded options, you will see that “at the money”options have value. And the longer the option term, the more valuethey have. That is because there is a chance that the stock will appre-ciate and the option will become “in the money”. But if the stock doesnot appreciate, and most importantly if the stock goes down, the op-tion holder does not lose money. The higher the chance that the optionbecomes “in the money”, the more valuable the option becomes. I amnot going to get into the math and science of option theory, but it isimportant to understand that “at the money” options are actuallyworth something, and that they can be very valuable if the holdingperiod is long.
Most stock options in startups have a long holding period. It can befive years and it often can be ten years. So if you join a startup and geta five year option to purchase 10,000 shares of common stock at$1/share, you are getting something of value. But you do not have topay taxes on it as long as the strike price of $1/share is “fair marketvalue” at the time you get the option grant. That explains why optionsare a great way to compensate employees. You issue them somethingof value and they don’t have to pay taxes on it at the time of issuance.
I’m going to talk about two more things and then end this post. Thosetwo things are vesting and exercise. I will address more issues thatimpact options in future posts in this series.
Stock options are both an attraction and a retention tool. The reten-tion happens via a technique called “vesting”. Vesting usually happensover a four year term, but some companies do use three year vesting.The way vesting works is your options don’t belong to you in theirentirety until you have vested into them. Let’s look at that 10,000share grant. If it were to vest over four years, you would take owner-
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ship of the option at the rate of 2,500 shares per year. Many companies“cliff vest” the first year meaning you don’t vest into any shares untilyour first anniversary. After that most companies vest monthly. Thenice thing about vesting is that you get the full grant struck at thefair market value when you join and even if that value goes up a lotduring your vesting period, you still get that initial strike price.Vesting is much better than doing an annual grant every year whichwould have to be struck at the fair market value at the time of grant.
Exercising an option is when you actually pay the strike price andacquire the underlying common stock. In our example, you wouldpay $10,000 and acquire 10,000 shares of common stock. Obviouslythis is a big step and you don’t want to do it lightly. There are twocommon times when you would likely exercise. The first is when youare preparing to sell the underlying common stock, mostly likely inconnection with a sale of the company or some sort of liquidity eventlike a secondary sale opportunity or a public offering. You might alsoexercise to start the clock ticking on long term capital gains treatment.The second is when you leave the company. Most companies requiretheir employees to exercise their options within a short period afterthey leave the company. Exercising options has a number of taxconsequences. I will address them in a future blog post. Be carefulwhen you exercise options and get tax advice if the value of your op-tions is significant.
That's it for now. Employee equity is a complicated subject and I amnow realizing I may end up doing a couple months worth of MBAMondays on this topic. And options are just a part of this topic andthey are equally complicated. I'll be back next Monday with more onthese topics.
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Employee Equity: The LiquidationOverhang
We're five posts into this MBA Mondays1 series on Employee Equity
and now we are going to start getting into details. We've laid out thebasics but we are not nearly done. I am just starting to realize howcomplicated the issues around employee equity are. That's not good.It's like paying taxes. Everybody does it and nobody but the tax ac-countants understand it. Ugh.
Anyway, enough of that. Let's get into the issue of liquidation over-hang.
When VC investors (and sometimes angels) invest in a startup com-pany, they almost always buy preferred stock. In most startups, thereare two classes of stock, common and preferred. The founders, em-ployees, advisors, and sometimes the angels will typically own com-mon stock. The investors will typically own preferred stock. Theeasiest way to think about this is the "sweat equity" will mostly becommon and the "cash equity" will mostly be preferred.
For the sake of this post, I am going to talk about a simple plain vanillastraight preferred stock. There are all kinds of preferred stock and itcan get really nasty. I am not a fan of variations on the straight pre-ferred but they exist and they can make the situation I am going totalk about even worse.
First, a quick bit on why preferred stock exists. Lets say you start acompany, bootstrap it for a year, and then raise $1mm for 10% of thecompany from a VC. And let's say a few months later, you are offered$8mm for the company. You decide to take the offer. If the VC boughtcommon, he or she gets $800k back on an investment of $1mm. Theylose $200k while you make $7.2mm. But if the VC buys preferred, heor she gets the option of taking their money back or the 10%. In that
1http://www.avc.com/a_vc/mba-mondays/
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instance, they will take their money back and get $1mm and you willget $7mm.
