Avoiding Vortex's - Unprofitable Work

In every business there is a balance between the need to keep cashflow rolling and really difficult and unprofitable work.

In professional services Firm's such risks are higher given the high human capital cost with limited ability to leverage man hours.

At LCC we have a strict approach of looking at potential engagements and attempting to avoid what I have labelled 'vortex's'. These are situations that might have cashflow attached but are very difficult pieces of work to complete.

They occur in every industry. Whilst it is always a balancing act, I recommend that you critically review larger opportunities that are presented where the profit is marginal. If such an opportunity / contract proved to be heavily unprofitable the associated 'stress' that it can place on the corporate system can be incredibly negative.

In my experience it is far better to avoid these situations and pursue other, more profitable, work.

Keeping a Clear Head

On the weekend I took to the water sailboarding for the first time in years.

Not only was it enjoyable it was a really useful experience from a professional perspective. Plonking along on a sailboard in a stiff breeze the only thing I could concentrate on was the waves, wind and my balance. An hour on the board focussing on these things delivered a refreshed mental feeling, being able (or forced in my instance on the water) to switch off mentally completely from business issues.

I thoroughly advise that you figure out that special sport or past time that allows you to immerse yourself in the 'present' and switch off from day to day issues. I only wish I had revisited this sport a few years ago.

Be Careful Using Consultants

There is always an issue for a young company as to whether they should hire or use collaborative initiatives / consultants. This can be a difficult issue to handle.

My own experience is that non payroll based employees rarely prove to be as effective as one imagines. The energy and dedication of consultant can wane if there are not quick wins, or alternatively the risks in work that the consultant wants to pursue can be outside of the box of what the Firm actually wants to pursue.

At LCC we have attempted collaborative engagements from time to time, but despite best efforts, dedication of resources and much time / money invested the recoupment from such initiatives is marginal at best.

In many ways this is similar to a 'channel' initiative. Not all channels work. With consulting services the risk are understandably higher given the intangible nature of services delivered. As such I would recommend that you wait until you can hire full timers - and approach any collaborative effort with caution.

Do Investors Have Money ?

Given the current economic turmoil I advise you to closely ask any potential investor in a project what their available capital is.

There are many venture capital and private equity managers that are still in business, and interested in reviewing things, but when push comes to shove they do not have the capital.

Recently LCC had a series of meetings with a well known PE manager in Australia.  After some weeks, however, we learned that the investor had enough money to pay their fees, but little else.  Additionally the planned new fund that that manager had for 2009 was put on ice.

So early in any discussion make sure you are aware of the investments that the party you are holding discussions with have made, and additionally what their free cash for each investment is.

Using Skeleton Documents

When preparing an information memorandum a simple but useful tip is to prepare a rigorous index to the document ahead of any full scale drafting.

Nothing is more annoying than rewriting documents over and over again.  Working through an index approach you can ensure that the framework of the document is put in good order and all stakeholders that are involved in the process can buy in.  THis will avoid lengthy redrafts (hopefully).

Using an index based framework approach will also give you direction in the preparation of the documentation.  You can work on a modular basis.

Indexes and substance to Information Memoranda are fairly standardised these days.  Any public company prospectus will give you good direction on the sections that a investor will seek to review.

You can also visit the resources section of our website :  www.lcc.asia for many useful tools in preparing an information memoranda.

Managing Inventory Down in a Recession

Today I had a long conversation with a very experienced businessman who was under pressure from a supplier.  This individual has had a very successful track record of managing (and making money from) the hospitality industry.

The issue was a pretty simple one as to why pressure was mounting :

• Inventory levels had been managed down slowly, but not swiftly enough to mirror the deteriorating economic climate.  The decision was a simple one - to stop ordering from a key supplier for a few weeks and to run inventory down.
• A new competitor had opened in the vicinity of the main establishment in the immediate past.  This had had the effect of distorting the typical inventory days for a number of product skews.  The opening of this competitor was no shock, and should have been planned for.
• With a tightening economy the number of days inventory was held in various products (skews) had increased.  A conscious effort was made to rebalance the inventory landscape by liquidating this slow moving stock as cost + 5% to allow capital to be freed and higher turnover inventory to be brought in.

