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Lean & Nonlean Startups [Finance
Posted on September 22, 2018 @ 08:30:00 AM by Paul Meagher

The image of the lean startup is often associated with spending as little as possible to verify your business model. The entrepreneur is living on ramen noodles, making a series of low cost minimal viable products and getting it out in front of potential customers to find out if they are on the right track. Eventually the entrepreneur reaches a moment when they can take on investment because they have reached a proof of concept and now need to scale. This type of business evolution is more likely to happen in the tech world because of the relatively low cost of entry.

Problems arise when we take this startup approach into a nonlean industry. A nonlean industry is one that is heavily regulated and which may require a high level of expenditure before you can even get started. You may need expensive licensing, meet standards that are costly to achieve, buy real estate, build structures, do extensive renovations, etc... You can't do all these things on a shoestring budget.

Take for example the production of wine. To make a good bottle of wine you can make it with inexpensive plastic pails and glass carboys. To be able to get into the marketplace with your wine is not so easy. There are many regulations and standards that you have to meet before you may do so, even though you may be in possession of a product that a customer would like. In a nonlean industry startups need to raise significant startup capital to deal with regulatory compliance and other costs of doing business before they can even begin to do business. The legal cannabis industry, for example, is a nonlean industry as there are high regulatory compliance costs to doing business in that industry. This is offset by the potentially high reward factor, as it is in any nonlean industry.

Vegetable farming is an example of an industry where you can startup in a relatively lean manner and become even leaner over time. You can start simple but in time your lean operation can become heavily invested in efficiency improving tools and systems like this one:


In conclusion, the lean startup movement has a tremendous amount going for it but the image of starting a business on a shoe string budget is not applicable to some industries where other factors (fund raising success, compliance, networking) may have more importance in determining whether you can create a startup in that market.


Hiring Money [Finance
Posted on September 5, 2017 @ 06:29:00 AM by Paul Meagher

One often cited classic of aglit (agriculture literature) is Maurice Grenville Kains' book Five Acres And Independence first published in 1935 and revised in 1940. The fact that it is still in print and easily purchased is a testament to its ongoing usefulness.

The book consists of 51 short chapters on a variety of critical areas of farm management from growing crops to managing finances. If you can't read the book, reading the table of contents alone (use Amazon's "Look inside" feature) is worthwhile because it is a masterful summary of the books contents.

The book contains lots of diagrams and figures because it is meant to provide practical instruction on a variety of farm matters. Again, if you don't have time to read the book cover to cover, simply browsing some of the diagrams would be a good way to quickly assimilate some useful content. For example, in the days before electric pumps, an hydraulic ram system was a way to use water to pump water. Here he shows how to setup an hydraulic ram system for use in the field:

Or in the home:

If you do have time to read the book, then you can consult the sections that are most relevant to you. The information does not seem too dated and it is useful to hear the perspective of a successful farmer from 80 years ago to see how they solved many of the same problems that farmers face today.

Some of the chapters that I read about first are his chapters on finance, capital, and accounting. In his chapter on Farm Finance I came across the idea of "hiring money". In the quote below, the masculinity of the pronouns dates the writing and the culture of farming that existed then but the points are still valid:

To determine ways to make money in farming the annual budget and the annual inventory are of prime importance. When the farmer starts business and at the beginning of each of his business years (which may be calendar or his own fiscal year, say March 1) he makes his inventory, then estimates his probable gross expenses and income for each month and for each crop or department so as to determine in advance at what time he is likely to be pinched for money, when he will have surplus, when he must borrow and when he can repay. Knowledge of business methods teaches him that hiring money is the same as hiring labor. [Emphasis mine] So he shows both his budget and his inventory to the cashier of his local bank and arranges for loans perhaps months before he will actually need to borrow. ~ p. 57

I think the notion of "hiring" money is an interesting one that potentially allows us to think more clearly about the role of capital than the notion of "borrowing" money. When a business needs money to startup, expand or as working capital that money is not borrowed but rather hired for a specific job that will ideally return an amount greater than the borrowed amount. We hire labor because their labor generates more revenue than it costs. Likewise, we hire money when we see an opportunity to generate more revenue than it costs.

The metaphor of hiring money encourages us to think about treating any money we might require to finance operations in the same way we would treat money used to hire labor. It needs to generate similar returns to be worth hiring. The metaphor of borrowing money is unhelpful in this regards - you are just putting it back into the original storage without any suggestion that it needs to generate a good ROI for the employer of the capital.

One other aspect of the book that intrigues me is the value assigned to "independence" in the title of the book. In these days of social media, I'm not sure you would be successful promoting the virtues of independence, but there was obviously a time when independence was highly valued, perhaps in the same way that resilience is valued today.


Getting Physically Organized [Finance
Posted on April 24, 2017 @ 02:17:00 PM by Paul Meagher

I am a fan of April Wilkerson's Do-It-Yourself YouTube Channel. She has developed lots of great video content and her channel continues to evolve. Recently, April and her husband sold their house so she does not have a shop to work from. Her husband agreed to share his shop space with her and this video shows them getting the shop organized for their upcoming DIY videos.

