Making a Ripple with Cryptocurrencies

A business is really just a legal structure that allows you to ring-fence the risks and returns associated with a particular model of exchanging value with others. Fiat money is used to exchange value with other individuals or organisations. In the old days we exchanged beads, coins, and even paper with special designs printed on them – a method still in use today! The reality is that while printed money used to have some notional link to an actual asset (e.g. the gold standard), for a long time money has really just been a digital concept – it’s a number associated with an account, rather than a physical asset. The money is stored in many systems, each of which need to know who you are and verify your identify before moving any money. Just think of moving funds from your local bank via a credit card via PayPal to a foreign sellers PayPal account linked to their credit card and bank on the other side. Currently, at each stage of exchanging value with someone there is a transaction cost that gobbles a few % of the total and there is risk that in the 2-7 days it takes to process the transaction even more can be lost to differences in exchange rates. So when a new way of exchanging money arises that offers fees 1000x lower, almost instant global transactions, and conversion into any currency, then it’s important stuff; hence the interest in crypto-currencies.

While Bitcoin has received most of the hype and press, it has some problems and is also not the only gig in town: this morning I was one of about 25 Thousand other Beta users to receive 1000 Ripples (currency code: XRP) into my wallet. With an exchange rate of about 180XRP to the USD, this is only about $10 to me (or ZAR 100 at time of writing) – but about USD 250K in total, just given away. is a cryptographic currency that allows you to send money anywhere in any currency instantly with transaction costs of a ridiculously low $0.0001 per transaction. There is no risk that exchange rates will move significantly in the few seconds that it takes to process your transaction, and because Ripple by design avoids the ACH, Banks or credit-card networks, it has none of the associated costs. Did I mention that it’s also not for profit and open-source? Anyone can use it and anyone can build on top of it. Unlike Bitcoin, there is no money to be made from mining for new bitcoins, but there are a finite number that have been made.

Ripple is a peer-to-peer (think Napster) network where the interconnected servers run a shared copy of the ledger. No one owns it. The ledger is kept up to date by a technical process called consensus, whereby all servers in the network verify and agree on the correct view of the database, in the processing allowing only legitimate transactions. The ledger tracks account balances not people, so its super easy to move money from one account to the next. Money moves across the world in the time it takes to update the ledger – literally a few seconds. To make this even easier, Ripple has its own network currency called Ripples (XRP) – essentially the first app built on top of the core technology. Since Ripple works off accounts not people, it means your wallet has to be treated like cash. Of course, Ripple as a system has to work within the overall banking system via gateways: these allow the entry and exist of fiat money. Anyone can build a gateway as long as they comply with local laws, and gateways will charge a fee that will probably close to what they currently charge.

100 Billion ripples have been made and no more will ever be. The minimal transaction cost for each transaction doesn’t go to anyone, its just destroyed within the network – the effect of which is to distribute them evenly to all account holders in proportion to their network. Unlike todays’ system where the transaction costs go to make profits for the banks, the Ripple costs are there purely to prevent someone sending millions of transactions and swamping the system.

You can send Ripples to any other Ripple account with no counter-party risk, but to send any currency, including Bitcoins to someone else, you need extend ‘trust’ to that person or gateway. The amount of trust you extended is set per transaction or business and is tracked by Ripple. Your trusted accounts send you an IOU no larger than the amount of trust you’ve extended to them. By extension, Ripple transactions are safe and irreversible – this gets around the problem with many international transactions where the customer disputes the transaction after goods have been delivered and charge-backs occur. Similar to a Public Key Infrastructure, Wallet IDs are public to receive money (mine is rDXx3WXLHJJM4YqJmnCZftzbbgTDa5ErBr), but only you know the Private key to access the wallet and make payments.

For a business trading internationally Ripple removes many issues: it reduces costs, makes transfer instant and irrevocable, and automatically finds the best price when converting currencies in or out of the network. If you’re doing any business internationally it’s something you should consider, seriously. Visit for more, its early days but this stuff will change the world and your life.