In its simplest (and best) form, preferred stock is simply the optionto get your negotiated ownership or your investment back, whicheveris more. It is designed to protect minority investors who put up signi-ficant amounts of cash from being at the whim of the owner whocontrols the company and cap table.
Now that we have that out of the way, let's talk about how this canimpact employee equity. Anytime the value of the company is lessthan the cash that has been invested, you are in a "liquidation over-hang" situation. If a small amount of venture capital, let's say $5mm,has been invested in your company, it is unlikely that you will findyourself in a liquidation overhang situation. But if a ton of venturecapital, say $50mm, has been invested in your company, it is a risk.
Let's keep going on the $50mm example. It comes time to sell thecompany. The VCs own 75% of the Company for their $50mm. Thefounders own 10%. And the employees own 15%. A sale offer comesand it is for $55mm. The employees do the math and multiply 15%times $55mm and figure they are in for a $8mm payday. They startplanning a party.
But that's not how the math works. The VCs are going to choose totake their money back in this situation because 75% of $55mm isroughly $41mm, less than their cash invested of $50mm. So the re-maining $5mm is going to get split between the founders and employ-ees. The investors are now "out of the cap table" so the final $5mmgets split between the founders and the employees in proportion totheir ownership. The employees get 60% of the remaining $5mm, or$3mm. The party is cancelled.
This story is even worse if the company that has $50mm of investmentis sold for $30mm, or $40mm, or even $50mm. In those scenarios, theemployee's equity is worthless.
I know this is complicated. So let's go back to the basics. If your com-pany has a lot of "liquidation preference" built up over the years, and
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if you think it is not worth that amount in a sale situation, yourcompany is in a liquidation overhang situation and your employeeequity is not worth anything at this very moment.
You can grow out of a liqudation overhang situation. If this hypothet-ical company we are talking about decided not to sell for $55mm andinstead grew for a few more years and ends up getting sold for$100mm, then the liquidation overhang will clear (at at sale price of$65mm) and the employees will get $15mm in the sale for $100mm.
So being in a liquidation overhang situation doesn't mean you arescrewed. It just means your equity isn't worth anything right nowand the value of the company has to grow in order for your equity tobe worthwhile. But it also means that a sale of the company duringthe liquidation overhang period will not be good for the employees.As JLM would say "you won't be going to the pay window."
This issue is front and center in the minds of many employees whoworked in tech companies in the late 90s and early part of the 2000s.The vast majority of companies built during that period raised toomuch money too early and built up large liquidation preferences.Many of them were sold for less than the liquidation preference andthe investors lost money on their investments and the employees gotnothing. That has hurt the value of employee equity in the minds ofmany.
We are in a different place in the tech startup world these days. Manyof our companies have raised less than $10mm in total investmentcapital. And the ones that have raised a lot more, like Zynga, Twitter,and Etsy, have enterprise values that are 10x the lquidation preferences(or more). This is the gift of web economics. It doesn't take as muchinvestment capital to build a web company anymore. That has madeinvesting in web companies better. And it has made being an employeeequity holder in web companies better.
But liquidation overhangs still do exist and when you are offered ajob in a startup where equity is being offered, it is worth asking a fewsimple questions. You need to know how many options you are beingoffered. You need to know where the company thinks the strike price
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will come in at (they can't promise you an exact price). You need toknow how many shares are outstanding in total so you can determinethe percentage ownership you are being offered and the impliedvaluation of the strike price. And finally, you need to know how muchtotal capital has been invested in the company to date so you can decideif there is a liquidation overhang situation.
Just because there is a liquidation overhang doesn't mean you shouldn'ttake the job. But it's a data point and an important one in valuing theequity you are being offfered. Figure this stuff out going into the job.Because standing at the pay window and finding out there's no checkfor you is painful. Don't let that happen to you if you can help it.
Employee Equity: The Option StrikePrice
A few weeks back we talked about stock options1 in some detail. I
explained that the strike price of an option is the price per share youwill pay when you exercise the option and buy the underlying com-mon stock. And I explained that the company is required to strikeemployee options at the fair market value of the company at the timethe option is granted.
The Board has the obligation to determine fair market value for thepurposes of issuing options. For many years, Boards would do thiswithout any third party input. They would just discuss it on a regularbasis and set a new price from time to time. This led to some cases ofabuse where Boards set the strike price artificially low in order tomake their company's options more attractive to potential employees.I sat on many Boards during this time and I can tell you that therewas always a tension between keeping the strike price low and livingup to our obligation to reflect the fair market value of the company.It was not a perfect system but it was a decent system.
