Atomic Energy

In the previous article, we laid out the main areas in which the efficiency and effectiveness of operations within a fairly small back-office finance department can impact the bottom-line. In this follow-up article, we will see just how severe the impact can be through a case-study, complete with actual numbers.

The Patient

The patient, firm X, is a $15MM annual revenue firm, so larger than a start-up, but still on the small side. All of the firm’s revenues come from professional services, with an average hourly billing rate is $110, giving 136k hours billed per year. As a professional services firm, its primary costs are labor expenses to the staff who work on billable projects, both salaries to employees and payments to contractors. Using the US Department of Labor standard of 2,000 labor hours per year, the firm uses 68 person-years to deliver its services. The firm has 25 billable employees with a fairly high utilization rate of 80%, or 1,600 hours per year. The rest of their time is spent on training, development, non-billable travel and paperwork. The total billed by employees is 40,000 hours per year, or 29.4% of the firm’s total revenues, with the remaining 96,000 or 70.6%, billed via contractors. The average billing per contractor is 700 hours per year.

The 25 employees cost the firm, on average, $100,000 in salary and benefits per year. Since each employee bills out 1,600 hours per year, for revenue of $176,000, the gross margin per employee is 43%. The average rate the firm pays its contractors is $80/hour, for a gross margin of $30/hour or 27%. Clearly, contractors are much more expensive than employees. However, the firm is subject to two forces that limit the use of employees.

1. Demand fluctuates greatly. Although the firm can reasonably expect to hold to its $15MM in revenues, it wants to keep its fixed costs down, and thus does not wish to be subject to layoffs when business takes a short or medium term downturn.
2. Demand is geographically dispersed. The firm cannot always expense travel costs and times to its customers. Thus, it uses contractors who may only bill 500 hours per year to the firm, but will be much closer to the customer.

Average gross margin for the firm is 27%*70.6%  (contractors) + 43%*29.4% (employees) = 31.7%. With $15MM in revenue and 31.7% average gross margin, the firm has $4.76MM in annual gross profit. Of that $4.76MM, $3MM should pay for various overhead - real estate, accounting, legal, and administrative, including, of course, the finance department. The remaining $1.76MM is operating profit that either goes to the shareholders as dividends or is reinvested in the business.

Back-Office: The Finance Department

The finance department is staffed by 5 people: a CFO and 4 employees. Its average invoice size to customers is $20,000, so it issues 750 invoices and receives an equal number of payments per year. It does no material business via credit cards, and most of its invoices are issued net 45, as is common practice in its industry. The average invoice received for payment to contractors is $2,000, so it pays 3,840 contractor invoices per year, in addition to invoices for basics such as real estate, consumables, bank interest, etc. Employee salaries are paid twice monthly, on the 15th and 30th of each month. Employee expenses are reimbursed at the “next available pay cycle,” which employees understand to mean the second paycheck after approval, or 5 business days plus 2 paychecks. Thus, if an expense is submitted on the 1st, the employee expected to get paid on the 30th, whereas one submitted on the 10th is expected to be paid on the following 15th. Employee expenses consist primarily of travel expenses to customers and training materials, as well as mobile phone bills. Consumables and other incidentals are paid directly by the firm to vendors.

The Issues

Let us examine each of the issues raised, and the cost to the business. 

Payroll

As a small business with 25 employees, some sales people and executive staff, and the 5 people in finance, total regular payroll is 40 people, a fairly small operation. Payroll has been outsourced entirely to SurePayroll. One of the key advantages to SurePayroll is that it sends out reminders to process pay on a regular basis. Thus, X almost never misses payroll and is rarely, if ever, late. Employees like SurePayroll as they can pull their entire pay stub - and its history, as well as end of year tax forms - online. 

Expense Processing

Expense processing is handled by submission to the finance department in a paperwork process. Receipts are attached to paper using Scotch tape, along with printed or handwritten expense reports. The average employee submits $200 per month in expenses. The employee pays the expense out of their own pocket, then awaits reimbursement. The reimbursement is manually entered into the SurePayroll pay stub with the appropriate billing cycle.

Because of the slow paperwork process, the following occurs:

• 25% of expenses are submitted at least two weeks after occurrence, while the remainder are submitted end of the same week. 
• 15% are lost and must be resubmitted. However, without any method of employees tracking the status, it is only once an invoice has failed to be paid do employees know of the lost expense and resubmit.
• Expenses are normally actually reimbursed three pay cycles after submission, rather than two. 

With 25 employees submitting one expense sheet per week, 100 are processed per month. Each expense submission requires 15 minutes of employee time, and 15 minutes of finance staff time, for a total of 3,000 minutes, or 50 hours. At the fully loaded cost of $100,000 per employee shown earlier, direct basic expense processing costs are $2,500 per month or $30,000 per year.

Lost invoices require one hour of employee time and one hour of finance employee time, or two hours total. With 15% lost and requiring resubmission, that is 15 per month, or 30 hours per month, 360 hours per year. At the fully loaded cost of $100,000 per employee, reprocessing of lost expenses is $18,000 per year.

Slowness of paying means that each employee is out, on average, $400 awaiting reimbursement at any given moment. At consumer unsecured debt rates of 15%, each employee is paying $60 per year to finance the business. From the employee’s perspective, however, all that they see is $400 in cash they need to carry for the business. As word has gotten around as to the slowness of paying of expenses, each new employee has insisted on a salary at least $400 per month higher than they would otherwise accept. This is an additional $5,000 per year per employee cost. With 25 billable employees, the cost to the business is $125,000. 

Total expense processing cost is $171,000 per year. Total cost due to late and missed payments is $141,000 per year. Average labor cost per basic processing is $25; this should be between $10 and $15. Cost due to inefficient process is $10-15,000 per year. 

None of these costs takes into account employee turnover and the cost of retaining new employees, which will not be calculated here.

Summary:$156,000 per year in direct waste.

Invoice Processing & Accounts Payable

X spends approximately $3.0MM each year in overhead. $500,000 of that overhead is the finance department, including benefits. Although slow accounts payable affects many vendors, we will focus on one area alone: consultant invoices. As described above, contractors bill the firm 96,000 hours per year. The average rate for contractors is $80 hour, for total billing of $7.68MM. These invoices are all due net 30. However, X loses approximately 15% of the invoices, a rate identical to the lost expense rate. Each lost invoice requires tracking down to ensure that it is truly lost, and then resubmission.

As stated above, 3,840 invoices by contractors are submitted per year, with each contractor performing, on average, 700 hours per year. The time to process invoices is similar to the time to process expenses, 15 minutes of finance department time and 15 minutes of contractor time. Due to the standard terms and conditions with contractors, the 15 minutes of contractor time is not billable. With 3,840 invoices and 15 minutes per invoice, basic invoice processing takes 960 hours per year, or $48,000 in costs. 

Lost invoices take one hour to process, including resubmission, if necessary. At 3,840 invoices per year and a loss rate of 15%, 576 invoices must be reprocessed at an hour of labor each, for a total cost of 576 hours or $29,000. 

The single largest element, however, is the increase in rates. Because the firm is known as one that pays late and frequently loses invoices  - and all contractors who do not know initially, find out very quickly - X is paying above-market rates for each contractors. The rate for this type of contractor is between $70 and $75 per hour. The $5 to $10 increment in rates is demanded by contractors to cover lost hours in following up on invoices as well as late payments. Since contractors bill 96,000 hours per year, the firm is paying, at minimum, $480,000 in excess fees, directly reducing its gross margin.

Summary: $509,000 per year in direct waste.

Invoice Issuance & Accounts Receivable

As stated above, X receives $15MM in revenue, spread over 750 invoices, each with an average amount of $20,000. Like X, most of X’s customers have a “must invoice by y days after service” policy to be paid. On average, the policies provide for full payment if invoices are received within 30 days of service, 10% penalty for invoices received within 60 days, and option to refuse to pay for invoices received after 60 days. X does not have a structured invoice issuance and follow-up process. Almost all of X’s invoices are issued net 45. The distribution for invoice issuance is as follows:

• 60% of invoices are issued within 30 days
• 30% of invoices are issued within 60 days
• 10%  of invoices are issued after 60 days, of which 3/4 are accepted with 15% penalty and the rest are rejected

Additionally, 25% of invoices are not paid within 45 days, but rather once finance personnel follow up, leading to payment within 75 days. Each invoice follow-up takes one hour of finance staff time. With 750 invoices per year, and 25% paid late, 187 invoices are late, costing 187 hours of employee time or $9,375.

The cost of late invoices is as composed of two components: reduced or lost revenues, and cost of carry. For simplicity sake, we will ignore cost of carry.