This video motivated me to get myself organized to get my taxes done. I am not the best example of how you should manage your taxes as I leave it to the last minute and throw all my receipts into piles that have to be sorted out later. If you find yourself in a similar situation, maybe you will find my method of getting receipts organized useful.

Below is a photo of my office computer and chair. In the middle, is a pile of receipts. The receipt piles come from different times of the year. I have 12 open folders positioned around my office chair, one for each month of 2016. The first level of sorting for me is to simply move all the receipts into the month folders. I do try to keep automotive receipts, gas receipts, construction receipts, small tools, and office receipts somewhat separated inside each folder but don't try to organize them more than that as I'm doing my initial month sorting.

This setup allows me to keep working on my computer and listen to YouTube videos for entertainment as I sort my receipts. Organizing myself by month allows me to more easily compare my receipts against my bank and credit card statements which are also organized by month.

Once I have my receipts organized by month along with printed monthly bank and visa statements, I then go through each folder month by month and assign receipts to expense categories I've developed for my sole proprietorship businesses. When I finish going through all the months I can then tally the totals in all my expense categories for 2016. The rest of my taxes are relatively easy to do once my expense totals for different expense categories are calculated.

I use an accountant to help me with my corporate taxes which are mostly all digital transactions so the organizational process is much different. I do try to improve my book-keeping system a bit every year. Last year I setup separate banking/credit card accounts for each separate business (3 of them) and my personal account. I can do alot more of my accounting work digitally this year so am less reliant on sifting through paper receipts; however, it can still be difficult to reconstruct what you did last year from a simple bank transaction - you often need the paper receipt to figure out what you purchased.

Someone more organized than me would be updating their expense categories on an ongoing or monthly basis. I hoped to do that last year, but it never happened and I'm not doing so hot again this year. I may have to repeat this process again to get caught up for 2017 so I have a better sense of what my expenses are. I know that monthly tracking of expenses is the next improvement I have to make to my accounting system so I have better real-time information about the state of my separate lines of business.


What is Profit Resilience? [Finance
Posted on March 21, 2017 @ 12:41:00 PM by Paul Meagher

I recently came into contact with the phrase Profit Resilience from reading Zach Loeks new book The Permaculture Market Garden: A VISUAL Guide to a Profitable Whole-systems FARM BUSINESS (2017). In the farming industry there is the problem that profits often don't come in steadily throughout the year and this can obviously be challenging for the farm business. To maintain income the farmer may have to take out loans to cover costs until the next production and sales period happens. Or, the farmer might create another line-of-business designed to generate income during these slow seasons so that a constant level of profits is achieved throughout the year. The latter option gets you closer to profit resilience.

Farmers can achieve more profit resilience if they don't rely upon one line-of-business to sustain them all through the year. Profit resilience is achieved by introducing specific amounts and specific types of diversity into their income stream. I say specific because too much or too little diversity can be detrimental. If we try to manage too many diverse types of business, then the complexity of managing it all can outweight the marginal benefit of adding a new line-of-business. One solution might be to make the businesses less diverse so that similar skills can be used to manage each line-of-business (e.g., CSA, specialty crop, Garlic seeds). Unfortunately, the lack of industry diversity means that income may all track the same seasonal pattern we are trying to avoid. To achieve greater profit resilience the diversity of the lines-of-business have to be greater (similar to portfolio investing).

Profit resilience depends upon having the proper amount and types of businesses in your enterprise portfolio. The proper amount is 3 lines-of-business and the proper types are lines-of business whose profits are not correlated in time. Why 3 lines-of-business? This is just to give you a feasible number of businesses to consider in your planning. Ultimately, the number should be chosen based upon looking at all the small enterprises out there that are demonstrating profit resilience and tallying the number of lines-of-business they are engaged in. Ideally we would also examine small enterprises that failed and examine the number of lines of business they were engaged in. If 3 lines-of-business was identified as ideal then this could be a normative suggestion. Why do the lines-of-business we select have to be uncorrelated? This is ultimately an empirical question but, in the case of farming, it is clear that there can be problems with seasonality of income and if you select all your lines-of-business without ensuring the profits from them are uncorrelated or anti-correlated then you may not achieve profit resilience. The Portfolio Theory of investing might also be used to justify the need for a higher level of diversity among the businesses you invest in. The portfolio theory is arguably about achieving profit resilience, and not just profits.

Is the goal of your business to be profitable or to have profit resilience? You can be profitable without having profit resilience. It happens in lots of businesses. The automotive shop I frequented went under in early February because they hit a low revenue part of their season and were carrying too many overhead expenses (they moved to a nicer shop with higher rents and more staff). Perhaps having more than 1 line-of-business would have helped but maintaining profit levels is made more difficult when you have higher expenses and encounter rough patches.

Everyone has to be concerned about profit resilience even if you are a senior on a fixed income. When you move from the daily grind into retirement it would be nice if you could achieve some profit resilience in the transition. Your income may be lower but if you also lower your expenses significantly you might be able to achieve some profit resilience during this transition. Likewise, if a business is going through a patch of low sales, then cutting out some expenses might help to achieve some profit resilience (difference between revenues and expenses remains relatively constant). You may also voluntarily decide to restructure your business to have lower income but also lower costs. If profit resilience is your goal rather than simply increasing gross revenue then this makes sense to do.

