Atomic Energy

My colleague, Jonathan Vanasco, has written an excellent piece on web-based business P&L operations & optimization. I have had the honour of contributing feedback to the piece.

I strongly recommend reading it here.

Recently, I had the pleasure (take that with a grain of salt) of discussing, with several colleagues, the pros and cons of taking venture capital investment. Everyone seems to have an opinion. I have seen articles published that VCs are the unsung heroes of modern American capitalism. I have seen others that vulture capital would be a better term.  Interesting how the world shifts.

Until the 1980s or even early 1990s, pretty much no one outside of the business knew what venture capital was, how it worked, or where to get it. Then came the Internet boom. Of course, numerous VC-backed firms had had successful exits long before that, making some VCs and founders quite wealthy, but the scale and speed of the Internet boom in the 1980s brought it very much to the public eye. Add some VCs driving their Lamborghinis (plural) around town, and suddenly everyone wanted to be VC-backed, if not an actual VC.

In 2000-2001, the whole thing crashed. Then, everyone believed VCs were terrible, money-losing, and would make you lose your business to boot. Then came social media, the whole concept of “eyeballs” actually began to make money with online advertising, and VCs had a big comeback.

In the 2007-08 recession, it all seems to have turned around.

The real question is: who are VCs, and are they good or bad for your business?  

In true engineering fashion, the answer is, “it depends.”

The VC Business Model

Let’s look at the VC business model, and then we will have a better understanding as to how they fit in. Venture capitalists are a niche of private equity. They are in the business of taking other people’s money, usually large institutional funds like Calpers or Duke University endowment but sometimes very wealthy individuals, and investing it on their behalf to earn outsized returns. The value the VC brings to the investor is their supposed ability to filter among the thousands, millions of potential early-stage private investments, determine which mix of business plan and team is most likely to be successful, and put money into the firm in exchange for equity.

The VC – and by extension the investors – get their money back when the “exit” occurs. The exit is a liquidity event, something that allows the investor to turn their privately held illiquid stock in the firm into a liquid form, usually cash.  There are normally two kinds of exits:

1. IPO: The Initial Public Offering. The firm lists itself on a public stock market – historically in the US this has been the Nasdaq for tech ventures, although others have listed on the NYSE, while others overseas list on the Deutsche Neuer Markt, the London Exchange, etc. –   and the investors can now sell their stock to the public. This exit has been in severe decline in the last decade. This is primarily due to two main factors: litigation, by which public companies and their directors and officers personally are sued for a decline in the stock price; and regulation, particularly the Sarbanes-Oxley act, and its notorious section 404, which dramatically increased the regulatory burden of being a public company. In response, most new firms have avoided the IPO as their stated exit. Others have chosen to list overseas to avoid the double-squeeze of US litigation and regulation.
2. Acquisition: The firm is acquired by an existing firm, for some mix of cash from the acquirer’s reserves and stock of the acquirer, which is likely already publicly traded and is thus liquid.

In other terms, the VC puts its money into the firm, fully expecting that at some point hence, normally 5-7 years, it will receive many multiples of it back in a liquid form. The VC will do everything necessary and within its power to move the firm towards that exit.

Of course, most new ventures fail, many within 1-2 years. The riskier the venture, the larger the market, the greater the probability of failure. To compensate, the VC must invest in lots of firms. So, the VC makes an assumption. For every 10 firms: 7 will fail, 2 will be going concerns but not worth very much (by the VC’s standards), and 1 will be a star. Thus, to make sure that the one star really does shine, and make up for all of the rest, the star must be worth $1BN, and thus must be in a $1BN market.

Result: It is in the VC’s interest to drive every firm in its portfolio to get as big as fast as possible. It doesn’t want successful firms; it wants hugely valuable firms. If that means that all 10 firms take outsize risks, so be it. One will succeed, and that is all it needs.