1http://www.avc.com/a_vc/2010/10/employee-equity-options.html
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About five years ago, the IRS got involved and issued a rule called409a
2. The IRS looks at options as deferred compensation and will
deem options as taxable compensation if they don't follow very spe-cific rules. Due to rampant abuse of the deferred compensation prac-tices in the late 90s and early part of the last decade, the IRS decidedto change some rules and and thus we got 409a. The 409a ruling isvery broad and deals with many forms of deferred compensation.And it directly addresses the setting of strike prices.
409a puts some real teeth into the Board's obligations to strike optionsat fair market value. If the strike prices are too low, the IRS will deemthe options to be current income and will seek to collect income taxesupon issuance. Not only will the employee have tax obligations at thetime of grant, but the company will have withholding obligations. Inorder to avoid all of this, the Board must document and prove thatthe strike price is fair market value. Most importantly, 409a allowsthe Board to use a third party valuation firm to advise and recommenda fair market value.
As you might expect, 409a has given rise to a new industry. There arenow many valuation firms that derive all or most of their incomedoing valuations on private companies so that Boards can feel com-fortable granting options without tax risk to the employees and thecompany. This valuation report from a third party firm is called a409a valuation.
The vast majority of privately held companies now do 409a valuationsat least once a year. And many do them on a more frequent basis.When your company grants options, or if you are an employee andare getting an option grant, the strike price will most likely be set bya third party valuation firm.
You'd think this system would be better. Certainly the IRS thinks itis better. But in my experience, nothing has really changed exceptthat companies are paying $5000 to $25,000 per year to consultantsto value their companies. There is still pressure on the companies tokeep the prices low so that their options are attractive to new employ-
2http://en.wikipedia.org/wiki/Internal_Revenue_Code_section_409A
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ees. And that pressure gets transferred to the 409a valuation firms.And any time someone is being paid to do something, you have toquestion how objective the result is. I look at the fees our companiespay to 409a valuation firms as the cost of continuing to issue optionsat attractive prices. It is the law and we comply. Not much has reallychanged.
There is one thing that has changed and it relates to timing of grants.It used to be that the Board could exercise a fair bit of "judgement"around the timing of grants and financing events. If you had a bighire and a financing planned, the Board could set fair market value,get the hire made, and then do the financing. Now that is so muchharder to do. It takes time and money to get a 409a valuation done.Most companies will do a new one after they conclude a financing.And most lawyers will advise a company to put a moratorium onoption grants for some time leading up and through a financing anddo all the grants post financing and post the new 409a. This has ledto a bunch of situations in my personal portfolio when a new employ-ee got "screwed" by a big up round. It behooves the Board and manage-ment to be really strategic around big hires and financing events toavoid these situations. And even with the best planning, you will runinto problems with this.
If the company you are joining is early in its development, the strikeprice will likely be low and you don't have to pay too much attentionto it. But as the company develops, the strike price will rise and itwilll become more important. If the Company is a "high flyer" and isheaded to a big exit or IPO, pay a lot of attention to the strike price.A low strike price can be worth a lot of money in a company wherethe value is rising quickly. In such a situation, if there has been a recent409a valuation, you are likely in a good situation. If the company is ahigh flyer and is overdue for a 409a valuation, you need to be particu-larly careful.
This whole area of option strike prices is complicated and full ofproblems for boards and employees. It has led to a growing trend awayfrom options and toward restriced stock units (RSUs). We'll talk aboutthem next week.
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Employee Equity: Restricted Stock andRSUs
For the past six weeks, we've been talking about employee equity onMBA Mondays
1. We've covered the basics, some specifics, and we've
discussed the main form of employee equity which are stock options.Today we are going to talk about two other ways companies grantstock to employees, restricted stock and restricted stock units (RSUs).
Restricted stock is fairly straight forward. The company issues com-mon stock to the employee and puts some restrictions on the stock.The restrictions typically include a vesting schedule and some limitson how the stock can be sold once it is vested.
The vesting schedule for restricted stock is typically the same vestingschedule as the company would use for stock options. I am a fan of afour year vest with a first year cliff. The sale restrictions usually in-clude a right of first refusal on sale for the company. That means ifyou get an offer to buy your vested restricted stock, you need to offerit to the company at that price before you can sell it. There are oftenother terms associated with restricted stock but these are the two bigones.
