What happens when you grow slower than your WACC?

The value of your business is calculated from 2 things: risk and return.

Returns can be forecast into the future – with some good modelling skills one can build a financial model that projects the likely growth of the firm into the future within ranges that are reasonably certain. My general approach to building a model is to work from the target customer first: understanding the market size, how it will be reached with what budget, then understanding actual customer behaviour in response to marketing and sales efforts. Through this we get to understand how much revenue happens when. Once you have the revenue line it’s relatively easy to work out Cost of Sales, operational expenses, profitability and then balance sheet effects – all of which distil down to the Free Cash Flow calculations a proper valuation model uses.

Risk is really the risk to the capital used by the business. In previous columns we’ve discussed the Weighted Average Cost of Capital (WACC) in some detail; the core concept is that each business has a mix of debt and equity capital that can be optimised. Equity costs more because it carries more risk; debt costs less because it’s typically secured by assets and gets paid out first if things go wrong. The trick is in reducing risk so that you can use more debt and thus reduce the overall cost of capital. The WACC is what’s used to discount the future earnings of the business to arrive at the present day valuation of the business.

How do you create long-term value? Simply put you need to grow free cash flows at a rate faster than your WACC. In other words, you need to grow returns faster than they’re discounted by the perceived risk to the capital used to create those returns.

I’ll use 2 different scenarios from our demo business on ValuationUp.com to illustrate how value is created or destroyed when free cash flows grow faster or slower than a firm’s WACC:

Run-Away Train

The first scenario is called ‘Run-away train’ and here the firms value grows from a baseline valuation of R13,7M (the red column on the left) to R38,5M (the green column on the right). To achieve this, the business must apply resources to a number of projects, each of which contributes differently to free cash flows and thus to valuation. For this business, the biggest wins come from reducing Cost of Sales, reducing Operational expenses, and in improving working capital management (which together give the business an extra R19M of valuation improvement and an extra R9M of free cash flows in year 1 alone). Contrast this to sales (the gold-coloured blocks in the graph), where growing the business at a steadily ambitious rate of 10% a year raises its value by only R6M with an almost negligible increase in free cash flows in year 1.

Slow coach

In the second scenario “Slow coach”, all variables are exactly the same except sales growth, which is set at 5% for all 5 years rather than the 10% used in the ‘Run-away train’ scenario above. It’s lower than the initial 8.2% used in the baseline valuation calculations, so sales achieving sales of only 5% immediately causes a drop in valuation by nearly R5M in year 1, and slower than forecast growth reduces the company valuation by a further R1.2M over the next 5 years.

The effect of this lower sales growth is that free cash flows in years 2-5 grow lower than the risk to the capital used to generate them (the WACC for this business is 18% in all scenarios). When your free cash flow growth rate (not the revenue growth rate) is lower than the Weighted Average Cost of Capital then value is destroyed over time, which is exactly what is shown the graph of the “Slow coach” scenario.

This difference between these scenarios is R12M of valuation – all of which comes down to whether the firm can grow at 10% or only 5%. The other R19M of valuation improvement comes entirely from operational measures that are far more controllable for most firms, and thus make a better bet as to where to focus efforts when growing the business.

Uncertainty and risk

Risk is a core part of any business, and understanding the risk associated with uncertain future returns is at the core of Valuation. As a result, we spend a lot of time trying to reduce uncertainty, which has two problems: firstly we don’t understand uncertainty very well and secondly, profitable opportunities only exist where returns are genuinely uncertain.

There are two different kinds of uncertainty: Risk is where we know the potential outcomes in advance, and even maybe their probability. Think of rolling a dice: we know the range of potential outcome in advance, as we do their probability. Genuine uncertainty is different and occurs when complex systems interact over time: we know neither the possible outcomes of their probabilities in advance. The Geo-political economy is an example.

In his seminal work on the topic, Frank Knight wrote (in his 1921 book “Risk, Uncertainty and Profit) that real opportunities for profit exist on in the face of real uncertainty. In other words, if you want to make a profit you must not just deal with uncertainty, you actually have to seek it out.