The result was that the initially horrendous picture was not bad at all.  It could have been avoided with a little forward planning.

So in a volatile economy manage inventory levels tightly.  It is better to forego a little bit of margin and order more frequently than just let inventory build up - as the financing cost on the holding of slow inventory will equate to the discount given to clear out.

Build Some 'Giving' into your business model

This is a really short one.

Work out how you can build some philanthropy into your business model.  It is not that hard and here are a couple of suggestions :

1. Work out if your business can donate a product / service to a charity auction to support a cause.  Does not cost that much and has a real benefit.
2. See if there is any way you can support / sponsor a charity - even the simplest amounts / efforts can have a substantial effect.
3. Allow employees to spend a day a quarter in a charity.  As a volunteer.

It is not that difficult to assist, and it gives your business a more balanced perspective than simply trying to generate profit.

Executive Pay in Startups

I know this is a hot issue, and one that many will not agree with, but here we go anyway.

Investors get pretty nervous when management teams are paid too much money in really young companies.  Basically because there is a belief that the overpaid emerging company executive should be 'hungry'.  

I often describe it as one pay lever that has 'equity' at one end and 'cash' at the other.  If the lever is pushed toward cash then less equity should be available.  If pulled towards more equity then less cash should be taken.

Any package should be generous, but it is the mix of equity and cash that is critical to get right.

The next issue is how much cash ?  The point I often make is that this can  always change over time - so the first award is not set in stone.  I have seen 2 examples of start ups where investor indigestion has taken place.  

The first was a few years ago when an inexperienced VC, but really successful property developer backed a venture where the CEO was on $500,000 package.  Basically all money that was going into the venture went to the CEO.  The VC became agitated and pushed for unrealistic results on an even more unrealistic timetable.  All very disappointing as both individuals were talented and the business model had real legs.  it all fell apart in my opinion because of the poor initial salary package which was unsustainable.

The second is more recent.  A management team is on a good wicket ($300k packages) and have sought funding.  Investors have pushed back on this as they want money to go into the development of the business - not the hip pockets of the executives running it.  And there is a difference.

In my opinion the right level for executive pay in start up land (depending on size of company) is between $80,000 and $150,000.  This assumes that equity grants will take place as well.

A tough issue, but these are my thoughts.  For the executive the balance needs to be struck between what they will be paid, and how investors will view those pay packets. If the pay packet is seen as off balance then it may have bigger ramifications for funding going forward. 

What IT Backup Systems do you have ?

Sydney has been recently undergoing a number of power failures which of course are really inconvenient.  Also pretty weird with all the sirens going off !

But more importantly they bring into question what protection you have in place across your business model.

When Sydney went down our Firm was pretty well placed because of 2 basic operational initiatives we have in place.

Firstly, we made the decision to host our Microsoft Exchange offshore with a global player.  Therefore when the power was cut our Blackberry's still worked.

Secondly we have a setup around our Server where the power is cut it immediately switches to an external power source and does an immediate backup.

The offshore hosting of email is provided by many players and is actually very reasonably priced.  The addition of the Uninterruptible Power Supply (UPS) is also pretty cost effective and when combined with a 1TB external backup means that your data will be protected.

This type of planning is very important - and if you are going through a corporate transaction it will also be a core area where the investor / counter party will definitely focus.  Unfortunately when in a young company there are so many things on the plate, it is often overlooked.

So free up a bit of time.  Have a look at how your IT system works.  Work through what you will do in crisis.  Put it into place.

Selecting Not Hiring Talent

A great book that I recommend that you read is the story of the RItz-Carlton Hotel Company.  It is titled 'The New Gold Standard'.

A section of this book covers the attraction and development of staff, with a key point within that section being the 'selecting' of individuals as opposed to the simple hiring of heads.  What does this mean ?

In a nutshell taking great care to ensure that those that are brought into an organisation can integrate with that organisation's values and vision.  The recruitment process is a crucial and highly time consuming event in the life of any organisation.  Great care needs to be taken (particularly by small companies) because losing an individual can cause a great distraction.