A big advantage of restricted stock is you own your stock outrightand do not have to buy it with a cash outlay. It is also true that youwill be eligible for long term capital gains if you hold your restrictedstock for at least one year past the vesting period. There currently isa significant tax differential between long term capital gains and or-dinary income so this is a big deal.
The one downside to restricted stock is you have to pay income taxeson the stock grant. The stock grant will be valued at fair market value
1http://www.avc.com/a_vc/mba-mondays/
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(which is likely to be the 409a valuation we discussed last week2) and
you will be taxed on it. Most commonly you will be taxed upon vestingat the fair market value of the stock at that time. You can make an83b election
3 which will accelerate the tax to the time of grant and
thus lock in a possibly lower valuation and lower taxes. But you takesignificant forfeiture risk if you make an 83b election and then don'tvest in all of the stock.
If you are a founder and are receiving restricted stock with nominalvalue (penny a share or something like that), you should do an 83belection because the total tax bill will be nominal and you do not wantto take a tax hit upon vesting later on as the company becomes morevaluable.
This taxation issue is the reason most companies issue options insteadof restricted stock. It is not attractive to most employees to get a bigtax bill along with some illiquid stock they cannot sell. The two timesrestricted stock make sense are at formation (or shortly thereafter)when the value of the granted stock is nominal and when the recipienthas sufficient means to pay the taxes and is willing to accept thetradeoff of paying taxes right up front in return for capital gainstreatment upon sale.
Recently, some venture backed companies have begun to issue restric-ted stock units (RSUs) in an attempt to get the best of stock optionsand restricted stock in a single security. This is a relatively new trendand the jury is still out on RSUs. Currently I am not aware of a singlecompany in our portfolio that issues RSUs but I do know of severalthat may start issuing them shortly.
A RSU is a promise to issue restricted stock upon the acheivement ofa certain vesting schedule. It is a lot like a stock option but you do nothave to exercise it. You simply get the stock like a restricted stockgrant. And there is an added twist in some RSU plans that allow therecipient of an RSU to delay the receipt of the stock until the stockis liquid. Combined, these two features may remove all of the tax
2http://www.avc.com/a_vc/2010/11/employee-equity-the-option-strike-price.html3http://www.fairmark.com/execcomp/sec83b.htm
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disadvantages of restricted stock because the employee would nothave a taxable event until the vesting schedule is over and possiblyuntil the stock becomes liquid. I say "may remove all of the tax disad-vantages" because I believe that the IRS has never tested the taxtreatment of RSUs. Therefore RSUs are an "adventure in tax land"as one general counsel in our portfolio would say.
I do not believe there is an optimal way to issue employee equity atthis time. Each of the three choices; options, restricted stock, andRSUs, has benefits and detriments. I believe that options are the bestunderstood, most tested, and most benign of the choices and thus arethe most popular in our portfolio and in startupland right now. Butrestricted stock and RSUs are gaining ground and we are seeing moreof each. I cannot predict how this will all change in the coming years.It is largely up to the IRS and so the best we can hope for is that theydon't mess up what is largely a good thing right now.
Employee equity is a critical factor in the success of the venture backedtechnology startup world. It has created significant wealth for someand has created meaningful additional compensation for many others.It aligns interests between the investors, founders, management, andemployee base and it a very positive influence on this part of theeconomy. We strongly encourage all of our portfolio companies tobe generous in their use of employee equity in their compensationplans and I believe that all of them are doing that.
Employee Equity: Vesting
We had a bunch of questions about vesting in the comments to lastweek’s MBA Mondays post. So this post is going to be about vesting.
Vesting is the technique used to allow employees to earn their equityover time. You could grant stock or options on a regular basis andaccomplish something similar, but that has all sorts of complicationsand is not ideal. So instead companies grant stock or options upfrontwhen the employee is hired and vest the stock over a set period of
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time. Companies also grant stock and options to employees after theyhave been employed for a number of years. These are called retentiongrants and they also use vesting.
Vesting works a little differently for stock and options. In the case ofoptions, you are granted a fixed number of options but they only be-come yours as you vest. In the case of stock, you are issued the entireamount of stock and you technically own all of it but you are subjectto a repurchase right on the unvested amount. While these are slightlydifferent techniques, the effect is the same. You earn your stock oroptions over a fixed period of time.