The problem is that we act like everything is just a risk: In other words, when we use our opinions to estimate the probability of something, we treat this opinion as if it’s a real probability. We give mathematical weight to our subjective opinions, to our gut feel, and we treat anything uncertain as a risk where assume we understand the possible outcomes and their probabilities.

The alternative, where we act like everything is unknowable, is also fraught with problems. We live in a world of denial, of a self-image far better than it really is. When the occasionally some event is strong enough to break through our mental image and force us to face facts, the façade is revealed the world is terrifying…and seems too uncertain to act with conviction. So it’s back to our happy mental model where we treat everything as a risk.

So how to deal with uncertainty?

  1. Aggregate: we have insurance because it’s possible that our house will burn down. Insurance works because when you add up individual cases of uncertainty you get a probability. From an innovation perspective that means that you have to have many ideas to have a good chance of having one really great one. Volume reduces uncertainty, and this is what VC firms do when they invest in a lot of smaller deals (such as the Y Combinator or 500 Startups models).
  2. Seek out uncertainty to hit it big: innovation is good bet – while the average innovation makes only a small return, a small number of these innovations produce returns that are orders of magnitude different. This means that we need to treat innovation like a portfolio – we should innovate widely and cheaply, then throw our weight behind the ones that show real promise.

The better VCs use both of these models: they are risk averse (ask any entrepreneur whose pitch has been rejected), but the better ones actively seek out uncertainty.

So how do we measure uncertainty? Through waste: As William Janeway writes in his book Doing Capitalism in the Innovation Economy:

“Schumpeter’s process of creative destruction can only proceed by trial and error. We see that which is created through the lens of survivors’ bias and ignore the “hopeful monsters” that economic evolution has spawned and left behind in metaphorical emulation of Darwin’s process of natural selection. No doubt every one of them was launched on the basis of an exercise in forecasting future revenues, costs and an expected value to be compared with a rough estimate of the cost of capital. As Schumpeter well knew, the wastage is the measure of the inescapable uncertainty that attends the practice of doing capitalism: We need only visualize the situation of a man who would … consider the possibility of setting up a new plant for the production of cheap airplanes which would pay only if all people who drove motorcars could be induced to fly. The major elements in such an undertaking simply cannot be known … Neither error nor risk expresses adequately what we mean.”

So here is my challenge to big corporate innovation departments, to university IP commercialisation efforts, to the venture capital community, bankers and entrepreneurs: what are you doing to minimise risk but seek out uncertainty? How wasteful are you? As an economy are we wasteful enough, or are we a socialist state?

Why entrepreneurs should drive old cars

About 10 years ago a friend of mine was starting a new training company. He called me in January asked me to come on a 1-day course on goal-setting the next week, for free; all he wanted was to get some feedback and to actually start his business. I had some free time and promised to attend; a course on goal setting sounded useful too.

The following Wednesday I arrived at the venue, a little early as I’d over-estimated traffic. As I sat there in my car the other attendees started to arrive. A new BMW pulled in, followed by a new Golf GTi and then a Mercedes. All new. More arrived, more very well dressed people with designer sunglasses and the latest mobile phones in new shiny cars. My first thought was that my friend had managed to attract some very successful people to his course: after all, everyone was giving up a full day of productive mid-week time to help a friend, and judging by the cars these were all people who were clearly already well-off. I hoped I could learn something from them.

The course duly began and we spent a very useful day unpacking our ambitions and making them into a single tangible, but stretch goal. At the end of the day we were asked to share our goal with the rest of the class. Here’s the surprise: for over 80% of the class, their single biggest goal was to ‘get out of debt within 5 years’. One guy even cried openly as he realised that he might be able to do this. I was astounded: all these well-dressed, well-bespectacled people in these bling flashy cars were drowning in debt. The worst part – in not one of their ‘plans to achieve’ there goals did any of them mention getting rid of the new car and buying a second hand model. No one mentioned cutting back on his or her addictive lifestyles. Every hope depended on earning more to clear debt. I’m pretty sure they’re still out there now, looking good, driving new cars, drowning in debt and making the auto-dealers and banks very wealthy indeed.