• 60% issued on time: no costs.
• 30% issued within 60 days: 10% * 30% * $15MM = $450,000
• 7.5% issued within 90 days but paid with 10% penalty: 7.5% * 10% * $15MM = $112,500
• 2.5% issued within 90 days and rejected: 2.5% * $15MM = $375,000

Summary: $937,500 in annual costs. 

Reporting

Cash management and reporting will not be calculated at this stage.

Summary

Total avoidable annual losses from suboptimal finance department management are as follows:

• Expense Processing: $156,000
• Invoice Processing and Accounts Payable: $509,000
• Invoice Issuance and Accounts Receivable: $937,500

Firm X is losing $1.6MM in direct profit each year due to the poor performance of a small back-office department. Recalling that the total annual profit of the firm was $1.76MM, this leaves barely $160,000 in profit for the owners or reinvestment each year. This paper profit of $1.76MM but actual cash availability of only $176,000 induces owners to seek out assistance.

Conclusion

Efficient and effective back-office operations can have a significant impact on a firm’s profitability. This is especially true with back-office operations that sit at the nexus of the firm’s business, whether finance, IT for information-intensive industries such as finance, supply-chain for manufacturing, and other critical departments. Firm X needed an operations expert to analyze the operations, isolate the costs and recommend improvements, at a reasonable cost to the business.

Before continuing back-office operations, we will take a short detour into a case study of how not to transition to new media.

As we all know, media properties have been suffering greatly, especially broadcast media. Advertising revenue is down, and enormous numbers of viewers have moved to what is termed new or interactive media, i.e. the Internet. Most media firms have been trying, with varying degrees of success, to find ways to make money on the Internet. Some studios have banded together, with hulu.com providing online streaming video for NBC, FOX and a few others. Other networks provide their content on their own Website, such as cwtv.com and abc.com. Still others provide their shows via iTunes or in partnership with existing video sites like YouTube. Finally, several have simply put their heads in the sand and said, “we don’t believe the Internet exists.” Every one of the properties that has gone online has come to some form of agreement with their local affiliates, who rely on the networks for content, advertisers for revenue, and worry that the availability of the shows online would further cannibalize from their viewers. The networks with better foresight used a mixture of muscle and diplomacy to come to an agreement with their local partners. 

Among the most lucrative broadcast franchises over the years have been the sports leagues: NHL, NFL, MLB, MBA. The strong fan loyalty and excitement of a game are good draws, and, unlike scripted shows or “reality” TV, one really never does know the outcome of the “show” until it is over. Combined, these are a great combination for viewer draws. However, the sports franchises suffer from several fragmentation issues:

1. Geographic fragmentation: Fans are mobile. A New York Rangers hockey fan might live in New York, but travel on a regular basis on business to Chicago, Los Angeles or Singapore, and yet want to see his games. Similarly, a Montreal Canadiens fan might actually live in New York, or Beijing, whether for a short period as an expat or diplomat, or permanently.
2. Broadcast fragmentation: Even without fans moving around, games for the same team are often broadcast on different networks. One day it will be local broadcast; they next day on a regular channel on Cablevision; the next day on a regular DirectTV channel; the next day on NHL Network, a special paid add-on channel on many cable/satellite systems; the next day it is not broadcast at all. Fans who do not bother with cable - cost, boredom, religious objections, or any reason at all - are huge untapped market.
3. Fan fragmentation: Many fans actually support different teams, sometimes in the same sport, sometimes in different sports. In theory, someone who already pays $60 per month for cable might pay an additional $160 per season for NFL or NHL. Almost no one will pay for both of those, plus NHL Network, plus another package, plus… all to view fewer games than they want to.

Given the twin challenges of declining viewership and increasing fragmentation, the Internet would appear to provide a beautiful solution. A league - or a conglomeration of leagues, like the hulu.com model - could sell packages online. If you remove the overhead of base cable or satellite, many fans would be happy to pay a monthly fee of $15-30 to receive all of the games in their league. Indeed, this is the price point that many leagues have come across, from NHL (a latecomer) to MLB. The key challenges are:

• Technology: Online video is not easy to implement if you have no experience in this space.
• Partners: Leagues sell rights to various broadcast and cable or satellite networks to broadcast live games. These partners will be unhappy if online availability moves viewers away from their advertising or subscription supported channels. This is exactly the same problem that networks have vis-a-vis their local affiliates.

So how has the NHL managed this transition with their NHL GameCenter Live? In a word: disastrously.

Technology

There are two ways to solve the technology problem. Either build (or buy) the expertise in-house, or get a partner. The NHL has partnered with NeuLion of Plainview, NY, to provide online streaming. About a year ago, I met an executive and founder of NeuLion. The video broadcasts themselves are sometimes great, sometimes choppy, sometimes terrible. To be fair, this cannot totally be the fault of NeuLion, as it is dependent on the bandwidth and latency of each customer, something they cannot entirely control.

Partners

Many leagues, including the NHL, solve the problem problem by creating blackouts. If you live in an area where the game is already broadcast, you cannot watch it online. This pleases all its partners: we won’t let anyone see it, unless it cannot take away from your viewers. NHL, however, has done this far worse than anyone could have predicted.

1. The blackout lists are enormous. Anytime a viewer could possibly view it in their area - it is broadcast on-air, it is on any cable or satellite channel anywhere that might reach the area - it is blacked out. In other terms, the chances are greater than 50%, and sometimes as high as 80-90%, that the game a fan wants to see will be blacked out. This may make the partners happy, but it infuriates the fans who, in the end, are the real source of league revenues. Most other leagues have a far more limited blackout regimen.
2. The blackout lists are secret. The entire league season schedule, and most of its broadcasting, is known well in advance. It would be quite simple for the NHL to post the blackout list prior to viewers signing up. The fact that it declines to - indeed, it hides the blackout terms quite well - speaks volumes about the respect the league has for its viewers… which is the real root cause of the league’s decline in the last several years.

Customer Service

Here, indeed, the NHL has exceeded everyone’s expectations for abysmal customer service. In a day of wireless carriers and their legendary poor customer services, this is pretty impressive. 

1.  Blackout: As listed above, the NHL seems to realizes, perhaps only subconsciously, that posting an extensive blackout list will only turn off potential customers. Thus, it actually hides the list. It simply cannot be found online prior to (or after) purchase. Every business tries to paint itself in the best light. However, a business that hides a material negative of a sale from a customer is asking for trouble. 
2. Subscription: Somewhere hidden in the terms and conditions of the signup is an automatic renewal. If someone buys the 2008-09 season for $160, they will receive a nice charge for another $160 in October 2009, unless they explicitly follow up and cancel. Automatic renewal does make sense with month-over-month sales, or sometimes even annual sales with explicit warnings and pre-approval. The NHL - and its partner, NeuLion, who actually does this billing, and thus takes equal share of the blame for these disgraceful business practices -  simply renews without agreement and without warning. Again, it appears that the NHL and NeuLion are afraid that if they gave customers the option, they would opt out. Generally, if your customers wouldn’t otherwise buy it, the problem is you, not your customers.
3. Cancellation: Cancellation is equally egregious. NHL.com offers two subscription models: pay once $160, or pay $20 per month over the season. Many people choose $20, despite the overall greater cost, for two reasons. First, it is easier on the cash flow. Second, it makes cancellation easier. If you do not like the broadcast quality, or the games, or anything at all, you can always cancel for next month. Theoretically, if you pay $160 for a season’s subscription and do not get the quality that you paid for, you should be able to get a full or, at least, a pro-rated refund, but it is always easier to just stop next month’s subscription. And here is the rub. Buried in its terms and conditions, NHL redefines the $20 monthly plan as actually just a payment plan for the entire $160 season. If you sign up, you are committing to the entire $160, just spreading out the payment terms. Additionally, they give viewers five days, yes, just five days, to cancel, after which no cancellation is possible. Five days is not enough to try out a bicycle, let alone a season-long online subscription. If on day 6 you discover that 80% of your games are blacked out, and the other 20% are choppy or poor quality, NHL will try to make you pay the rest. A short warranty period, which is what this is, is always a strong sign that a seller knows its product is garbage. 
4. Civility: Unsurprising when coming from a company that views its customers this way, its customer service reps are abysmal. They are rude and condescending to the viewers who call their customer support number. This point has been reinforced by legions of frustrated viewers across the Internet. At this point, it is unclear if the representatives are NHL staff, NeuLion staff, or a third-party provider. Either way, the NHL will suffer from the poor reputation.