The current market conditions are an ideal time to upskill your organisation.  With unemployment on the rise there are an abundance of really talented people out there.

So work out what you need.  Be selective on whom you engage with.  Upskill in an opportunistic marketplace.

Building a Data Room for Due Diligence

The first thing that needs to be built inside a client's operation (in any corporate transaction) is a data room.

Be in it physical or online form, this is a place where all information on the Company is presented so that it is able to be inspected by interested parties.  Everything from contracts through to corporate information (shareholders, funding documents, shareholder agreements, etc.).

I suggest that you build this on a progressive basis, interweaving it with the day to day operations of the Company.  As such information can be built out gradually as opposed to a mad rush in the face of a transaction.

Standard due diligence lists are readily available, and you can access one from the 'Resources' section of the Lincoln Crowne & Company website.

Do You Have An Operations Manual ?

This is a really simple one but again something that is consistently overlooked. Does your Company have an operations manual ?  A central document / information site that lists all sorts of basic information on your organisation.

In this day and age it is difficult to keep track of all the passwords, account numbers and contacts that are spinning around a Company.  Take the time to develop and store this in a central location.  It makes finding information and dealing with administrative things much simpler.

You should include anything you can think of from an administrative perspective into this.  Account numbers.  Websites that you use (and passwords).  Service providers.  Contact details. etc.

You can also look at storing things in a central location online.  Services such as WEBEX are absolutely brilliant and also give the added benefit of ensuring information is secured and accessible from anywhere in the world.

Valuation in Young Companies / Commercial Readiness

A current job we are doing entails advising a 'green' company with raising capital.  The financial projections are seeing revenue increasing rapidly.  We have been working with the company to ensure that the financial model can be defended in a commercially sensible fashion.

To this end we have the client focussing on 2 specific things :

Firstly, explaining how the maturing of the business and its products are in turn leading to an increased volume of inquiry.  That is, the company is positioned to meet customer demand (which it wasn't a year ago).  Constraints of supply have been overcome.  The message is out there.  Commercial model 'attachment' is taking place.

Secondly, the development of a distribution strategy using channels and offshore alliance partners.  The important thing here is not so much the projection of sales, but the establishment of the fact that the company is casting its net wider and therefore better positioning itself to effect sales.

This approach focusses on building credibility into the business model - as opposed to just throwing numbers out there.  When dialoging with an investor the financial model becomes part of the conversation as opposed to all of it.  The majority of the conversation can be directed to the verification of the commercial readiness of the organisation - without which the financial projections are most probably just academic.

Redirect the Pennies

It is amazing how easy it is for financial waste to creep into a business model.

Even inside LCC one of the 'Nick Assef Principles' is to review the cost base on a quarterly basis, challenge all service provider agreements and any other expenditure.  And this is not necessarily to just save money.

Our challenge as a Firm has been to get the best possible tools and staff.  Every time we save some money we can afford to upgrade our resources.  So it is well worth doing.

I recommend you take a couple of hours to really study the cost basis of your operations every few months.  It is a simple but effective exercise.

Upgrading Skills in a Downturn

Now is the time to be hiring.  Might sound a little strange, but given the global downturn there is an abundance of talent out there - and these conditions will continue for a while yet.

I often use the term 'trawling for talent'.  Given the prevalence of online search engines this is a relatively easy and cheap exercise in this day in age.  Look at the talent pool you have and just test how easy it might be to upgrade.

Those businesses that survive the downturn will come out much stronger.  And that strength will be led by the ability to develop talent.

Develop a Terms Sheet

A Terms Sheet is one of the final documents that will be developed by parties in a corporate transaction - be that capital raising or other deal.

Beyond the Information Memorandum the Terms Sheet summarises the co factors that will make up the deal.

It becomes a focal point of negotiation, and as such also becomes a simple document to instruct lawyers with. If drafted correctly the Terms Sheet will expand into the full legal contract.

For the very organised, the development and presentation of a Terms Sheet is a high credibility tool to gain the attention of the counter party and lead the deal to a conclusion (hopefully positive one).