I’ll contrast that quickly with a man I know who voluntarily retired 10 years early (how many people ever really achieve that with financial independence?). This same man never bought bling, he never spent lavishly and he paid off debt while friends (who are still working now) took overseas holidays. When he retired he took over the company car he had driven for 5 years and has driven it for the next 20 years. He remarked to me last week that it’s time to sell the car, which he’s now driven for over 400 thousand km and had for a third of his life. That man is my father. He worked hard to earn money, and he worked hard not to spend it on lifestyle when he was young. He got to retire early and enjoy his retirement.

You can choose to spend money on bling or you can choose to scrimp and save now. Compound interest (a regular theme on this column) will make those choices not seem very different initially, but they make a huge difference in the long-term.

So back to cars: a friend who sells businesses told me that the best businesses he sees are run by people who drive old cars. It’s the first test he has when he visits a prospective customer. He knows that when people spend on their own egos then they’re stripping cash out of the business that could be used instead to accelerate its growth. He knows that when people buy new cars they immediately lose 20% of value in depreciation. He knows that cars are tools – they get us from A to B in comfort and safety but they carry on-going maintenance costs. They carry finance costs, or opportunity costs if you pay in cash. When you sell your old car and buy a new one the value is much higher so insurance costs jump too. The smell of new leather and shine of new paint makes you feel good, no doubt, but how many clients ever see what car you drive?

The right time to buy a new car is never, but if you really can’t resist then at least be aware of the trade-offs you are making. Would you rather spend the money on a depreciating asset or invest it in a well thought-out marketing campaign which has a 200% ROI? Would you rather drive a nice new car now, or bootstrap for a while longer and drive a really nice super car in 5 years time? You can buy the bling and look good now, probably attracting friends and lovers who demand that you maintain that lifestyle and will keep you in that trap until you die. Or, like my father, will you be sad to sell a car you’ve driven for 25 years yet have retired 10 years before your peers? Are you an ideal bank customer or are you an entrepreneur striving every day to build something more impactful and more valuable?

Accountants for entrepreneurs

Entrepreneurship can be a very lonely and harrowing journey – the best entrepreneurs know when to reach out for help and there are few who can help more towards your success than your accountant. Not only do they help you understand the financial side of your business and comply with the regulatory environment, but since entrepreneurs are typically advised by the smaller accounting firms, you accountant is an entrepreneur too and is far more likely to be able to give general business advice than pure accounting-related work.

In this article we take a look at the role of the Accountant in your success and how this industry is organised.

Some background: A Chartered Accountant, or CA (in the USA they are know as Certified Public Accountants) is a highly-qualified individual who has typically studied accounting for 4 years, then written the board exam and done 2 years of practical apprenticeship before being recognised by the association. The CA (SA) qualification is awarded by SAICA, who oversee the quality of the profession at large.

I interviewed Bridgitte Kriel CA(SA) who heads up SAICA’s Small and Medium Practise (SMP) division whose aim is to promote the interests of SMPs and Small and Medium Enterprises within the SAICA strategy. It’s the SMP accountants who deal mostly with entrepreneurs.

What is SAICA? What role does it play and where do you fit in? 

The South African Institute of Chartered Accountants (SAICA), South Africa’s pre-eminent accountancy body, is widely recognised as one of the world’s leading accounting institutes. The Institute provides a wide range of support services to more than 35 000 members who are Chartered Accountants [CAs(SA)] and hold positions as CEOs, MDs, board directors, business owners, chief financial officers, auditors, business advisors and leaders in their spheres of business operation. Most of these members operate in commerce and industry, and play a significant role in the nation’s highly dynamic business sector and economic development.

What size of accounting firm services entrepreneurs?

This can vary greatly from the one man firm to the big corporate practise, however majority of entrepreneurs or small businesses are serviced by the SMP, which includes sole practitioners to a 2 – 5 partner firms. They normally offer a wide range of services and strive to be a “one stop shop” for the small business.

So these Accountants are really entrepreneurs too?

Many SMPs have started their own practise, or gone into practise through similar motivations to those that are experienced by the small business owner/entrepreneur. This also often gives them the edge when servicing entrepreneurs and small business as they not only advise from their wealth of knowledge but can draw on their experience as well, as we all know that the life of an entrepreneur is not an easy one, and thus having an advisor who understands, and has been through the experience and has triumphed, can add a lot of value to any business.