Vesting periods are not standard but I prefer a four year vest with aretention grant after two years of service. That way no employee ismore than half vested on their entire equity position. Another ap-proach is to go with a shorter vesting period, like three years, and dothe retention grants as the employee becomes fully vested on theoriginal grant. I like that approach less because there is a period oftime when the employee is close to fully vested on their entire equityposition. It is also true that four year vesting grants tend to be slightlylarger than three year vesting grants and I like the idea of a largergrant size.
If you are an employee, the thing to focus on is how many stock oroptions you vest into every year. The size of the grant is importantbut the annual vesting amount is really your equity based compensa-tion amount.
Most vesting schedules come with a one year cliff vest. That meansyou have to be employed for one full year before you vest into any ofyour stock or options. When the first year anniversary happens, youwill vest a lump sum equal to one year’s worth of equity and normallythe vesting schedule will be monthly or quarterly after that. Cliffvesting is not well understood but it is very common. The reason forthe one year cliff is to protect the company and its shareholders (in-cluding the employees) from a bad hire which gets a huge grant ofstock or options but proves to be a mistake right away. A cliff vest
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allows the company to move the bad hire out of the company withoutany dilution.
There are a couple things about cliff vesting worth discussing. First,if you are close to an employee’s anniversary and decide to move themout of the company, you should vest some of their equity even thoughyou are not required to do so. If it took you a year to figure out it wasa bad hire then there is some blame on everyone and it is just bad faithto fire someone on the cusp of a cliff vesting event and not vest somestock. It may have been a bad hire but a year is a meaningful amountof employment and should be recognized.
The second thing about cliff vesting that is problematic is if a salehappens during the first year of employment. I believe that the cliffshould not apply if the sale happens in the first year of employment.When you sell a company, you want everyone to get to go to the “paywindow” as JLM calls it. And so the cliff should not apply in a saleevent.
And now that we are talking about a sale event, there are some im-portant things to know about vesting upon change of control. Whena sale event happens, your vested stock or options will become liquid(or at least will be “sold” for cash or exchanged for acquirer’s securities).Your unvested stock and options will not. Many times the acquirerassumes the stock or option plan and your unvested equity will be-come unvested equity in the acquirer and will continue to vest onyour established schedule.
So sometimes a company will offer accelerated vesting upon a changeof control to certain employees. This is not generally done for theeveryday hire. But it is commonly done for employees that are likelygoing to be extraneous in a sale transaction. CFOs and GeneralCounsels are good examples of such employees. It is also true thatmany founders and early key hires negotiate for acceleration uponchange of control. I advise our companies to be very careful aboutagreeing to acceleration upon change of control. I’ve seen these provi-sions become very painful and difficult to deal with in sale transactionsin the past.
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And I also advise our companies to avoid full acceleration upon changeof control and to use a “double trigger.” I will explain both. Full accel-eration upon change of control means all of your unvested stock be-comes vested. That’s generally a bad idea. But an acceleration of oneyear of unvested stock upon change of control is not a bad idea forcertain key employees, particularly if they are likely to be without agood role in the acquirer’s organization. The double trigger meanstwo things have to happen in order to get the acceleration. The firstis the change of control. The second is a termination or a proposedrole that is a demotion (which would likely lead to the employeeleaving).
I know that all of this, particularly the change of control stuff, iscomplicated. If there is anything I’ve come to realize from writingthese employee equity posts, it is that employee equity is a complextopic with a lot of pitfalls for everyone. I hope this post has made thetopic of vesting at least a little bit easier to understand. The commentthreads to these MBA Mondays posts have been terrific and I am surethere is even more to be learned about vesting in the comments tothis post.
Employee Equity: How Much?
The most common comment in this long and complicated MBAMondays
1 series on Employee Equity is the question of how much
equity should you grant when you make a hire. I am going to try toaddress that question in this post.
First, a caveat. For your first key hires, three, five, maybe as much asten, you will probably not be able to use any kind of formula. Gettingsomeone to join your dream before it is much of anything is an artnot a science. And the amount of equity you need to grant to accom-plish these hires is also an art and most certainly not a science. How-ever, a rule of thumb for those first few hires is that you will be
1http://www.avc.com/a_vc/mba-mondays/
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granting them in terms of points of equity (ie 1%, 2%, 5%, 10%). To beclear, these are hires we are talking about, not co-founders. Co-founders are an entirely different discussion and I am not talkingabout them in this post.