Do Option Grants Work ?

There is alot written on options for employees, and generally they can work - but there are also potential issues.

One problem is when the options go deep out of the money / or the Company cannot reach IPO to give the options value. I often call them Jacques Cousteau Options because they are so deep underwater they will never see the surface.

The problem with this situation is that employees who hold such options will often just leave. They have little incentive to stay. So if you have an option plan, and it is not working for whatever reason, don't assume that it does not need to be amended in order to ensure employees don't leave. It will need attention.

Don't Give Free Carry If You Can Avoid It

In a recent engagement I was working on I saw a really bad instance of the result of giving a number of people really small amounts of shares in exchange for services, or help.  Those small shareholders basically did not give a hoot and were prepared to sell the dominant VC and management down the river when a ridiculous offer came around the corner.

The free carry situation can create the following issues :

1. When you have to get any documentation signed, like a shareholders agreement,  you will be spending an awful lot of time and legal fees running around getting those little shareholders to sign documents.
2. Small shareholders who are given shares don't have the same agenda as Founders and VCs.  Simply because their 'pain' in investment is typically low to nothing.  So whenever anyone even thinks about selling they are the ones in line first with their hands out.
3. You have to communicate with them all.  Constantly.  And it can be a bit of a pain.

So if you really need to do the free shares thing, or take in small parcels of money, then do it - but just be aware that from a housekeeping perspective it will undoubtedly get messy at some point in time.

Valuation Clawback

An interesting negotiation technique if you are after a high valuation, but the VC does not agree, is to agree to some form of valuation clawback mechanism.

Sounds complicated but it is not.  It can be very simple and goes along the following lines :

1. The parties agree to the higher valuation.

2. The parties agree to the typically aggressive financial milestones that accompany (1).

3. If you miss the targets in 2, the VC is issued additional shares on a predetermined formula.

Pretty straightforward approach that has the Investee have to back its numbers in order for the high valuation to hold.  In the milestones are missed then the VC benefits as more shares are issued for free, and the effective entry price of the VC lowers (as they now have more shares for the same amount of investment capital).

Business Plan or Fundraising Tool ?

Are you building a business or just trying to get funding ?

From time to time I have come across individuals who seem to think that a Business Plan is just a tick the box item for gaining venture capital funding. Well the horrible truth is that it is not...... It is meant to be the credible blueprint by which your concept will become commercial reality.

There is a fantastic term which I probably overuse. Originally came from a great Private Equity guy - Rupert Harrington - at Advent Private Capital in Melbourne Australia. I have been fortunate to work with Rupert a couple of times now (www.adventprivatecapital.com.au ).

The term is 'DEFEND'. Can you defend your business plan. Plain and simple. Is it something that if a third party brought it to you - you would invest your own money in ?

If it is just a fundraising document you are going to find it pretty hard to get people to believe the core data, because you probably don't believe it yourself.

So when you are spending your valuable time cooking up your next great idea I encourage you to think at every stage with every key element - can I defend it ? How will I prove that this assumption is credible ? What third party evidence can I bring forward ?

If you can defend it you are on the right track of a business plan. If not - perhaps think about saving yourself a little embarassment by spending more time working through the fundamental assumptions so that it is defendable.

'Group Think'

Grant McCarthy who runs LCC's Singapore operations has a really great term - Group Think. Basically this is a couple of entrepeneurs in a venture that think they are right on an issue - but the rest of the world is wrong. They usually think this right up until the time that their venture is about to collapse...............

Grant and I have actually seen it up close in 2 deals we invested in. Really smart people. Great people to have a beer with. But unable to see clearly as a collaborative the errors that they were making.

One of these deals in particular is a great example. A venture which had IP of only 'timing'. There were competitors in the northern hemisphere but it had the clear jump on the field in Asia. The Founder was a super smart guy and a really nice person. The people he recruited were super smart people. Resume's to die for.

But when they worked together it was as if they were right and the rest of the world was wrong. Unfortunately the venture rather than evolving and improving just was flat simply because the rest of the competitive field was overtaking it. But the management pod just would not accept that they needed to build a business rather than a technological marvel.