Summary

In order to claim that it is getting “into the Internet,” the NHL has done so in a manner that gave the maximum number of its business partners the most short-term satisfaction (i.e. avoiding conflict), at the direct expense of its viewers, while doing its best to seduce them into buying something they would not spend a penny on if they had known what was really inside the box, then locking them into it under onerous terms and renewing them surreptitiously and without approval. If I am not mistaken (and I am not an attorney), I believe the phrase is “fraud.” Most people call it “bait and switch.” Either way, the NHL smacks of desperation. The real pity of it is that it could do so much better, gaining revenue, fans (for the game and the league as a business), and consumer protection kudos. How it could do that is something I will not explain here; any business strategist with a real understanding of the Internet could do that (but apparently not NHL).

Perhaps the NHL’s new tagline should be: “watch us drive our Zamboni… right over the cliff.”

As an expert in operations efficiency and effectiveness, I am often asked how much of a difference back-office operations can make to a firm’s profitability? After all, sales are what drive any business, and so the front-office should be the primary focus. While I agree wholeheartedly that sales drive a business - one of the best stories I have heard in this regard is of a startup where everyone had a little box on their desk that went “cha-ching” with each sale, reminding everyone that the company lives or dies by sales - sales are only the tip of the iceberg. If the company cannot deliver on its promises, or if it fails to collect its payments in a timely manner, a profitable sale can quickly turn into a loss. Too many losses and the business is history.

There are a lot of areas to focus on when it comes to operations. For the purposes of this article, we will focus on that historical bastion of efficiency, the finance department.

In addition to strategic issues relating to issuance of debt and equity, as well as currency and commodity hedging, a finance department has several operational functions. These include:

• Payroll: making sure all employees gets paid on time and the appropriate amount
• Expense processing: making sure employee expenses get reimbursed on time and the appropriate amount
• Accounts payable: paying vendors more or less as agreed, whether upon receipt, net 30, 45, 60, 90, etc.
• Invoice processing: closely related to accounts payable, ensuring that invoices get entered and tracked as rapidly as possible
• Accounts receivable: making sure the firm gets paid for its products and services on time, more or less as agreed, or preferably faster
• Invoice issuance: closely related to accounts receivable, making sure invoices get issued to the firm’s customers, that the invoices reflect all the information needed to process the invoice, and that the information is correct.
• Reporting: the department is responsible for managing all of the above so that management can understand the current and future cash position of the firm.

Suboptimal operations in any of these areas can significantly impact a firm’s profitability. Since these are all processed by one department, they normally move together. Worse, these are all considered fixed costs, and thus come after the gross margins. In this section, we will examine each of the functions in turn. In part 2, we will look at a hypothetical firm and the impact on its business.

Payroll

Payroll must be paid on time and accurately. What happens if payroll is late?

1. Angry employees: Very few employees, if any, are willing to work for a firm that does not pay them as agreed. The rare exception is employees of a startup that has no cash, and thus have agreed to be paid in equity. Other than that, however, your employees expect to be paid. If they are regularly paid incorrectly or late, turnover increases and lawsuits are sure to come your way. What is the cost of turnover? The general rule of thumb is somewhere from 50-200% of the employee’s annual compensation, depending on the level of an employee. Put in other terms, an $8/hour employee will cost you from $8,000 upwards in loss and replacement costs. Higher-wage salaried employees cost much more. Additionally, if word gets out that people left because of payroll issues, replacement may be near impossible, until the issue is fixed and significant funds are spent marketing the improvements. 
2. Lawsuits: It is hard to travel a subway or through an airport nowadays without an ad for some law firm that is only too happy to sue anyone who wronged you, however accidentally. For payroll negligence, you can expect to be sued. The costs of these potential suits is difficult to estimate, but one can expect to spend at least $20,000 in legal costs alone defending a single lawsuit, even if filed the suit is dismissed. If there are multiple employees, large amounts of pay, or you have to settle out of court or, worst of all, lose the costs can be orders of magnitude greater.
3. Penalties: Some states assess penalties for late payroll. However, the IRS and almost all states assess significant penalties if you do not pay withholding and payroll taxes on time. 

Fortunately, most firms outsource their payroll nowadays, from small business providers like PayCycle and SurePayroll to the giants like ADP, which reduces the likelihood of problems. Nonetheless, all of these payroll providers depend on timely input from their customers’ management to ensure that the payroll information is correct and approved, and that the appropriate cash is in the bank.

Expense Processing

Even the best-run firms regularly have difficulties with expense processing. I have rarely seen a firm that handles it expeditiously. Even when the approval requirements are onerous, most employees will get the appropriate approval within a few days… after which it languishes in the expense processing area of the finance department.  This is partially because it is an “unimportant” back-office function, and partially because some firms view their employees as a bank. Because of this, expectations for expense processing are so low that as long as the rest runs well, most employees have greater tolerance for expense processing. Conversely, a place that reimburses in a timely manner will gain a large amount of employee goodwill. What happens if expense processing is late or incorrect?

1. Angry employees: Employees are more willing to work for a firm that is late in reimbursing expenses than one that is late in paying salaries. Nonetheless, resentment does build.
2. Reduced investment by employees: Assume you are working for a firm that asks you top travel to San Francisco for 5 days on business. You whip out your AmEx, and buy a JetBlue plane ticket for $400, 4 nights in a hotel at $800 including taxes, another $300 in food and $200 in cabs here and there, a grand total of $1700. The trip is a grand success and you close two new accounts. Now your employer takes 7 weeks to reimburse you, in which time you need to pay off the AmEx bill with your own funds, money you may or may not have lying around. You never intended to become your employer’s bank, and are quite stressed during the lag. The next time an opportunity comes for you to fly to Miami to close a big account, how likely are you to go?

Accounts Payable

Assuming you know what invoices you have received and what you have to pay by when, you have an obligation to pay these invoices on time, or reasonably close to on time. Some businesses explicitly rely on paying invoices late as a way to generate cash; I have worked with and for several firms like this. What happens when firms do not pay invoices on time?

1. Loss of vendors: Some vendors refuse to do business with the firm. No one wants to spend time chasing down accounts receivable. Most vendors are in business to sell a product or service, get paid for it, then do it again. If chasing down payment becomes too burdensome, thus reducing the profitability of a client, eventually some vendors will simply refuse to do any more business with the firm. The cost of switching vendors as well as the increase in prices due to less competition both have direct costs to the firm.
2. Higher prices: Other vendors raise their prices or impose penalties. In many businesses, when dealing with firms of questionable payment practices, vendors have imposed percentage penalties per day late. When compounding comes in, that can get very expensive. Effectively, even if you can get services, their prices increase.
3. Worse payment terms: Other vendors insist on upfront payment. This can make managing cash flow particularly difficult. The difference between net 30 and upfront payment on a $10,000 sale at 12% cost of capital is $100 more than it was the last time you did it. 
4. Bad business reputation: This makes it even harder to close deals with vendors at reasonable prices, or get decent payment terms. It may also affect your credit rating and banking relationships. A firm with annual revenues of $10MM and debt of $1MM that sees a difference in rates of 2% can pay an extra $20,000 a year in interest.
5. Bad owner reputation: Unlike poor service or products, if the firm does not pay its bills responsibly and on time, the stigma attaches to the people. Quite simply, people expect business owners and managers to be responsible and pay their bills. If they do not, the person himself or herself is viewed as contemptible.
6. Higher processing costs: Every time a vendor does not get paid, they call you, they harass you, they harass your staff. Besides the lowered morale and turnover among the staff, you are paying for the staff’s time. 

Invoice Processing

Before bills can possibly be paid on time, invoices received from vendors must be processed and managed. What happens when invoices are not properly entered?

1. Delayed payments to vendors: Accounts payable are delayed, with all of the negative impacts discussed above.
2. Higher processing costs: Since each payment is now a scramble to find, enter and process an invoice, your costs increase.
3. Impossible cash-flow planning: Without an understanding of what invoices are due in the next period of time, management cannot do short-term cash management. It then will find itself either keeping too much cash on hand, depriving it of investment income or returns on investment in growth of the business, or too little, leaving it to scramble at the last minute for more expensive, usually high-interest debt, cash to pay its bills.

Accounts Receivable

Accounts receivable is directly responsible for turning sales made into the cash the business needs to survive. What happens when accounts receivable is poorly run?

1. Lost payments: Cash due to the firm is never received. This might be because the invoice was not known about or never issued, the customer is intentionally or accidentally slow, the check was never received, or any of a myriad of other reasons. Either way, this is worse than a lost sale. If a $10,000 sale was never made, it was never made. But a $10,000 sale that has a gross margin of 20% has already cost the firm $8,000 in direct cost of sales or cost of goods sold. 
2. Late payments: Cash due to the firm is received late. Every time you do a sale on receivable, you are lending your customer money. If a $10,000 payment is received 30 days late, you just lent your customer $10,000 for 30 days. You never wanted to be a banker, and you certainly don’t want to be one if it means lending money for zero interest.
3. Higher processing costs: Since inevitably management realizes it is missing cash, a “fire drill” occurs in which everyone in accounts receivable scrambles to find and recover the missing payments. This processing time is expensive.