The VC’s Compensation

In general, the VC is compensated with two elements:

1. Management Fee: Each year, a certain percentage of the money committed to the VC is paid out to the VC’s firm as a management fee. In the VC world, it is normally 2%. Thus, if the VC has raised a $10MM fund, he can expect to receive $200,000 per year as a management fee, which covers everything from legal expenses to accounting to office space to salaries. It is easy to see that a small 3-partner VC firm requires a lot of money under management just to get by. 
2. Upside: When the VC returns money to its investors, it shares in the upside. Sometimes it is after a certain minimum return, sometimes it is before or after the management fee, but the general rule of thumb is to share in the upside. Thus, if a $100MM fund returns $130MM, the VC takes $6MM and the investors take $24MM, ignoring the effects of minimum return, management fees, etc. It is important to note that the VC does not share in the downside. Thus, if the $100MM fund loses money and ends up at $80MM, the investors take the entire $20MM loss.

This management fee plus upside model is very common in private equity, of which VC is a small niche, and is almost non-existent outside of it. In general, most US regulation disallows upside sharing for publicly available investment vehicles, e.g. mutual funds. This structure is normally expressed as “management fee / upside.” Thus, the VC model is normally described as 2/20.       

The Founder’s Model 

The founder of the firm, on the other hand, is putting all of his or her life’s energy into this one firm. He wants this firm to succeed, and may be willing to take fewer risks than an investor. He may or may not be satisfied with a $20MM valuation, whereas the VC wants a $1BN or higher valuation. The founder cannot diversify away his risk the way the VC can.

So What is the VC

The VC is a businessman, like any other. He is usually financially savvy, often strategically savvy, and infrequently but sometimes understands operations and execution. It is also usually a he, not a she, for reasons that I do not fully understand. It is unlikely to be any form of discrimination; many of these VCs hire high-powered extremely capable women to run their companies, like Meg Whitman of eBay, Carol Bartz of Autodesk (now at Yahoo) and many others.

The VC has his or her own interests and needs. His model is built around certain assumptions about diversification, risks, size and speed, and he has certain expectations. There is nothing wrong or right, good or bad, with his model and interests. It just is, however, the model the VC has chosen.

When to Take VC Money

By this point, the answer should be fairly straightforward: take VC money when the founder’s interests and the VC’s interests align. If the two do not align, then chances are strong there will be a nasty falling-out at some point in the future. Charles de Gaulle was famous for saying, “countries have no friends, only interests.” The same should be said for VCs.

The overwhelming majority of new business ventures that are founded start off as, and intend to grow as, small businesses. Of the rest, many have a maximum intended growth of a few $MM to a few tens of $MM over many years. A few, a very few, are intended to be game-changers: Google, Amazon, Intel, the kinds of companies that change the face of an industry, if not the world.

If you are building a company that intended to change an industry or the entire world, and in order to succeed you must get very big, reasonably fast, and are thus willing to take very big risks, go for the platinum ring, then VCs are the right vehicle for you. Even if you get funding, 70% of the time you will fail, 20% you will sort of hang on, but the last 10% will be home runs. 

On the other hand, if you are looking to build a successful small or midsize business, intending to grow a decent market share and have solid revenues and profits, but do not want to risk the whole thing on a single throw of the dice – go for the brass ring or silver ring, rather than the platinum – then VC is not for you. There are plenty of other sources of capital – angels, friends and family, banks, SBA, the list goes on – that are much better suited. If you approach the VC, and especially if you take their money, you are doing a disservice to everyone: your investors, your friends, your employees, your customers, your VCs and most especially yourself. Fortunately, many VCs are very sharp, some of the smartest people I have met (but not all) are VC partners, and they will winnow out the ones that do not suit their model. But sometimes they will see one that can fit their model very well, even if the founder does not. It is in their interest to find and invest in these companies. If you do not want that growth, risk, size and relationship, do everyone a favour and stay away.

Clearly, the United States (and much of the rest of the world) is in a recession, and has been for some time. Opinions differ greatly as to how long the pain will last – some say weeks, some say months, others years (and some say decades unless we adopt their solutions, whatever they are) – but it is clear that corporate revenues have dropped significantly and the pressure on profitability has increased dramatically. This article proposes to explore the various types of cost-savings and cost-cutting available, and draw some lessons. These are applicable to all businesses, but have some special resonance for small to midsize businesses.

In general, there are four overall types of cost-savings that can be performed. Each one is appropriate for particular circumstances, some are better short-term, others are better long-term. Do not implement any of these without taking a serious assessment of what your short-term and long-term goals, revenue projections, competencies, competitive landscape and cash flows are. 