Once you have assembled a core team that is operating the business,you need to move from art to science in terms of granting employeeequity. And most importantly you need to move away from pointsof equity to the dollar value of equity. Giving out equity in terms ofpoints is very expensive and you need to move away from it as soonas it is reasonable to do so.
We have developed a formula that we like to use for this purpose. Igot this formula from a big compensation consulting firm. We hiredthem to advise a company I was on the board of that was going publica long time ago. I've modified it in a few places to simplify it. But it isbased on a common practive in compensation consulting. And it isbased on the dollar value of equity.
The first thing you do is you figure out how valuable your companyis (we call this "best value"). This is NOT your 409a valuation (we callthat "fair value"). This "best value" can be the valuation on the lastround of financing. Or it can be a recent offer to buy your companythat you turned down. Or it can be the discounted value of future cashflows. Or it can be a public market comp analysis. Whatever approachyou use, it should be the value of your company that you would sellor finance your business at right now. Let's say the number is $25mm.This is an important data point for this effort. The other importantdata point is the number of fully diluted shares. Let's say that is 10mmshares outstanding.
The second thing you do is break up your org chart into brackets.There is no bracket for the CEO and COO. Grants for CEOs and COOsshould and will be made by the Board. The first bracket is the seniormanagement team; the CFO, Chief Revenue Officer/VP Sales, ChiefMarketing Officer/VP Marketing, Chief Product Officer/VP Product,CTO, VP Eng, Chief People Officer/VP HR, General Counsel, andanyone else on the senior team. The second bracket is Director level
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managers and key people (engineering and design superstars for sure).The third bracket are employees who are in the key functions likeengineering, product, marketing, etc. And the fourth bracket areemployees who are not in key functions. This could include reception,clerical employees, etc.
When you have the brackets set up, you put a multiplier next to them.There are no hard and fast rules on multipliers. You can also havemany more brackets than four. I am sticking with four brackets tomake this post simple. Here are our default brackets:
Senior Team: 0.5x
Director Level: 0.25x
Key Functions: 0.1x
All Others: 0.05x
Then you multiply the employee's base salary by the multiplier toget to a dollar value of equity. Let's say your VP Product is making$175k per year. Then the dollar value of equity you offer them is 0.5x $175k, which is equal to $87.5k. Let's say a director level productperson is making $125k. Then the dollar value of equity you offerthem is 0.25 x $125k which is equal to $31.25k.
Then you divide the dollar value of equity by the "best value" of yourbusiness and multiply the result by the number of fully diluted sharesoutstanding to get the grant amount. We said that the business wasworth $25mm and there are 10mm shares outstanding. So the VPProduct gets an equity grant of ((87.5k/25mm) * 10mm) which is 35kshares. And the the director level product person gets an equity grantof ((31.25k/25mm) *10mm) which is 12.5k shares.
Another, possibly simpler, way to do this is to use the current shareprice. You get that by dividing the best value of your company($25mm) by the fully diluted shares outstanding (10mm). In this case,it would be $2.50 per share. Then you simply divide the dollar value
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of equity by the current share price. You'll get the same numbers andit is easier to explain and understand.
The key thing is to communicate the equity grant in dollar values,not in percentage of the company. Startups should be able to dramat-ically increase the value of their equity over the four years a stockgrant vests. We expect our companies to be able to increase in valuethree to five times over a four year period. So a grant with a value of$125k could be worth $400k to $600k over the time period it vests.And of course, there is always the possiblilty of a breakout that in-creases 10x over that time. Talking about grants in dollar values em-phasizes that equity aligns interests around increasing the value ofthe company and makes it tangible to the employees.
When you are doing retention grants, I like to use the same formulabut divide the dollar value of the retention grant by two to reflectthat they are being made every two years. That means the the unvestedequity at the time of the retention grant should be roughly equal tothe dollar value of unvested equity at the time of the initial grant.
We have a very sophisticated spreadsheet that Andrew Parker2 built
that lays all of this out for current employees and future hires. Weshare it with our portfolio companies but I do not want to post it herebecause it is very complicated and requires someone to hand hold theusers. And this blog doesn't come with end user support.