Invoice Issuance

Before payment can be received, an invoice must be issued. What happens if invoice issuance is not running smoothly?

1. Wasted multiple processing runs: Since invoices are not entered and managed properly, many invoices will need to be submitted multiple times. This eats up time from: finance staff, who must issue the invoice; management, who need to understand and give special approval to an unusual invoice; and sales staff, who need to follow up and explain the sale and its terms. These sales staff do not want to spend time on administration, let alone doing so twice, and cost far too much to do so. Not only is their time expensive, but could have been spent making sales rather than processing invoices.
2. Late payments: Even if the customer is responsible and timely, they are only responsible to pay an invoice based on the days from issue. If the terms of our $10,000 sale specify net 30, and the invoice is issued 30 days late because of invoice sloth, you just lent them $10,000 for another 30 days at zero percent interest.
3. Rejected payments: Many businesses have a “maximum invoice by” policy. Quite simply, you must invoice within a certain time period of service rendered or product sold, or the invoice will be rejected. This is understandable. If you issue them an invoice months late, it is difficult for them to manage their cash reliably.
4. Impossible cash-flow planning: Just like outgoing invoice management allows you to predict cash outflow, incoming invoice management allows you to predict cash inflow. Both are critical to cash management.

Reporting

The finance department has a critical role to play in providing historical, current and future information on the financial state of the business to management. It is expected to have accurate and timely information. What happens when this information is incorrect, slow or out-of-date?

1. Impossible short-term cash-flow management: The business will not know what bills are due nor what payments can be expected in the near future. As a result, the business will either have too much cash on hand, leading to lost investment opportunities - how many businesses do you know that don’t wish they could have had an extra little bit of cash to invest in an opportunity - or too little cash on hand, leading to a scramble for cash when the bills are actually due. This additional cash will have to come either from suddenly cancelled investments, which lead to lost future revenue and demoralized staff, or high-interest lending facilities, which increase unnecessary interest costs.
2. Impossible customer profitability management: The business will not know with any level of reliability what percentage of its receivables comes late or not at all. This makes: provisions for lower profit impossible; provisions for bad debt difficult or inaccurate, a significant problem in public companies that must report accurately; management of customers for maximum profitability impossible. Put in other terms, management cannot know which sales are truly profitable and which ones look profitable but are actually low-margin or losers, and thus a drag on profitability. 
3. Weakened negotiations: Since management does not know what the historical payment record of its customers and suppliers has been, it is in a weak negotiating position for its next negotiating round, either with a new customer/vendor or renewal of a contract.
4. Difficult long-term planning: As the business does not have accurate and timely information on its revenue and expenses, it will have a severely delayed view of its future position. Without this information, it is difficult, at best, for the firm to plan hiring, capital investment, growth or other initiatives. Significant growth opportunities will be missed, while downturns that could have been better managed will be dealt with in crisis mode.

Summary

Efficiently and effectively running operations are important to any organization. Looking at the finance department, we can see how just one poorly run department, one that is not even sales or front-office, can significantly impact the profitability of an organization and its owners and managers.

In a follow-up post, we will look at a case study using real numbers and see the impact of these operations on the profits of an organization.

As a follow-up to the previous discussions, we will analyse a particular merger that was looked at before it occurred - a rare event - and understand how we knew well in advance it was doomed to failure. 

Background

A number of years ago, I was asked to analyze two firms contemplating a merger. Because of confidentiality considerations, I cannot give the locations, names or industries of the firms. The details I can provide are as follows. Firm A was a US-based, technology service firm providing management and support services for legacy technologies, mostly to large customers. These legacy technologies provide critical customer management services for these firms, but is largely viewed as back-office costs. Firm B was overseas, with an Anglo culture and language, providing related software. This software was the next generation of the back-office technology services that firm A managed. Firm B’s software is viewed as providing greater flexibility and the ability to provide new, more closely integrated services for customers. In other terms, the new software becomes more closely related to the front office and even a possible revenue driver, if used correctly. 

The management teams of both firms were looking for ways to jump-start growth, and, upon discovering each other, decided to explore a merger. For many reasons it seemed to make a lot of sense, with each firm providing benefits to the other firm that its partner would have great difficulty in achieving on its own.

1. Firm A:  Firm A had excellent contacts and a trusted relationship with many Fortune 500 customers. It was already on approved vendor lists, regularly received payments from these firms, knew the systems managers and their needs intimately, had direct access to people with budgets to spend. All of these were critical assets that Firm B, with its new technology and overseas base, were struggling greatly to achieve. 
2. Firm B: Firm B had new technology with a much longer lifespan than the current technology, proprietary software with intellectual property protections, much higher operating margins and, like most software firms, very high gross margins due to lower variable costs. Firm A, recognizing that the next generation of technology would eventually replace that which Firm A managed for its customers, was hungry to extend its viability and increase its profitability.

Merger Plan

To the management of both firms, the merger seemed a slam-dunk. Firm A would gain higher margins, intellectual property, and a renewed lease on life, while Firm B would gain access not only to the large US market, but direct entree to senior executives at its preferred clients. This is a classic horizontal merger with cross-selling advantages in mind.

Neither of the two firms had a significant size or cash advantage over the other, leading it to be a true merger of equals rather than an acquisition of one party by the other. In order to maintain expertise advantage where it was best suited, and to avoid a sense of “defeat” and “takeover” by one firm, the merged firm would be managed by a co-CEO team, with joint headquarters in the US and overseas. The overseas headquarters would focus on new technology development, while the US headquarters would focus on sales and support.  

While the potential merger was in advanced planning stages, I was contacted by the investment bank advising Firm A to analyze the merger and give my opinion. Interestingly, it was the investment bank that contacted me, rather than one of the two parties.

Issues

At first blush, the strategy made sense: a horizontal merger where each party brings something to the table that makes the whole greater than the sum of the parts. When digging deeper, however, it became clear that this merger was a very bad idea.

1. Market Position: One of the key elements that Firm A brought to Firm B is access to the markets. Firm A, the servicer, already had a very positive market reputation… as a servicer. Firm A was known as a stable, reliable, staid provider of back-office services. They understand how to keep the systems running, and stick to service levels (SLAs) when there are issues. They are the utility, the one you call for more power. However, no one ever calls PSE&G or Consolidated Edison to design a new computer system, only to provide the power to it. Firm A simply did not have the market reputation it would need to bring cutting-edge, revenue-driving, high-profit services to customers. It would be as difficult, if not more so, for Firm A to change its reputation - and likely harm its existing “utility” business at the same time - as for Firm B to penetrate the market directly or, preferably, find a better partner.
2. Sales: Related to the market position, Firm B expected that Firm A had direct entree to senior executives, decision-makers who could spend money on Firm B’s new software. Indeed, Firm B did have direct access… to the operations managers, plant managers, systems managers, everyone who ran the back office, everyone except the front-office people who were exploring new areas, new revenue opportunities. Depending on the politics of a target customer, the back-office contacts could introduce the new merged Firm to the front-office people, along with their solid, dependable, utility reputation, exactly what front-office is not looking to hear. Once again, Firm B could do better directly accessing the front-office decision-makers, or finding a more suited partner, than with Firm A. Once again, Firm B was likely to harm its back-office relationship and cash cow business by leveraging it into front-office for Firm A.

At core, the assumptions underlying the value of the merger were not only incorrect - they were diametrically opposed to reality and likely to harm both firms, possibly permanently.

Execution

Even if the firms nonetheless decided to merge, operational issues with the merger plan itself were serious enough to give pause.

1. Geographic Culture: Although both firms spoke English and were from Anglo-oriented countries, there were enough cultural differences to make close cooperation difficult, at the very least. These were overlooked by the management plan with a wishful, “both are Anglo.”
2. Professional Culture: Unsurprisingly, and a requirement for any kind of success, each firm had an internal culture that reflected its market brand. Firm A had defined hours, detailed procedures, innovation in a well-defined space, essentially a utility firm: dependable, reliable, always the same result. Firm B, on the other hand, was largely staffed with software developers, each pushing the envelope in his or her own way. The ability of the staff of the firms to merge and leverage the skills of the other was questionable at best. It is doable, but requires a very strong hand on the tiller, rapid success, good cultural leadership, and significant investment in human needs and skills, the “touchy-feely” employee satisfaction needs on which small firms rarely have the cash or time to focus. Exacerbating the issues was…
3. Poor Management Structure: Even in a merged firm, the buck has to stop somewhere. In order to make the merger politically palatable to both sets of owners and management, the co-CEO structure was replicated throughout. The planned structure, a company of a few dozen people at most, had an organization chart that would have made the HR staff from my old days at Deutsche Bank blush. The lack of a clear chain of command, and a clear sign that the best interests of the firm’s growth, not political sops, were what mattered, would have drained the merged entity of energy and skilled personnel just as fast as its market failures.