1. Reduction: Reduction is quite simply the process of reducing the number of inputs to your process. This can take the form of selling off manufacturing equipment, buying fewer chairs, or, in its most common form, layoffs (i.e. reducing headcount). In many ways, this is the most painful – you are hurting real people with real needs, especially with headcount reductions – but it is also the most simple for CFOs and CEOs to figure out: “We have $10MM per year in labour expenses, if we lay off 20% of our staff, we will save $2MM.” Reduction is most appropriate when gross units of sale have dropped, or are expected to drop, and the reductions are performed on the variable cost inputs. Thus, if your business sells hammers, and you expect to reduce sales from 2MM hammers to 1.5MM hammers this year, it would make sense to reduce the amount of handle-quality wood purchased by 25%. Similarly, if you sell consulting services or investment banking services, both of which are human labour intensive activities, and you expect a reduction in service revenues of 20%, it makes sense to reduce the labour inputs to these services by 25%. In those circumstances, and normally only in those circumstances, do direct reductions make sense. Unfortunately, this is often too simplistic, the refuge of executive simpletons. Obviously, if the marketing or sales departments are overstaffed, by all means they should be reduced, but that is not restricted to lean times. Reducing marketing or sales by 25% just because every other department is getting hit is akin chopping off your leg because it needs to give its fair share when getting a haircut. In these times, driving up sales – which is what marketing and sales do – is exactly what the company should focus on. Similarly, R&D, which focuses on new products, may be crucial. While everyone else is cutting back on these “not today” investments, targeted marketing, sales and engineering investments will put the smart company in a position to leap ahead of competitors during the downturn and especially as business picks up. The only time that cutting back on these areas make sense are when the business is in survival mode. Specifically, if cash flow is so tight that not cutting back will leave the company short of necessary cash to survive. In that case, any cutbacks that allow the business to survive to fight another day make sense. But as a general rule of thumb, when someone utters the phrase, “business is down so we are laying off across the board,” or the more pernicious, “the other departments are cutting so you have to as well,” you know you are in the presence of a poor businessperson, failed executive and ineffectual leader. Across-the-board reductions are too often the “refuge of scoundrels.”
2. Pricing: Pricing is purchasing the same quantity of inputs – labor, telecom, real estate, office chairs, coffee, whatever – but at a lower unit cost. This normally comes from renegotiation or consolidation (i.e. economies of scale) of purchasing. Quite simply, it is a lot cheaper to buy office chairs in bulk for the 500 staff spread around 10 offices, than for each office manager to go to Staples or wherever and pay retail. Like the reductions in bloated departments, these are cost reductions that should be performed at all times, flush and lean. Unsurprisingly, most organizations do not look at these issues during flush times, focusing much more intently on growth. The few businesses that do tend to be those whose market strategy is to focus on being cost-leaders, like Dell or Wal-Mart, and thus are constantly looking to squeeze every extra dollar (or penny) out of costs. Companies should always look to save in this area. However, a quick assessment upfront should help determine if the savings are realistic. This assessment should come as part of an overall cost-savings analysis, and should not cost significant extra sums. Unless your firm spends millions of dollars a year on telecom, there is no way a telecom consultant at many thousands of dollars is going to have a significantly positive ROI. 
3. Efficiency: Efficiency means running your organization with fewer inputs for the same outputs. Some of the efficiency may lead to repricing or reductions. However, unlike reduction, where the goal is to reduce inputs to match reduced outputs, the goal with efficiency is to reduce inputs while keeping the same level of outputs. The flip side of the coin is the ability to increase outputs without linearly increasing inputs. For example, a business may look to take advantage of competitors’ challenges during a downturn by increasing customer service levels. However, due to the downturn, it cannot afford to spend the additional 20% in investment required. If the customer service organization can improve its efficiency by the same 20%, it will have the additional capacity to increase customer service levels by 20% (actually, more like 25%) without a concurrent increase in costs. Efficiency gains come from several areas:
   • Real estate: A good architect or designer can reallocate space usage so that less real estate is required, thus reducing costs, without reducing usable space. Unless a business has significant real estate costs, normally the province of larger organizations or those with large physical plant, this is unlikely to yield outsize returns.
   • Organization: An organizational structure that is best suited to the activities and process flows of the organization, along with the proper incentives to do what best benefits the organization, not just the individual, can yield significant benefits. 
   • Skills alignment: Skills and their requirement vary by role within an organization, as do the labour costs for those skills. Rarely do organizations reassess their structures in light of skills requirements and costs. In the last year, I worked with an organization where $100,000 per year engineers were performing all the roles of a general support organization: telephone support, first-level support, second-level support, outage management and toolset design. Some of those require $40,000 per year staffers, others $150,000. Half the time the engineers were bored, the other half in over their head, and customer service failed throughout. Putting the right kinds of staff in the right roles, along with the processes required to support them, saved a $10MM organization upwards of $3MM per year while increasing service levels by double-digit percentages.
   • Transaction processing: Technology-driven transaction-intensive processes demand large amounts of infrastructure investment. Restructuring the transaction flows so that they are as efficient and optimal as possible can lead to outsized savings. The most recent Inc magazine (Jan/Feb 2009) has a cover article on PlentyOfFish.com, a dating sight with over 1.5BN page views per month, all database driven, with only 8 servers and 4 staff. 
4. Finance: Efficiency in the back-office can lead to significant financial savings. Unfortunately, back-office processing, especially finance department activities like accounts receivable, accounts payable, payroll and expense processing, are normally given short shrift and treated like the poor sister. Improving efficiency in these areas not only can improve the operations themselves, but also can have a strong impact on the finances of the organization. I recently examined a large food retailer, which, despite many millions per year in sales, still does inventory management by walking through the facilities. As a result, their inventory turns were low and their wastage write-offs (not to mention the infamous “shrinkage”) were high. Yes, improving the efficiency of taking inventory saves on direct costs of labor, paper, pen (or laptop). But far more importantly, it allows the firm to increase its inventory turns, reducing carrying costs, and reduce write-offs, improving the bottom line of the business without a single additional dollar of revenue or reduction cost-savings. Another organization I worked with had accounts receivable issues, leading to slow A/R to cash turnaround times and a certain percentage written off. A longer series of articles about this is available on this blog site.