I hope this methodology makes sense to all of you and helps answerthe question of "how much?". Issuing equity to employees does nothave to be an art form, particularly once the company has grown intoa real business and is scaling up. Using a methodology, whether it isthis one or some other one, is a good practice to promote fairness andrigor in a very important part of the compensation scheme.
2http://twitter.com/#!/andrewparker
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Merger s andAcqu i s i t i ons
Acquisition Finance
It's monday and it's time to move on from the MBA Mondays1 series
on Employee Equity2. We did nine posts on employee equity and
hopefully we moved the needle a bit on understanding that complic-ated topic.
I'd like to switch topics now and talk about acquisition finance. Theother day Chris Dixon
3 said this in a comment here at AVC
4:
the two biggest tech companies alone (apple and google)are approaching $100B in cash that they will likely usefor acquisition to support their incredibly profitablebusinesses
The point Chris was making with that comment is there is a lot ofbuying power out there in the big tech companies that can be spentto buy tech startups. And he is right about that. Google has $34bn incash. Apple has $50bn in cash and short term investments. Microsofthas $44bn in cash and short term investments. eBay and Amazon eachhave more than $5bn. The numbers add up to a lot of buying powerout there.
But just because they have the cash doesn't mean they will use it. Thereare a number of factors that acquirers consider before pulling thetrigger on an acquisition. They look at whether the acquisition willimprove or hurt earnings going forward. They look at how they will
1http://www.avc.com/a_vc/mba-mondays/2http://www.avc.com/a_vc/2010/09/employee-equity.html3http://twitter.com/#!/cdixon4http://www.avc.com/a_vc/2010/11/pacing-yourself.html#comment-100256188
have to book the acquisition on their balance sheet. They look at howdilutive the acquisition will be to shareholders (even if it is a cash ac-quisition, they may need to issue employee equity for retention). Andmost of all, they attempt to determine how the acquisition will berecieved by their shareholders and what impact it will have on theirstock price.
I am calling this entire topic acquisition finance. I am not an experton this topic but I've got a working knowledge of it and I am goingto share that working knowledge with all of you over the comingweeks.
M&A Fundamentals
This is the first post on the "acquisition finance" series we started lastweek in MBA Mondays
1. I am going to try to lay out the basics of
mergers and acquisitions in this post. Then we can move on to somedetails.
As the term M&A suggests, there are two types of deals, mergers andacquisitions. Acquisitions are way more common. It is when onecompany is taking control of the other. A merger is when two likesized businesses combine. An example of a merger is the AOL/TimeWarner business combination ten years ago. I am not a fan of mergers.I believe it is way better when one company is taking control of theother. At least then you know who is in charge. Mergers are verycomplicated to pull off organizationally.
I have done a few mergers in the startup world. The best example isReturn Path and Veripost
2 which merged in 2002. The two companies
started at about the same time, both got venture funding, and builtalmost identical businesses. They were beating each other up in themarket and getting nowhere quickly. The management teams knew
1http://www.avc.com/a_vc/mba-mondays/2http://findarticles.com/p/articles/mi_m0BOR/is_2_17/ai_82780035/
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each other and the VCs (Brad Feld3 and yours truly) knew each other.
We finally decided to put the two companies together in a merger. Itworked because we decided that Matt Blumberg
4, Return Path's CEO,
would run the combined companies and because Eric Kirby, Veripost'sCEO, was fully supportive of that decision. Even so, it was not easyto execute.
Acquisitions are way more common and I believe way better. Mostof the deals you can think of in startupland are acquisitions. A largercompany is acquiring a smaller company and taking control of it.
The next distinction that matters a lot is how the consideration ispaid. The most common forms of payment are cash and stock. In fact,you'll often hear corporate development people say "it's a stock deal"or "it's a cash deal." Companies can pay with other consideration aswell. Debt is sometimes used as consideration, for example. But instartupland, you'll mostly see stock and cash.
Most people think cash is preferable. If you are selling your company,you want to know how much you are getting for it. And with cash,that is clear as crystal. With stock you are simply trading stock inyour own company, which you control, for stock in someone else'scompany, which you don't control.
However, over the years in maybe a hundred deals now I have mademore money in stock based deals with the acquirer's stock than I havelost in acquirer's stock. I don't know if that is just my good fortuneor not. But I certainly have had the experience of taking stock in anacquisition and having that stock crumble and lose it all. So if you aredoing a stock based deal, make sure you do your homework on thecompany and its stock.