Even a merger with the best strategic alignment, which this one certainly did not have, operational execution is paramount. A merger of acquisition must be planned and executed with an eye towards market and business success, and must trumpet it to competitors, customers and, especially, staff. In this case, not only were the strategic assumptions wrong, but the execution plan was awful.

Results

I presented a report, detailing all of the above, along with an executive summary to my client. Before opening it, the investment banker asked me for the verbal summary. I told him, “the merger sucks; don’t do it.” If I had known how he would react, I would have had paramedics standing by; I am glad he didn’t go into cardiac arrest. I am not sure to this day if it was the tone - as a consultant, I am paid to speak the truth as bluntly as necessary - or the content that did it. 

As most people know, investment bankers make their money as a percent of the deal. In this case, not doing the deal would have cost the banker a lot of potential income. Needless to say, he was displeased. He then forbid me from speaking directly to his client, Firm A, and blowing his deal. Of course, in this case, the investment banker was my client, and confidentiality forbid me from even letting Firm A or Firm B know that the banker asked me to analyze the deal, unless either approached me and retained my services for a separate analysis. In my opinion, the banker was ethically and legally bound to inform his client that he had received an expert opinion about the deal that was negative and to recommend to his client not to do the deal, or, at the very least, to share the concerns. I do not know if he did so. 

Conclusions

• Always examine your assumptions as deeply as possible
• When done, have an outsider without a stake in them reexamine them
• When you perform any transaction (or any project), structure the results for business success
• Broadcast to everyone - competitors, customers and especially employees - that you are building for success and how
• Politics should serve the business, not the other way around
• Never, ever, ever rely on an investment banker, business broker (or large consulting firm that stands to make money from the integration) or anyone with a vested interest in the deal going through to figure out if a deal is good or bad. Their job is to get you the best deal possible from an immediate financial standpoint. Get someone who will get paid exactly the same amount whether you do a billion-dollar deal or no deal at all to determine if a deal really makes sense. Once you decide it does, then get the banker or broker to do it for you.

In an earlier post we discussed what are the reasons that a firm, at least theoretically, decides to merge with or acquire another firm. These basically fell into two categories, horizontal integration and vertical integration. And yet, we know that a huge number, 70% to 80% or more, depending on who you ask, fail, most miserably. A question that recurs regularly is why these events fail, and, by extension, what can be done to reduce the failure?

In the closing of the previous post, we looked at the very basic mathematics. For an M&A transaction to not be considered a failure - which is distinct from achieving the publicly stated goals, something that is much more difficult - the total return from the transaction, the value of the combined entities, must be at least 1 penny (or pence, or ruble, or yen, etc.) more than the amount paid plus transaction costs. Of course, almost every acquisition involves payment of more than the value of the firm on its current trajectory, so there is the added burden. Thus, the total amount gained must be at least one penny more than:

1. The current value of the firm, which is normally the market capitalization for a publicly held company, or some discounted cash flow (DCF) or similar valuation for a privately held firm. For example, as of close of trading on Friday, September 12, Merrill Lynch was valued at $17.05 per share with 1.53BN shares outstanding gives a value of $26.1BN; plus
2. The premium paid for the firm, i.e. the amount that was paid above and beyond the current value. Bank of America agreed to buy Merrill Lynch this past Sunday, Sept 14, 2008, for $44BN, a premium of about $18BN; plus
3. The costs of the transaction. These fall into several categories, and include investment bankers fees, often around 7% of the value of the deal, lawyers fees, and other related fees; plus
4. The costs of integration. These are the costs of actually putting the two businesses together. These involve everything from managing people and conducting hiring or layoffs, through systems integration and books merging, to joining sales forces and merging headquarters. 

Offsetting all of these, of course, is the value gained. This value is really composed of two very simple components:

1. The current value of the firm, which should be fairly identical to #1 above; plus
2. The integration value, i.e. the horizontal and/or vertical value added discussed in the previous article.

Looking at the above, the basic reasons why so many M&A fail to achieve real value and usually lead to a loss is as follows. The first three costs and the first value are fairly fixed and straightforward, known right from the beginning of the transaction. The real killers in the deal are always the costs of integration and the integration value. Inevitably, in every failed transaction, either the integration costs are much higher than expected or the value of integration is much lower than expected, or both. 

Costs of Integration

Why do the costs of integration end up being so much higher? To be fair, I cannot think of a single transaction I have seen, read about or been involved with that the costs of integration estimated upfront are even close to the final costs of integration. Most firms that have some form of integration have some element of integration that is literally left hanging for many years thereafter. There are a lot of reasons for this cost underestimate: 

• Humanity: People are human and make mistakes. They make the same mistakes again and again. What holds true for renovating a kitchen or building a house - the final cost is always much higher - holds true for merging firms. 
• Secrecy: Very often, these transactions are discussed in secret, due to fears of market manipulation, pressure to complete or undo the deal, or regulatory requirements. This secrecy causes many employees - those who daily deal in facilities, sales, technology or other areas that would need to be integrated - to be unaware of the deal and unable to give their input. The same management that seeks this input as critical before engaging on expansion into a new line of business avoids it before engaging in a merger of acquisition.
• Consultants: Coming from a consultant, this may sound self-defeating, but consultants are often a source of the problem. Many of the large consulting firms bill out untold millions in consulting hours to plan and assist in the integration. First, in order to get the business, they will often underbid, expecting to make up in “additional hours” or “change requests” to the contract. These additional hours come through as additional transaction costs. Second, if they feel the need to stick to the bid, they will do less work than management expected, leaving the clean-up to the in-house staff, creating additional hidden costs. Third, the large consulting firms have an unenviable track record of putting large numbers of young, just-out-of-college-or-business-school associates on the job in order to bill lots of hours at a higher profit margin. These associates, quite frankly, do not know how to manage the integration, let alone the people involved. Fourth, to be brutally honest, many of the partners at these firms do not have a clue how to piece together the elements and costs of integration. Many have climbed the consulting ladder by billing our more hours, but have never had to actually live through and manage an integration from the corporate side, i.e. pay the price for failure and receive the rewards for success. I have seen consultants from PriceWaterhouseCoopers, Ernst & Young, Accenture and all of the other firms destroy the goodwill within a firm for the transaction by their heavy-handed behaviour and absolute ineptness. Even the high end firms such as Boston Consulting and McKinsey have shown similar lack of true understanding of the real world. 
• Hubris: It had to come up eventually. Executives often have inflated views of their own abilities to manage the integration. Further, these numbers often come from the CEO, rather than the COO and line managers who really know what it takes. 
• Incentives: CEO pay is often tied not to profit margins or comparable margins, but absolute revenues, profit or comparables. Thus, the CEO of a $1BN revenue $200MM profit company will make a lot more money as the CEO of a $2BN revenue $300MM profit company, even though the margins have now shrunk from 20% to 15%. Many of these contracts are not available to the public - and kudos to John Mack of Morgan Stanley who instituted high transparency and close tie of compensation to company performance, as well as full annual director elections, after his successful coup against Phil Purcell in June 2005.

Value of Integration

From the value of integration side, similar factors come into play. Executives consistently overestimate the value the integration will bring to the merged entity. The reasons are actually quite similar to the reasons costs are underestimated.

• Humanity: People make mistakes, and executives are no different. People overestimate how big a market will be, how much value cross-selling or how much cost-saving will bring. Using the prior analogy, people invariable underestimate the cost of renovating the house, and overestimate the increase in resale value the renovations will bring.
• Secrecy: Once again, because of the secrecy in transactions, the very people who truly know what that value will be - the IT managers who are expected to wring cost savings out of the systems, the sales staff who are expected to bring more profit per sale due to cross-selling, the marketing managers who are expected to drive demand for the better and more complete “whole package” - are left out of the conversation. It is often said that startup CEOs are the best, because they spend real time talking to every single customer, until they can practically step into the customers’ shoes. In larger firms, the sales staff and marketing managers are the ones who spend time living and breathing the customer and must be involved.
• Consultants: Once again, consultants, who have a strong incentive to push a transaction that will bring them huge consulting fees, along with too strong a belief in themselves and their firms’ abilities, push for a transaction by sugar-coating the results. To their credit, it is highly likely that the consultants themselves do not realize what they are doing. It is unlikely to be malicious or intentionally misleading except in rare circumstances. Nonetheless, the damage is done. One of the top brand of consulting firm in the world once gave a strategic presentation, which I was not privileged to attend but did see the slides, in which they showed a “hockey stick” graph of net present value over time. If the two top country partners of this firm do not understand “net present value” and what it means, they cannot possibly understand the true value of a merger.
• Hubris: Every CEO likes to believe that he or she is the next coming, will make their mark as a really huge CEO. In software, Eric Raymond once said (and I paraphrase, errors are mine) that the software is finished not when there is nothing left to add, but when there is nothing left to remove. A really great CEO is not one who knows how to build his/her empire, but one who knows how to focus a business. Like presidents (and I always avoid politics in these posts), the CEO who focuses on his or her legacy does damage to both their charge and their legacy; one who focuses on just doing the best job, is a benefit to their charge and their legacy.
• Incentives: These incentives are the same. If pay is tied to size, rather than profitability, who can possibly blame the CEO or Board for wanting to jumpstart company grow the company 

The only way to get properly estimate these costs and the value gained upfront is to get a fully independent person, working with the board and the line staff (managers on down) to fully figure out the costs, and ensure that the compensation of the CEO is not tied to the overall size of the company, but rather its profitability. Whoever does this analysis - consultant, executive, anyone - must have zero incentive to make it work. They must be paid to figure the value and costs out, and not have millions in bonuses or consulting fees hanging on recommending a transaction. Finally, the staff who live and breathe the day-to-day operations - running the business, marketing its goods and selling to customers - must give input on the true value and costs of the integration.