Given all of these major ways to improve the bottom line, even during lean (or painful) times, how does one find these? How do you know when you are cutting fat rather than meat or bone? And more importantly, how do you know when to cut, when to invest, when to improve? Here are some rules of thumb:

1. If cash flow problems leading to immediate survival is your issue, do everything you need to survive. Try hard not to survive today just to die tomorrow, but if the alternative is going under today, do what you need to. 
2. Once immediate survival is not the question, you have some room to maneouvre.
   1. Look for low-hanging fruit, any area where efficiencies can be gained rapidly and obviously. This not only helps you gain some more profits, it builds credibility within the organization that you are trying to improve, not just cut. A major side-benefit to efficiencies is that once they are implemented, most employees’ lives get easier. They look forward to it. 
   2. Look for pricing opportunities, but do not expend too much effort. If you can save $1MM per year on telecoms costs, then likely you are already a billion-dollar+ revenue organization. There are easier ways to save money, most of which will lead to a lot more than $1MM in savings. Go for the obvious easy ones, and rely on your overall efficiencies consultant to find them for you, rather than paying extra for someone else. If the opportunities are there, s/he will quickly get you a good person to renegotiate, if relevant.
   3. Drive your efficiencies up. Most of your savings and your ability to survive will come from these. 
   4. Use your improvements to improve your market position. If you used to have Dell-quality customer service and now have HP-quality, make sure every single one of your customers (and potential customers) knows it. You were looking to save money; you gained a competitive advantage in employee satisfaction and customer service on the way. 

The devil, of course, is in the details. Knowing what to do, how to do it, gaining perspective when you are busy 24×7x365 running the business, seeing the cross-silo and cross-function picture, and getting around the politics that even small organizations have is challenging in the best of times. During the stresses of a downturn they are all amplified. Unless you have someone on staff who specializes in this, get outside help. Big consulting firms will cost a lot; personally, I have always found it ironic that a firm selling efficiency analyses will use 5 consultants, at $2,400 per day for 3 months… to help you save money!

There are better ways. but there are good boutique firms, tailored to your size, that can perform analyses like these in a matter of weeks and minimal cost. Atomic Inc was built around these principles.