The third and final distinction we will cover in this post is what theacquirer is purchasing. Typically the purchaser can either buy assetsor buy the company (via its stock). If you are selling your company,you'll generally want to sell the entire company and thus all of itsstock to the buyer. The buyer may not want to entire company and
3http://twitter.com/#!/bfeld4http://twitter.com/#!/mattblumberg
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may suggest that it wants to do an "asset deal" which means it cherrypicks what it wants and leaves you holding the bag on the unwantedassets and some or all of the liabilities.
For obvious reasons, fire sales are often done as asset deals. Healthycompanies with bright futures are not often purchased in asset deals.They almost always sell the entire company in a stock deal. If you areselling your company you should try very hard to do a stock deal forthe entire company.
That's it for this post. We've covered the three most important dis-tinctions; merger or acquisition, paying with stock or cash, and buyingassets or the entire business. We'll get into more detail on each ofthese issues and more in the coming weeks.
Buying and Selling Assets
MBA Mondays1 are back after a week hiatus. We are several posts
into a series on Merger and Acquisitions. In our last post, we talkedabout the key characteristics of mergers and acquisitions
2. And we
touched on the two kinds of purchases, the asset purchase and thecompany purchase. Today I’d like to talk about the asset purchase.
As I said in the prior post, a buyer can either purchase the entirecompany or the buyer can purchase select assets and assume select li-abilities. This kind of transaction is known as an asset sale.
Asset sales can happen as a partial exit or a complete exit. In the partialexit, a company transfers certain assets and certain liabilities to anoth-er company in exchange for some consideration, and then continuesoperating as a going concern. In the complete exit, the companytransfers all of the assets and liabilities that the acquirer is interestedin and then winds down the company and settles all remaining liabil-ities and then liquidates.
1http://www.avc.com/a_vc/mba-mondays/2http://www.avc.com/a_vc/2010/12/ma-fundamentals.html
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In the partial exit, the asset sale is a desirable transaction. It is the waythat many spinoffs are done. Many companies will build or buythemselves into a diverse set of operating businesses and they ulti-mately realize that the business has gotten too complex to operate ortoo complicated to explain to investors. They can simplify theirbusiness by spinning off, selling, and otherwise exiting some, but notall, of their businesses.
In the complete exit, the asset sale is often an undesirable transaction.If there is not going to be an ongoing business left after the saletransaction, it is most often best to get the purchaser to take all theassets and all the liabilities via a company purchase.
The asset sale allows the purchaser to “cherry pick” the desirable assetsand take on the liabilities they are comfortable with and leave theseller with undesirable assets and remaining liabilities. The seller thenhas to unwind what is left and liquidate the company. The seller mayhave to use some or all of the consideration that was given (cash orstock) for the desirable assets to settle the remaining liabilities. Theseller cannot liquidate the business and take out the considerationbefore settling with the creditors. If the liabilities are larger than theconsideration obtained, a bankruptcy or some other settlement pro-cedure with creditors may be necessary.
The asset sale may also be undesirable for tax reasons. In a companypurchase, the acquirer purchases the stock from each of the stockhold-ers and takes control of the entire business. The stockholders get acapital gain, either short term or long term depending on the lengthof time they held the stock. In an asset sale, the consideration goesinto the seller’s company and is used to settle liabilities and wind downand liquidate. Any remaining cash after all that will be distributedout in a liquidating distribution. There may be taxes to be paid at thecompany level on the sale transaction which will further eat into theproceeds which can be paid out. And there is the possibility of taxationof the liquidating distribution depending on what kind of businessentity the seller was operating. That is called “double taxation” andyou want to avoid that in an acquisition transaction.
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There may be times when an exit is best done via an asset sale. I canimagine a set of circumstances where it might actually be desirablefor a seller to do that. But those circumstances are not very commonand it is generally true that if you are looking to exit a business, youwant to do it via a company purchase transaction, not an asset saletransaction.
If you are the acquirer however, asset purchases can be very desirable.They allow you to avoid liabilities you don’t want to take on andcherry pick the assets you want.
In my experience, asset sale transactions are generally done in “firesale” situations and company sale transactions are generally done inall other M&A transactions. At least that is how I’ve seen it done inventure backed technology companies.
Next week we will talk more about the company sale transaction.
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