Its really disappointing to see. Great people who don't achieve their potential because they can't see the woods for the trees. They convince each other that they are right. Don't take external advice. Perform sub optimally as a result.

Lesson learned : Don't become emotional about your business model. Don't try and convince yourself and others that you are right. This is not about ego, its about building a compelling business proposition.

Researching Competitors

Before you spend time constructing the business plan and building that financial model I encourage you to spend as much time finding out what is going on in the marketplace as you can.

Ideas seldomly are unique in this day and age. This is simply the result of too much capital and lots of smart hungry business builders like you.

Too many times I have had someone say - this is unique - only to be very disappointed when the 3 or 4 competitors that they did not know about are pointed out to them.

If all competitors are small and poorly funded then no problem. But if an experienced team or multinational is throwing resources at the same thing that you are - well unless you have an edge (which you may well have) your valuable time might be better spent elsewhere.

So be protective of yourself, and your time - do as much research as you can to establish if you are onto something that is unique.

Customer Demand Modelling

This is an easy one, but something I come across all the time.

The entrepreneur that says 'well if we get 1% of the market share this thing will be worth..........' - I am sure you know how it goes.

In building a demand estimate one cannot do enough grass roots research. Building the customer demand proposition from the ground up. An obvious problem with the 'Top Down' approach, besides being lazy, is that as soon as a question is asked at any depth it can lead to those awkward moments because the business promoter has not really thought about it all that much.

Please don't be lured by the false hope that the educated will subscribe to the percentage of market approach. They won't.

Do as much research as you can, including conducting simple surveys of your target customer group. Nothing presents more compellingly than being able to say that you have proprietary research to back your demand estimates / financial model. And that proprietary research can be done quite simply, be that interview, mailouts, telephone canvassing, etc. By doing this grass roots work you will also give yourself the opportunity to really think independently if what you are getting up to is in fact going to be the next big thing - or whether you are simply kidding yourself (don't worry we all do) and your really valuable time is better spent somewhere else.

Early Stage Valuation

This is a real toughie. How do you value a business in its early stage of development ? Unfortunately the answer is not what everyone might want to hear.

The accepted approaches to valuation, such as asset value, Discounted Cashflow, Comparable Analysis, Break Up Value, etc simply do not really apply. Generally because the risk associated with the early stage of the venture is so high that mature valuation tools provide little more than fodder for academic argument.

I have even heard one venture capitalist suggest that there should be a dollar amount entered for every engineer in a software firm, and the same amount substracted for each MBA graduate in the same firm..........

My personal recommendation is for hte budding entrepeneur to fund the investment themselves, along with family and friends, until it is at least a visible commercial proposition. By this I mean there is something more to show than scribbling on the back of a coaster. Beond htre 'angel round'.

At this stage the valuation argument takes on a little bit more relevance as the project has taken its first young steps towards success. To argue value I believe you should ensure that you have specific knowledge of the sucessful and failed businesses that are similar to yours. Particularly the later - as VCs will always research failures and bring these up with you. So be prepared.

At the end of the day the early stage valuation, in my experience, tends to be a justification styled process where a VC that really likes a business plan will be more flexible in approach to value than if they are only luke warm. And the level of interest can often be driven by previous successes or failures - so in preparation of the business model and the valuation argument consider trying to enlist the assistance of someone who has done it all before - and with whom the VCs will gain comfort.

Comfort = lower risk. Lower risk means you will be better placed to argue value.

Thinking Independently

One of hte most common problems I have encountered with budding entrepeneurs is their inability to be flexible in their thinking. That is it is a 'their way or the highway' approach to the development of a business concept. Unfortunately investors don't really warm to this sort of approach.

Constructive observation should be filtered into the thinking of every business person. In developing my own Firm I have learned so much from making mistakes, backing the wrong people and ideas and making numerous other mistakes. Although the strategy has always ben there, the ability to execute has been held back at times by simple mistakes.

Today I counsel with as many people whom I respect in business as I can. I have learned to think independently about all issues, and to be flexible in business planning.