In an earlier post, we discussed the justifications, at least theoretically, for a merger or acquisition. Of course, like any financial event, whether buying a company or buying an iPod, the numbers have to make sense. Put in other terms, you have to gain more out of it than you put into it (in business terms, being profitable), otherwise you simply do not do it. In this discussion, we will examine some of the financials behind these events, and how they are justified.

In general, you buy something because it is worthwhile to you. If that something is not a simple expenditure (like an iPod), but rather an investment, you do so because you expect to make a return on that investment. The obvious question is, in the case of an acquisition, shouldn’t the net return be neutral? In short, if a company’s profitability (and, more importantly, its free cash), is worth $500MM right now, then shouldn’t its price be exactly $500MM? If so, if you spend $500MM, you have gained nothing; if you spend greater than $500MM, you have lost money, and if you spend less than $500MM, well, the current owners will not sell, since they make more money by holding onto the company, at least until a better buyer comes along.

The core to understanding this is the integration value discussed in the previous article. We will use the horizontal integration example of earlier with two car companies. In that case, the competing companies may well have been worth $500MM each as they stand today, but since each one will cut $5,000, or 25%, of their expenses by working together through economies of scale, when joined each is worth some amount more than $500MM, say, $600MM. Thus, the buying company will pay something more than $500MM, to make it worthwhile for the sellers, and less than $600MM, to make it worthwhile for the buyers. Everyone wins (except for the remaining competitors, who now face a stronger player, but we are not too concerned about them). From a growth perspective, using the cross-selling example, if each company, again, is worth $500MM, but together, without having to cut any costs, they can grow their revenues and hence their profits by 20%, then each one, when joined together, is worth $600MM, or 20% more. Thus, the acquiring company will pay something more than $500MM, to make it worthwhile to the sellers, and something less than $600MM to make it worthwhile to the buyers.

As we can see from the above financial examples, mergers and acquisitions really only make sense in one of two cases:

1. Where the value of integration is great enough that the acquirer can pay more than the current value of the company, yet still have a positive return on the investment, such that the company standing alone could not gain this new value.
2. Where the existing company is so poorly run that the current value is significantly below what the value will be when the new owners turn it around and fix it up.

The final twist in this is the operational cost of the transaction. In addition to the significant sums to pay to acquire (or merge with) the company, there are operational and transactional costs:

1. Investment banker fees
2. Legal fees
3. Regulatory fees
4. Employee severance
5. Facilities mergers
6. Accounting mergers
7. IT systems mergers
8. Benefits management

The list goes on and on.

So why, in the end, do so many mergers and acquisitions fail? The short form, of course, is that the cost paid plus the operational costs is greater than the value the managers/owners perceived they could extract from the merged entity. The obvious question, then, is why are these numbers off for so many transactions? A follow-up post will discuss this issue.

Earlier today, someone posted on a mailing list an attempt to understand why eBay bought Skype in the first place. For those who have forgotten, eBay, the online auction giant, bought Skype, the VOIP/IM newcomer with around 57MM registered users at the time, for $2.6BN in 2005. The poster wanted to understand why they bought Skype, and how they feared Skype upending their business model. This article is a short introduction to the reasoning behind most acquisitions, in an attempt to improve understanding.

First, one very big caveat. Depending on whose analysis you use, over 70% of mergers and acquisitions fail. The definition of failure here is that they do not achieve their targeted goals, and often end up costing more than if they had just let things be. Why do they fail, and given those statistics, why do they try? That has a lot to do with psychology, and will be the subject of a follow-up post.

In general, there are two reasons for entering into an acquisition: vertical integration and horizontal integration. These sound like business-school-buzzwords, which to some extent they are, but they help categorize and explain why a business buys another one.

Vertical Integration

Vertical integration is the process of buying out your supplier or customer, essentially someone in your supply chain. Let us say you make cars (not a very profitable thing nowadays, especially if you are a US car company). You decide, for various reasons, that it will be more profitable for you to own your own windshield maker rather than buy them from one or more suppliers. This acquisition is known as vertical integration. Similarly, if you are Fidelity, and you sell lots of mutual fund via a network of brokers owned by Charles Schwab, and you decide to buy out part of Schwab’s business, that is vertical integration.

Why would a company perform vertical integration? There are several possible reasons:

•  Supply: For whatever reason, you are concerned about supply, and thus you buy a supplier to guarantee good supply. You do not expect cost savings per se; this acquisition is about ensuring a good supply for your business.
• Savings: Each stage of middle-man in a business adds a cost, both cost of operation and profit requirements. If you can perform that function better in-house, then you can realize cost savings.
• Competitive advantage: If there is only one or a few suppliers or customers for a business, buying them can put your competition at a significant disadvantage.

Clearly, vertical integration can be done for cost reasons, but is primarily done for strategic reasons, either to improve your ability to manufacture, deliver and market goods and services, or to make it more challenging for your competitors to do so.

Horizontal Integration

Horizontal integration is the process of buying out another firm that is not in your supply chain, and is either complementary to or competitive to your business. For example, if you are General Motors, and you buy out Ford (difficult to do when you just lost $15.5BN in a quarter), that is horizontal integration. Similarly, if you are Morgan Stanley and you merge with Dean Witter so that each one can feed the other’s business, that is horizontal integration.

Why would a company perform horizontal integration? There are several possible reasons:

• Economies of scale: Quite simply, if you produce 100,000 cars at a cost to you of $20,000 each, and your competitor does likewise, it is possible that manufacturing 200,000 cars together will only cost you $15,000 each, leading to a $5,000 cost savings per car, or $1BN a year. This is one example of that awful buzzword, “synergies.”
• Economies of scope: Similar to economies of scale, it is possible that although you each manufacture, separate, non-competitive items, together you can manufacture each of them more cheaply. This is very similar to economies of scale, except that you are not manufacturing the same item, but nonetheless gaining cost advantage.
• Fixed cost savings: There is a certain amount of overhead in running a firm of a given size. These costs are not lines. For example, in the second quarter of 2008, Google had general and administrative costs (think executives, some facilities, HR, legal, etc.) of $319MM for just under 20,000 employees, yet it would cost much less than double that, or $638MM, for 40,000 employees. Given Google’s notorious inefficiencies in operations, perhaps this is overstating the case, but the principle holds. This is usually what executives of public companies when they refer to “cost savings via synergies” in a vague sense (also usually known as, “we hope we will save some money, else we cannot justify the acquisition”).
• Competitive reduction: You buy a competitor. Using the above example, if GM bought Ford (which is difficult, but then again, Ford lost over $1BN in the second quarter of 2008 and its shares are at around $4.62 for a total capitalization of just over $10BN, so perhaps not so far-fetched), it would have the ability to control a greater share of the market, raise prices or reduce output (if the UAW even let them).
• Cross-selling: You buy a complementary company, expecting that you will each use the advantages of the other to build a bigger business. The whole is greater than the sum of its parts. This was the rationale behind most of the “financial supermarket” mergers and acquisitions of the late 1990s through recent years. Morgan Stanley merged with Dean Witter because they each felt that they could use the other’s strengths and especially markets to sell more than they could on their own. The same holds true for Citi and Travellers, and all the others. It is important to remember that this is not primarily about saving money (reducing expenses), but about increasing revenue (top-line).

Clearly, horizontal integration can be done for either cost or strategic reasons. 

Skype and eBay

So given the above, what type of merger was Skype and eBay? It is difficult to tell. Two primary rationales have been given for the acquisition at various times.