As many entrepreneurs are born through identifying a need, so are SMPs. Many CAs(SA) start their own practises after identifying a need or a specific market segment that requires the use of their specific and specialist skill set.

What are the main issues facing the SMP accountants?

The main challenge facing the SMPs is the pace of regulatory change and this is not uncommon as it is cited as the number one challenge facing accountants worldwide. More recently, the change required to the SMP’s business model due to the new Companies Act requirements regarding audits has posed one of the bigger challenges and opportunities facing the firms. As a result of these changes, many SMPs are refocusing their marketing and sales strategy to service their clientele better.

What impact have the changes to the Companies Act had on the SMP accountants?

The Companies Act brought about change in the requirement of companies to have an audit. Smaller companies now often have a choice as to whether they wish to have an audit, an independent review or only a compilation. This has resulted in a broadening of services provided by the SMP to the SME. However we have found that the majority of SMEs have stuck to the audit, and this is often due to it carrying more weight than independent reviews or compilations.

Are the SMP accountants coping with the transition towards becoming business advisors?

SMPs have always played the role of business advisors but have in the past rolled this into one product as part and parcel of the audit or bookkeeping. As such, this is not a new area of expertise but rather that the challenge has been for the SMPs to re-package their product and to expand the offering of the business advisor services to be able to stand alone as an attractive value offering which businesses are willing to invest in.

What data can you provide that shows the importance of a CA to the entrepreneur?

We have conducted research amongst five big banks and three SME specialist lenders. Some of the stats and comments from the research:

  • Funders agree that financials endorsed by CAs(SA) are more trustworthy for funders than financials produced by companies themselves or by other independent accountants (8.4/10 for total sample, 10/10 for specialist SME lenders)
  • Funders agree that one of the greatest challenges facing small businesses is governance. They agree that the SMP could fill a governance and “non-executive” director’s role for their clients. They indicate that business owners who do this are more fundable
  • Funders agree that SMP CAs(SA) could position themselves as a channel to funders for businesses wishing to fund acquisition, gearing, growth or even exit strategies. Funders all believe that these applications need audits as opposed to reviews or management accounts to support them.
  • Funders agree that even if SMEs opt for reviews, there is good reason for clients to stay with CA(SA) SMP practices. Reviews can be more easily and cheaply upgraded to audits if the provider of the review is a CA(SA). The audit will inevitably be needed when gearing or exit is to be contemplated

Who else operates in this space? (Advising entrepreneurs) 

There are a number of accounting bodies within South Africa, however Entrepreneurs should ensure that their service provider belongs to a body that requires Continuous Professional Education from their members and has a code of conduct which members need to adhere to, as many small businesses have been caught by unscrupulous persons claiming to be accountants, who have cost business in the long run.

How much do accountants typically charge clients for bookkeeping, audit, other work? 

This is a difficult question, as each fee is determined based on size of the company, the state of the companies own record keeping and the work and output required. This is something that needs to be negotiated on a case by case basis. It would also stand to reason that bookkeeping services would be a lower hourly rate than an audit or certain advisory fees due to the level of expertise involved.

How do you suggest an entrepreneur best finds the right accountant for them? Is this word of mouth, or are there directories, reviews etc?

Referrals are one of the best ways to find an accountant which best services the needs of the business, however there is a directory for SMEs and entrepreneurs to use to find a CA(SA) who operates in their area www.findacasa.co.za

What impact is the rise of cloud accounting (Quicken, Freshbooks, Xero and locally Sage/Pastel) having on the SMP accountants?

The role of the software, has provided accountants with choice. The software and tools at the accountants’ disposal assist them to service clients better by producing accurate and quality information in the shortest possible time. Some businesses may look to providing this function themselves rather than using their accountant for this, but then should look to their accountant for assisting with interpretation of the data and advising them on the opportunities, challenges and risks being highlighted by the said data.

SAICA are doing some innovative stuff with SEFA and SEDA. Can you explain how these projects work, how they’re priced, and what plans are for their future?

SAICA, in partnership with the Economic Development Department, Guarantee Trust, and SEFA, has formed an enterprise development and SME support hub called Enterprisation. This hub seeks to service two main objectives, namely, up skilling unemployed graduates and providing back office support to black entrepreneurs and small businesses. Enterprisation can assist a small business in formalising their back office function in their start-up phase.