If you’d like to test the system, send me a few XRP, and I’ll send them back to you. Less transaction fees of $0.0001 of course…

Selling your business: getting the price you want

In selling any asset, there are two factors that work together hand in hand to comprise ‘the deal’ – price and terms. The money you receive from the sale of your business and when you will receive it. In theory, you could have an infinitely high price for the business if you were to accept infinitely long payback periods and low interest rates, or you can have an all cash deal paid immediately, but at a much lower price.

What happens when you have a buyer who can pay only $1M including all the money he can raise from his commercial bank, yet the seller wants $1.5M? How do you strike a deal to make this happen? The answer is that the seller needs to finance the remaining $500K of the sale, in the form of a promissory note where the buyer makes payments to the seller over time.  This is called seller carry-back financing.

It’s interesting to see where the actual behavioural ranges sit: as statistics on sales of SMBs over the last 1997-2012 period in the USA show:

  1. In only 40% of deals was the seller paid 100% of the price in cash on closure, with the seller providing some financing in the other 60%.
  2. The amount of financing provided ranged from 10% to 100%.
  3. The mix of deals with 20%, 30%, 40%, 50%, 60% and 70% paid in cash was fairly even. Very few had 0%, 10% or 80% or 90% cash.
  4. Most sellers financed their deals at 6% to 12% over the prevailing cost of a bank loan.
  5. Deals were typically financed over 4,5 or 10 years, but the range varied from 1 to 20 years.
  6. 100% cash deals were typically priced 20% lower than deals where the seller provided financing.

The significant part of this is that seller financing happens 60% of the time and where the seller finances part of the deal, the typical price achieved is 20% higher than 100% cash transactions. That’s a potentially huge premium to be earned in exchange for taking on more risk. The other points suggest that the deal structure itself is highly negotiable, with a range of interest rates, repayment periods and upfront payments. If it was easy to compute an ‘average’ deal it would probably carry a fixed interest rate of 5% above commercially available credit, be repaid over 5 years, and pay 50% of the price in cash. Note that interest rates have to comply with Usury laws.

It’s easy to think that the seller-financed deal gets a 20% price premium only because the buyer isn’t paying the full price with his own money and thus feels free to spend, but that’s not the whole picture: what the seller does, by agreeing to finance the deal over time, is to share in risk. By doing so, the seller signals that the deal is worth backing and that increases the confidence of the buyer who then is willing to pay the higher price. There is risk to the seller however: seller financing is often done because the buyer can’t afford the required commercial credit facility; typically because they have a poor credit history. This is why the terms of the deal are often 5+ years – it’s enough time for the buyer’s credit history to clear and for him to then be able to raise commercial finance to cover the outstanding amount, which is often structured as a balloon payment. Obviously there’s a risk that a person who isn’t credit-worthy to begin with stays that way and the deal falls apart, in which case the seller is probably left with only the cash portion they received upfront. The buyer may also run the business into the ground and be unable to make the remaining payments. Given the inherent risks in SMBs, the 20% price-premium achieved starts to sound low.

I noted earlier that sales dataset reflected sales up the end of last year. In early 2013 the USA gov’t passed updates to the Dodd-Frank act (which was a sweeping reform of their whole financial system introduced in 2010). Part of the act requires all residential mortgage loans, including seller carry-back financing, to be negotiated by licensed mortgage originators.  In other words, offering these loans is treated as a financial service and is now regulated. Although some loopholes/exclusions remain, repayment periods, interest rates, due diligence on the credit-worthiness of the buyer, and more are all now stipulated by the act. How much the Dodd-Frank act will impact on seller-financing in the sales of SMBs (as opposed to mortgage-backed property sales) in the USA remains to be seen, but its popularity and premium suggest its certainly something you want to consider when buying or selling a business. While normal ranges apply, everything is ultimately negotiable and two parties with sufficient flexibility will always get a deal done.