1. Members: eBay saw a slowdown in membership growth, while Skype had tens of millions of active members (around 57MM as of the acquisition). eBay saw Skype as a way to bring many new members into the eBay fold. Essentially, eBay bought Skype for its users. This is straight horizontal acquisition, with cross-selling as a rationale. 
2. Communications: eBay saw a slowdown in membership growth, and believed that Skype, with its popular instant messaging and voice channels, could act as a strong method of communications between buyers and sellers on eBay. Although eBay could have built an IM or VoIP platform on their own, the technical challenges are not insignificant, and the marketing challenges - how many IM and VoIP systems do most users want - are even greater. Essentially, they bought out a good and well-positioned supplier. This is straight vertical acquisition.

Either way, it did not fare well. eBay bought Skype in 2005 for $2.6BN in September 2005. By October 2007, two years later, eBay had to take an impairment charge of $900MM. Put in more normal terms, eBay is saying, “Oops, we seriously overpaid.”

A final note on non-integration acquisitions

As a final note, there is a type of acquisition that has nothing to do with integration. In short, if an investor sees a company that is poorly run, and believes that, without integrating its business with any other business, s/he can run it better, they may buy out the firm to do so. A famous recent example is the 2007 Cerberus Capital acquisition of Chrysler Corp. Chrysler lost $1.5BN on more than $60BN in revenue in 2006 (their last year as a public company). Cerberus took a look and said, “What a mess. We can do better than $1.5BN in losses and growing.” They acquired the company, installed new management (Bob Nardelli, deposed for good reason former CEO of Home Depot), and started a turnaround plan. The Chrysler case will be the subject of a follow-up analysis on this site in the coming weeks. Many of these acquisitions were made famous in the 1980s as hostile takeovers, so-called because the existing Board and management resisted the acquisition directly from shareholders. Considering that this is the same Board and management that mismanaged the company in the first place, and were likely to lose their positions and income as a direct result of the takeover, their rejection was not exactly surprising.

It is a well-known truism that companies lose their market share (and their shirts, and sometimes their life), when they are so tied into their big, currently lucrative business model to support the small opportunities that can grow into big ones. In this instance, I am referring to the credit-card companies who missed the boat on micro-payments, got lucky in that no one stepped in fully (or at least successfully), and seem dead set on doing so again.

Most people think of credit cards in terms of the consumer side. You make a purchase, the agreed price is $x, you swipe your card (or put the number on the Web page or through the phone), and within some period of time get a bill that you pay off. From the seller (a.k.a. merchant) side, it is a little more complex, with all sorts of pricing and fees that you pay. Put in other terms, if I sell you an iPod for $299 and charge your Visa or MasterCard, my store will pay some amount in fees to the credit card company for the privilege of processing the transaction. Why would I do that?

1. It is very hard to do business nowadays without accepting credit cards. This is just a cost of doing business.
2. It is a lot easier and safer to manage my funds via the credit cards, rather than have to worry about cash, which can physically take up space, get ruined, become misplaced, or be stolen, anywhere in my store or on the way to the bank.

The fees paid by merchants vary widely and are very confusing. Many claim this is done intentionally by the processors and credit card companies in order to get more from merchants. If you want a good introduction to how to read the bills, check out the article in the April 2007 issue of Inc magazine. I would also recommend a good credit card consultant if you process any serious volume. In a very simplified version, the merchant essentially pays several fees:

1. Monthly fee: This is a flat monthly fee for the right to accept and process credit cards, and may include a terminal (that card-swipe machine you see at your local store), support or other services.
2. Per-transaction fee: This is a flat fee that is charged per transaction. Average rates tend to be $0.10 to $0.15, according to the aforementioned Inc article and several experts I have spoken with, but tend to move higher for Internet merchant accounts, i.e. those accounts specifically set up for processing payments online.
3. Discount rate: This is anything but a discount. It is the percentage of the transaction the processor takes. It covers both the interchange fees from Visa and MasterCard, as well as profit to the processor. 

 Using as an example PayPal, the most popular processing engine on the Internet, the fees in its two basic plans are as follows. It is important to note that PayPal has dramatically simplified the structures. Most processors do not provide the advanced online services PayPal does, and charge different rates based on card type, etc.

• Website Payments Standard
  1. Monthly fee: $0
  2. Per-transaction fee: $0.30
  3. Discount rate: 1.9% to 2.9%
• Website Payments Pro
  1. Monthly fee: $30.00
  2. Per-transaction fee: $0.30
  3. Discount rate: 1.9% to 2.9%

If you look at the numbers, you quickly see that if your average sale size is $50, $100 or more, the per-transaction fee of $0.10-0.30 is only a tiny amount of the total sale, bumping your discount rate up by at most 1%, and usually far less. No one wants to give up 1% in additional costs, but it is not disastrous. If it is, you have more fundamental business problems and need professional help.

On the other hand, when you make sales of under $10, and especially really small ones like under $1, you can see that the per-transaction fees can double, triple, or worse your discount rate. If you sell 2 readings of an ebook for $5, even if you somehow got a discount rate of 2%, the $0.30 per transaction fee adds 6%, quadrupling your discount rate. This is a serious issue.

These very costs - which used to be worse - are the main reason many stores have those wonderful signs that say, “minimum charge for credit card $10/$20″ or similar.  And it is for this very reason that many businesses built around selling items for small amounts online took a very long time to take off.

How did it get this way? Visa, MC and the like are really just passing their costs on. They have a fixed cost to process each transaction, and they have a percentage cost for each transaction, hence it makes sense to pass it on that way. However, those fixed costs are, largely, minimal. In the early days of the credit card industry, for those of us who remember it, there were no Internet or dial-up terminals. The merchant took your card, made an impression, and then forwarded it on to the processor. Handling all these paper slips was quite a labour-intensive and capital-intensive proposition for both merchant and processor. Add to that the probability of lost slips, meaning lost ability to get the funds as well as possible theft, and the costs could get quite high.

No longer. Today, nearly every credit card transaction is handled electronically. The per-transaction costs are tiny. Visa does not even break it out separately in its 10K. Thus, although these charges may have dropped, they certainly do not reflect the lower costs. Given the efficiencies of electronic transaction processing, the card companies certainly viewed it as in their best interests to reap the rewards of the information technology revolution and earn higher profits.

The issue here is that if they did, indeed, reduce these amounts, the minimum size of a credit card transaction would go down, opening a whole new class of transactions, i.e. micro-payments.

As a result of the credit card firms clinging to their old models, many new attempts to support micro-payments has opened up:

1. Carriers: The wireless carriers have opened up their billing infrastructure. Although their costs are still high, they are certainly more flexible and lower than the credit card companies. Thus, many companies have begun to offer small transactions that would not be economically feasible via credit cards, charging instead via the carriers. Although many of these do eventually get passed through to the credit cards when the carriers charge their bills: (a) any extra middleman means someone is taking a profit they could have had; (b) when AT&T or Verizon wireless, with their massive size, process payments, it is undoubtedly at a far less profitable rate to the processors than the many smaller providers. 
2. ISPs: A number of ISPs began to offer services similar to mobile carriers. This has not taken off in the United States.
3. PayPal: PayPal has been very wise, effectively becoming a bank. Sure, the traditional PayPal is where I have an account with a credit card number, as do you, and I can send money to your PayPal account from mine, thus charging my card. But many people now maintain PayPal balances and send funds from one person to another, or one consumer to a merchant, without ever going near credit cards. The cost to PayPal of these transactions is near-zero, while the lost profit of these transactions to the credit card firms is quite large. Let’s look at it via the numbers. In the last quarter for which information was reported, Visa received $749MM in service fees on payments transaction volume of $652BN. Put in other terms, it makes revenue of 0.11% of processed volume. PayPal, which is both a competitor and a customer of Visa, had $602MM in revenue on $14.93BN in payments volume. In similar terms, PayPal makes revenue of 4.0% on processed volume, or 36 times the revenue per dollar of transaction. Some of this is simply due to PayPal being in a higher-fee business, further down the food chain from Visa. But a large amount of it is due to PayPal being able to simplify transactions between accounts without needing the credit card companies.

Other similar firms are slowly (or not so slowly) popping up.

The credit card companies missed the boat. They viewed themselves as indispensible, that no one can do non-cash or slow-check transactions without them, thus:

1. We can charge what we want.
2. We can structure it how we want.

Along came the carriers, and especially the PayPals, and said, “we will change the model”:

1. We will provide low-cost person-to-person or business-to-business transactions without the credit cards
2. We will make it a “push” model: the money is transferred when I push out to my merchant, rather than giving the merchant enough sort-of-secret information, like my credit card number, known in industry parlance as PAN, and lately lots more information, like the address, secret number/CVV/CSC/CVV2/etc., wherein they now can “pull” information out of my account. I recently was involved in a PCI compliance project with a company that processes large amounts of credit card transactions each month.