This initiative hopes to achieve a domino effect whereby the black entrepreneurs and small businesses are able to provide further employment of individuals within the many differing markets that they operate.  This can only be possible if the SME market in South Africa receives the back-office support that it requires in order for these small businesses to be educated in the day-to-day accounting and reporting requirements that they need in order to become sustainable operations themselves. As these small businesses grow and become sustainable, we hope that they will migrate into the SMP market once they are operationally mature enough to do so.

Are the issues the smaller accountants are facing in South Africa the same as elsewhere in the world? 

Yes, Quarterly there is a survey done by the International Federation of Accountants (IFAC), and consistently the results of the top 5 challenges worldwide reflect those of the South African environment, only the order of priority may vary within the top 5.

What excites you about accounting? and about working with the SMP accountants in general?

Its more than just accounting! It is being able to advise the “Youth” of the business world in their infancy and growing phase, ensuring that they have strong foundations on which to build a sturdy and successful business.

Many times the world of an entrepreneur or business owner can be a lonely place, there is satisfaction in being there to offer a helping hand and see the success of your advice and efforts.

Updates on previous posts

In previous articles we’ve discussed Tesla’s innovative use of financing to help sell its products, and also how Apple have managed to pay an effective tax rate of under 1% on their foreign earnings, both of which are updated below.

Apple goes to congress & the scale of tax minimisation schemes amongst big tech companies:

A few weeks back I described Apple’s use of an innovative corporate structure that allows it to pay very little tax on offshore earnings, as long as the profits aren’t repatriated to the USA. The structure they use to achieve this is a called a ‘Double Irish with a Dutch Sandwich’ which refers to the use of 2 Irish companies and a Dutch offshore company to minimise taxes on foreign and EU earnings. Calculations show that Apple are paying an effective tax rate of <2% on their offshore earnings.

What’s emerged recently is that they’re not the only ones taking advantages of these loopholes. The list of companies that have more than $5B (i.e. ZAR 50,000,000,000) or more kept ‘offshore’ includes Apple, Microsoft, General Electric, Cisco, Google, Oracle, J&J, Pfizer, Amgen, Qualcomm, Coca-Cola, Wal-Mart and many others.

What’s most interesting to me is that these companies typically hold 80-90% of their cash reserves offshore.

If you think about it, what’s really happening here is a power-law in capitalism: the big global companies can afford to invest in such structures. This means that they get to pay far less tax and retain far more earnings than those that don’t. This means they can invest more and grow far faster. With strong balance sheets they can borrow more and pay less for their debt, so they can grow even faster. It’s probably unfair not so much because they avoid taxes, but because by doing so they have such a competitive advantage: it’s easier for them to outspend or simply crush smaller companies that may emerge.

My guess is that congress tolerates this because although these companies pay less tax, the same system has allowed these big American firms to dominate their respective global markets. Congress has probably figured out that removing these loopholes would get them a larger share of a much smaller pie…

Tesla’s battery economics get questioned:

A core concept in strategy consulting is the experience curve. While I’ll get to cover the full workings in a forthcoming article, the core concept is that costs of producing units (or more or less anything) come down as the cumulative number of units produced by the industry goes up. Note: defining the units against which ‘experience’ accumulates is the tricky part. In some industries learning is slow and the prices fall slowly. In other industries the slope of the curve is steep. Competition tends to accelerate the fall in costs. As long as your selling price is above the cost then you’re probably ok. With some analysis, these cost curves become predictable and this allows brave companies to price now based on where costs will be in future. They do this often to win market share that allows them to learn faster than competitors and drive their costs down faster than the industry. For example, when Amazon launched its S3 service (whereby anyone could store data on Amazon’s infrastructure), they priced at a rate many believe was below their actual costs at the time.

Something just like this is going on in the Electric car industry, where Toyota, Nissan and Tesla seem to make all the headlines. Its important to note that Toyota and Nissan have sold far more of the Prius or the Leaf than Tesla – they are much further down the curve (and these 3 companies are further down the curve than the rest of the industry combined).