How Phish make millions from music

The Internet has impacted many industries and the music industry in particular has been fundamentally and permanently re-invented. Digital distribution means that the marginal cost of a song has fallen to almost zero and that an industry built around the sale of CDs or even LPs has gone through immense pain. At the top of the pile, value has shifted from the big four labels (as they were in early 2000) to Apple. Meanwhile the tools for recording and producing high quality music are available to almost anyone: a global market is in reach of any musician. Yet music remains an experiential good – a song must be heard to be valued, and music remains driven by songs that we hear and good times we share. So as much as there is very definitely a long tail in place, the breakout hits still dominate the earnings in what physicists refer to as a ‘Power law’: the top 10 artists make multitudes more than the next 100, and so on.

So how does a band make money when each song they painstakingly compose, rehearse, record and produce competes with over 15 Thousand new songs created each day? When to get radio play a new song must force a popular favourite to be played less often, which means a new song must be good enough to warrant creating new memories over recalling the old?

There’s a band that started in 1983, have never made the top of anything in album sales, and most people have never heard of. That band made over $120M in the last four years, and their story is worth telling as an example of what it takes to be very successful entrepreneurs before, during and after the complete upheaval of your industry. That band is Phish. You’re probably hearing about them here for the first time, 883 songs after they started 30 years ago.

The band members each started playing music around 5 years old and practically dedicated their lives to it. By University, each was a highly skilled musician and they joined forces to form Phish. They started slowly, largely skipping class to practice, and playing their own kind of music to bars in Vermont; spending the 10,000 hours to become perfectionists at what they loved. Audiences were tiny but grew steadily, and by the time the first label showed any interest in them they were already profitable from their live gigs alone. 5 hard years of bootstrapping allowed them to hone their art and justify their independence. Without the allure of an advance and a record deal, they focussed on audience interaction and built a very loyal following. They also built a business based on ticket sales, not album sales. With no label even showing interest, they built their own organisation to manage their shows, sell tickets and merchandise.

Their fan base taped early shows and shared those tapes with friends, who then attended the next shows. This ‘piracy’ was encouraged by Phish: it was cheap marketing and also created a secondary market for memorabilia amongst fans. Importantly, growth was steady and predictable – to the point that there manager could predict how many tickets they’d sell in a town based on how many times they’d played there before. By 1989, just 5 years old they were unknown but selling out shows that they sold themselves. In 1990 they did over 130 different shows around the country: clear proof of a huge work ethic that included practising the set for hours until they played live, after which the live set was a celebration…and so Phish developed the ability to enthral fans through live music – their most valuable asset.

So when file-sharing destroyed the music industry, Phish continued to make money from their primary business –selling access to live music not recorded music. They took advantage of digital downloads and streaming by bundling digital downloads of live performances with ticket sales. So if you love the concert then you relive the experience through downloads the next day (and share them prolifically without retribution). Those that can’t attend shows live can pay to stream the performance from Phish’s website.

What very interesting is analysis into Phish’s fan base: A typical big act has many fans in many cities and produces the same show to each group of fans. Phish plays to many of the same fans in its shows – in other words, people regularly fly from city to city just to watch them play again. In business terms we’d say that Phish have a very high share of their customer’s wallets.

Phish called it quits in 2004, but in 2009 they surprised everyone by announcing their return. They trimmed down their support team, mended broken relationships and got back to wowing crowds with a performance that is different every time they play. Since 2009 they have made over $120M in ticket sales. A close friend of mine saw them live in Madison Square in NY on 30th December and was upset not to be able to get a ticket for the New Years Eve show the next night, to the point that he will see them again in New York this year.

What are the lessons we can draw from Phish? Aside from their talent and dedication (which speak right to the 10,000 hours concept), Phish have made their value the uniqueness of their live performances – something that isn’t commoditized by a digital download. They also started slowly and revenue grew very predictably, which means they could plan, build their own managerial and support infrastructure, and be profitable long before a label came knocking. Lastly, they’ve taken 30 years to build their passion and talents into a following that is very strong. It’s very hard to see that Phish would ever be short of money, so long as they can carry on doing what they love and improvising as much on the business end as they have with their live shows. Each new live performance adds to the collection of good times their fans have had at prior ones, and makes it harder for their fans to feel more for anyone else, or spend their entertainment money anywhere else.