What will happen next?

1. Smaller competitors (assuming PayPal and similar to be “small”) will continue to provide more secure, easier-to-use, easier-to-protect and lower-cost models, eating into the smaller, and even larger, transactions that used to be the sole domain of the credit card industry.
2. These competitors will begin to see how they can provide better solutions even for larger transactions and will begin to offer methods to make payments not only online, but directly compete with the cards’ bread-and-butter, “card present transactions.”
3. Eventually, some of these may dwarf or even acquire a credit card company. Certainly the turmoil in the financial services industry, between the credit crunch and corporate troubles, will leave at least one weak enough to be acquired.

It is hard for those of us who remember the radical notion of a credit card, “will that be cash… or Chargex,” to think of the credit card industry as a dinosaur. But the reality is that it is an old-time business. Unless it changes its model, it will be in trouble soon.

In the first part of this post, we analyzed what the position of the dominant player (Google) is, where there are opportunities, and what they need to succeed. In this part, we will briefly review the one I interviewed recently, hakia. FYI, hakia is, indeed, spelled lower-case; this is not a typo. 

Given our list of criteria above for success, how well do hakia meet the requirements?

1. User Requirements. hakia seems to really get this space. They are investing some amount in making the results more user-friendly, not just fancier-looking - which users are not looking for - but enough content on the search results page itself to reduce the number of unnecessary click-throughs. More importantly, they understand that users want: (a) to ask questions in a normal human manner; (b) to receive highly relevant results. Additionally, hakia understands the concept of credibility. People want not just relevant results, but credible results. Your local massage parlour home page is great and credible for deep-tissue massage and back rubs (Google pun intended), but extremely low on the credibility scale for cancer treatments. This is an area that I have not heard clearly expressed by any provider outside of hakia.
2. Operations. This part concerns me. Even Google needs to struggle to index the exponentially growing Internet, and they have customized hardware, software, data centers and huge amounts of cash to invest in it. In FY2007, Google spent $630MM on R&D and $377MM on general and administrative. Although Google does not break down how much of that is directly related to crawling and indexing, $1BN on G&A and R&D, separate from sales costs, is a lot of money, and hard to play catch-up for anyone. hakia recognizes that they need to find a different model, one that is not as cost-intensive, but there is no avoiding the fact that the amount of Web content is enormous and keeps growing.
3. Customer acquisition. I have not seen indications one way or the other on this. However, I have rarely seen a consumer-focused Internet start-up that really calculates the customer acquisition cost. I saw one recently in the virtual world space and another in a related semantic advertising space that may or may not have properly calculated this, but do correctly recognize that individual/retail acquisition is incredibly expensive. In their cases, they took a saner route and are instead becoming infrastructure providers to those who already have millions or tens of millions of users acquired.
4. Business-model validity. hakia is building on direct advertising, unsurprisingly, yet is also diversifying into other areas where it can sell usage of the technology. They seem to have a good model but are hedging their bets, a good call, given the unpredictability of the cyberspace advertising market.
5. Investor patience. hakia gets a plus one on this one. They seem to have lined up investors who get the idea of long-term investment, and are even, in this day and age, focused on IPO, not on being bought out. They will need to get a lot bigger to deal with the registration requirements (=expenses), Sarbox nightmares, and securities class-action exposures (possibly fewer since Milberg Weiss has been cut down to size) that so plague any company attempting to go public, but they seem to be prepared for it.
6. Google response. Obviously, hakia has little control over this, although they seem somewhat dismissive of it. To their credit, they get that they need to focus on the first 5, get them right, and 6 becomes less of an issue.

Summary: good model, diversification, excellent customer grasp, investor management. Weakness or underplanning in operations and customer acquisition.

In the year 2008, there is one 80-pound-gorilla in the corner in the world of search, and its name is Google. FY2007 revenues were $16.6BN with net income of $4BN. In any industry, and especially one as R&D- (and hence expense-) intensive as technology and search, net margins of 24.1% is nothing to laugh it. Microsoft had slightly higher consolidated net margins (29%), while Cisco had only 21%, and both are much more mature businesses, having been around a lot longer than baby Google.

Several factors combine to create great opportunities in search:

1. Blinded by the size: It is hard to remember that Google didn’t really exist a decade ago, and most people searched, if at all, using Yahoo or similar. Given that history, Google’s invincibility should be taken carefully. No company is perfect or immune to a driven upstart, and larger companies tend to be more bureaucratic and slower-moving. More and more reports have been coming out of Silicon Valley disparaging some of Google’s internal issues, including poor hiring practices, bad politics and even internecine warfare. Personally, I take no pleasure in these - Google is a good company that did much good in and to the Internet, despite its warts - except insofar as it indicates that Google is going through some of the maturing growth that all companies go through. What it further indicates is that Google is becoming a company like any other - probably a lot of fun to work at, good perks, but quickly losing some of the hypercompetitive edge that and nimbleness that allows it to lead the pack.  Google is big, but there are serious chinks in the armour.
2. Speed of light: Technology evolves very rapidly, and what was great yesterday is basic expectation today. As a colleague I was working with today described, 5 years ago chat/messaging on a dating site was an extra; today no dating site can survive without it. It is simply the base level required. Put in other terms, the bar keeps getting higher. Google has done an excellent job on making its infrastructure faster, its index larger, its crawling better, and its PageRank algorithm truer. It has also been aggressive in adoption of new technologies or paradigms, especially some of the Ajax work, to make its interfaces better. Nonetheless, at its heart, Google relies on its index of keywords to pages. In 1995, when Sergey Brin and Larry Page were working on BackRub, this was the wave of the future, since the alternative was either no search, one driven by paid placing, manual search or manual placement. Clearly this system is much better. However, as users have gotten used to the abilities of index-based searching, they have come to demand more, that it more closely reflect human interaction. You do not ask your HR department, “2007 holiday schedule officer rank seattle.” Rather, you say, “what is the 2007 holiday schedule for officers who are based on seattle but rotate around the country supporting sales?” Anyone who grew up on Star Trek in the 1960s or 1970s cannot forget the crew talking to the female-sounding computer in normal, human language. Even back then, they got it.
3.  The Content Monster: The amount of content on the Internet, let alone corporate Intranets or the so-called “Deep Web,” has grown exponentially, or probably more. What provides reasonable answers for 1MM pages of fairly narrow reliability does not necessarily do so for 1BN or 1TN. This is completely separate of the operational question of having a good enough engine to both index these pages and provide responses to queries in user-acceptable time. Even given those (which are not insignificant challenges), the results can become poor as too much irrelevant or unreliable content overwhelms the desired results. In engineering terms, this is known as having a low and dropping signal-to-noise ratio.

Given the above - inherent weakness of the dominant player, rising expectations, improved technology and overloaded content - there is plenty of room for several small, nimble competitors today to enter the search space and make meaningful advances. Their success will largely depend upon:

1. How well they really understand user requirements. They must meet and exceed user expectations, but not to a point that users cannot appreciate it. This is the classical engineer’s problem: engineering a solution too far ahead of what people want.
2. How well they manage their operations. Too many companies, especially small start-ups, underestimate what it takes to grow, especially in the technology space, where operations costs can be huge, and the cost of failure of either results or availability on the long-term can be extraordinarily painful, sometimes fatal.  
3. How well they market. Anyone in marketing (including the author) will tell you that acquiring consumers is a very expensive proposition. Most wireless carriers measure the cost of acquiring a customer and the cost of losing one to the penny. The “churn rate”, akin to employee turnover rate but as applied to wireless customers, is measured and followed rigidly (at least the better run ones, if such a thing exists in the United States). The newer players must account for customer acquisition costs. 
4. Business-model validity. Google built itself up on advertising. The advertising market is shrinking due to the current perceived economy and diffusing across the proliferation of publishers, making building a large business on advertising harder.
5. Investor patience. It takes a long time to build up a solid profitable consumer-oriented search business. Most investors, especially in Silicon Valley and the tech sector in general, lack the patience to wait for these models to play out.
6. How well Google responds. Notice this is last. Google will likely be around for a long time. Whether or not they can be nimble enough to respond to this depends on the company, its culture, its structure, and its ability to step outside itself. This is akin to the music labels in Part II of my analysis of the music industry.

Most new search entrants are focused on the semantic search space. Semantic search depends not on keywords, at least not directly, but on really understanding what a query means. I recently interviewed the founder & CEO of one of the leading firms in this space, hakia. The interview was on behalf of ArnoldIT, one of the top experts in search. The owner’s blog is listed in the blogroll, at right, and the interview itself is here. I will review hakia and its interview in a follow-up article.