Tesla shares have done well lately. So it’s worth noting that while Tesla has a stated aim to slash the cost of their cars by half by 2016, the core cost of these cars is their battery. If you think about, electric cars differ from petrol cars only really in their motor and their fuel source. Electric motors have been around for years and are unlikely to suddenly get more efficient. Batteries are the single place where technologies have to advance to make the cars more affordable and more useful – their limited range is the biggest issue at the moment.  The problem for Tesla is that few experts believe the cost of the battery will drop by more than 30% in this time. So Elon Musk needs to take care that his cost curve (which falls at only 30%) doesn’t end up higher than his price curve (which he wants to fall at 50%). The bottom line is that savvy analysts are urging caution about the bet on falling battery prices that Tesla shares represent…

Very long-term interest rates

At Finweek and ValuationUp.com were big fans of compound interest. It’s quite simply the most powerful concept to understand in finance and underpins everything from the interest on debt to valuation. So it’s interesting to see just how old and universal this concept is: it turns out that the idea that loans can be made, and periodic interest payments can be accrue on those loans has been with us since we took the first steps to becoming agricultural.

A move to an agricultural society implies property rights: if you are to invest in preparing soil by clearing forests, removing rocks, digging up the earth, planting seeds and then caring for your crop you need to know that it will be yours to reap when its ready. Agriculture has always required large capital investment, but the returns can literally accrue for several generations, if not centuries. What’s interesting is that seed is a form of currency. Say you take 100 seeds, plant and care for them. If all goes well you should have 100 plants that each produce 100 of their own seed. So within a season you could take 100 seeds and make that 10,000. Now if you’re a farmer starting out you need seed. So very early on, there’s proof that people were buying seed and paying back out of future ‘capital’ growth. Animals were also loaned in a similar way – with payback in terms of a share of progeny. Investing seed or animal capital to share in the growth of the pool (the gene pool, if you think about it), is what we do today, just money was invented in-between. The invention of money meant that you could lend someone seed and be paid back in Silver, which could then be exchanged for something else. There is evidence that around 3000BC Interest rates in Sumeria were about 20% on these deals.

Compound interest was viewed as being morally suspect for a long time, and was derided as usury. This in part driven by a speculative credit boom that coincided with Silver mines in German and the Christian invasion of Islamic Spain. The ‘shaming’ of compound interest forced capital providers to invest in such a way that they could make a collective profit from what people did with their money…and so the venture capital business was born. It as no longer a sin to profit from the money one lent to an agent. However people who made a lot of money this way still felt guilty – its been suggested that wealth which 14th century banks accumulated in Italy lead so the banks owners investing in philanthropy as a way to ‘give back’. This investment allowed the Italian renaissance and pulled Europe out of the dark ages.

Religion has never been far from money and although ‘taking from the poor’ via interest wasn’t initially popular, the rise of Protestantism and its associated work ethic lead to increased tolerances from religious leaders that in turn allowed the middle class to accumulate capital. The Calvinists saw business as something you could pursue while caring for morals at the same time. Thus it was in the 16th century that compound interest became mainstream and acceptable again. In 1545 England passed laws allowing annual interest rates of up to 10%. Rather like taxing prostitution or drug trades this legitimised and regulated the trade that until then had been the domain of loan sharks (the micro-lenders of their time). Bear in mind though, that at this time if you wanted the farm land someone else had invested their life into getting ready, it was quite possible that you’d just fight them for it, so capital was still at risk.

In 1613 Richard Witt published ‘Arithmetical Questions’ – a landmark book that included tables of compound interest and formula for their practical application in merchants and traders. The book laid the framework for the English banking system, which remains fairly central to global financial trade.

The other side of the coin is that Karl Marx viewed compound interest as an evil force that allowed capitalists to have far more control than their proportional share of the assets they actually owned. It would be hard to argue against this today, even though communism clearly hasn’t been the answer to the problem.

Compound interest remains at the heart of the financial system. If you eat food its production has been financed by compound interest. It’s the same with your house, car, education and most likely the business where you earn your living. Interest rates vary widely – our systems are far more complex now and we also have a far more granular understanding of risk. Capitalism remains the dominant economic model and that is entirely due to compound interest. My guess is things will stay in the 10%-20% for a long time to come…

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.

Ripple.com 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 Ripple.com 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.