Incentivising staff, avoiding multiples

First, some feedback: since writing a few weeks ago on how much money could be saved by switching between cellular service providers, I’ve been contacted by representatives of ‘Yellow’ who point out that their new offerings include BYOD (bring your own device) and are far more competitive with ‘Black’. I suggest you strongly consider whether you need a new device and look closely at the actual offerings that each of the cellular providers has in the market at the time, before you blindly upgrade. Your negotiating power is stronger than you think and the savings over a 24-month contract can be substantial. Your negotiating power begins roughly 5 months before your existing contract ends – most cellular providers offer existing customers upgrades and other deals around that time.

Back to business:

A client of mine approached me recently to help with the valuation of his business so that he could reward long-term staff with an incentive based on the growth in the valuation of the business over time. He is building his business for the long-term and it’s likely that he’ll want to sell it at some stage. So his thinking is in the right direction: if you want to sell then you have to build something that’s attractive and valuable to a potential buyer (an asset of value). In a services business like his, what someone is really buying are the people – their expertise and the relationships they have with clients. So the question becomes how do you attract the right people to the business, retain the brilliant ones, and keep them in the business long after the original owners have sold out? Answering this question is the key to reducing risk in the sale and thus making sure you get a fair price for the business. Building a long-term incentive that rewards key staff for the increase in the value of a business is something I whole-heartedly support.

My client wanted to give away real shares to the approximate value of 20% of the business to certain key employees (the amounts awarded to each were based on his discretion/feeling and not on any formal performance review). He also wanted these shares to vest over time, and lastly he wanted his staff to be able to sell the shares back to the company once they had vested or if the business was sold. Most importantly, he wanted to fix the price they would get for the shares if he sold the business or if they wanted to sell them back to the firm– and he wanted this to be 4x PAT. So where are the problems in this thinking?

Firstly, any awards of shares need to be done based on merit/performance. If you award different levels of shares to staff without a transparent and fair mechanism then you have to expect that sooner or later this will become public knowledge and someone will feel aggrieved (usually with a lot of angst and disastrous results). My suggestion is always to link any long-term performance award to the performance of the company and the individual in a given year (which must be formally and fairly reviewed), so that short-term performance drives long-term wealth creation. Secondly, while vesting over time is the norm and his thinking was right (a 3-5 years is the norm), it’s dangerous to fix a price on the shares now – the shares could be worth more (or less) at the actual time of sale that will irritate one party at least. The other major issue is that the firm might not have enough cash to buy the shares back at that price at the time; being forced to do so could put the firm at risk. Lastly, the structure my client was proposing would have allowed his key staff to walk out of the business with real wealth in their pockets if he ever sold it (when you ideally want them to be able to leave with a lot more upside in two years time!). So some re-thinking was required…

My suggestion was to make use of a phantom share scheme rather than actual shares. Phantom share schemes mimic real shares but are far easier to administer – you simply update a spreadsheet. For phantom shares to have any real value the amount of dividends they get must be part of your shareholders agreement. What should ideally happen is that the business sets a dividend policy that pays out a fixed portion of profits above the threshold needed to de-risk the business (i.e. provide working capital for 6+months of operation). Then from the dividend that is declared, a portion e.g. 20% goes to the phantom shareholders and the balance to the actual shareholders. The phantom shares can vest over time and can be allocated based on the persons salary + bonus in any given year, thus linking actual performance to long-term reward in a meritocratic way. If someone resigns or leaves they can be sold for a pre-arranged price or simply deleted, and if the business is sold then the new owner needs to carry on the arrangement or face losing key staff. The flip side is that phantom scheme benefits the new owner because they won’t lose key staff when buying the business, so its raises the price of the sale.

Note that phantom share schemes and other long-term incentives linked to the financial performance of the firm need care in their design and implementation.