Profit resilience is a temporal concept in the sense that our time to rebound back to a previous level of profitability is measured by some time interval. If your income nosedives and you rebound back to your previous profit level a year later, is that still an example of profit resilience? Probably not. In the business world we tend to measure things in business quarters and that is probably as good an interval as any to use for measuring profit resilience, although monthly accounting is also a very popular accounting time frame.

Profit resilience can be achieved if we plant things today (e.g., apple trees) that might bear fruit in the future. We can't invest too heavily in the future, however, if we want to retain profit resilience because the future is not generating revenue today. When selecting another line-of-business to add to the enterprises we should have a significant bias towards adding lines-of-business that will generate profits in the near term. One useful example comes from Mark Shepard who purchased more nut tree seedlings that he needed and used the proceeds from selling the extra seedlings to cover his purchase cost and then some. Even though something is being done for the long term it is nice when you can obtain a yield from it in the short term as well.

The term Resilience is popular these days so when I heard the phrase Profit Resilience I thought it was worth spending some time reflecting on various aspects of that phrase might mean. The last observation that I want make about the term Resilience is that it has been contrasted with two other terms - Fragile and Antifragile - by Nicholas Taleb in his important book Antifragile: Things That Gain from Disorder (2012). Profit resilience might be contrasted with profit fragility and profit antifragility, the latter being another concept worth exploring in a future blog.


Predicting Bank Failure [Finance
Posted on July 5, 2016 @ 08:56:00 AM by Paul Meagher

The 2016 Behavioral Economics Guide (PDF) was recently published. The introductory article by Gerd Gigerenzer discussed a research program between his research group and the Bank of England. Some of that research is reported in a paper called Taking Uncertainty Seriously: Simplicity versus Complexity in Financial Regulation (2014). The basic argument being made in these papers is that we would probably do better in regulating banks if we used simple heuristics to decide if a bank was at risk of failing rather that relying upon increasingly complex metrics to arrive at that assessment. Indeed it can be argued that the complexity of the metrics is making it even more difficult to assess the risk of bank failure.

How do we go about deriving these simple heuristics? You can use a framework of multiple fallible indicators to come up with the best set of indicators to determine if a bank might fail or not. Here are some of the indicators they looked at.

Using the indicators that had the most explanatory power, they proposed the following "fast and frugal" decision tree as a basis for evaluating whether a bank is likely to succeed or fail. A fast and frugal decision tree involves making a pass/fail decision at each node so you don't have to traverse all the nodes to potentially make a decision as to the vulnerability of the bank.

The purpose of this blog is to whet your appetite to read some of the linked to papers to read more. It is also to demonstrate an approach to coming up with your own fast and frugal approach for dealing with complex assessment problems (identify indicators, rank order them, and incorporate them into a fast and frugal decision tree or lens model). I'm not aware of this approach having much traction yet among bank regulators and the authors offered up this model as "illustrative" of a suggested approach rather than a real proposed model. That is too bad because such a model would allow the general public to gain a sense of how vulnerable a bank might be to failure. We can't do that with more complex approaches and therein lies one of the the problems with overly complex approaches that don't necessarily perform any better at predicting bank vulnerability that simple approaches.


Banking & Accounting [Finance
Posted on March 16, 2016 @ 09:45:00 AM by Paul Meagher

If you have been self-employed for awhile there is a good chance that will end up owning more than one business entity which you are deriving an income from or which you are investing money into starting up (and want to claim those expenses).

I personally have three businesses and resisted the urge to complicate my banking by setting up a separate bank account and a separate credit card for each account. It seemed crazy that I would need 4 banking accounts (which also includes my personal banking account) and 4 credit cards to manage my accounting properly so I resisted setting up a banking account for one of my businesses and getting a credit card for two of my businesses. I convinced myself that all I needed was a "personal" and a "business" credit card. I also convinced myself that I didn't need a bank account for one of my businesses because I was investing money from my other businesses into getting it started and until it was a "real" business I would hold off on setting up accounts.

The fact is that not having all of these banking accounts and credit cards made my life more complicated because it made it more difficult to create a proper accounting trail of where money was coming from and where it was going to. So yesterday I started the process of setting up a new bank account and two new credit cards. In the future if I decide to setup a new business it will be with the knowledge that I will need to also setup a banking account for it and a corresponding credit card. The credit card is not because I'll need the extra credit, it is simply that purchasing by credit card is often the most convenient way to make purchase and record it to a specific business entity.

So my advice to anyone setting up a second business is to make sure you setup a new banking account and a new credit card for your new business right away so you can use them to create an easy-to-follow accounting trail for your new business. Don't make the mistake I made and imagine that your banking will get more complicated because you have more accounts and cards; it will actually get easier because the accounting side of your business will get easier and more justifiable.

The rule I now follow is:

1 business entity = 1 bank account + 1 credit card.


Financial Forecasting [Finance
Posted on March 2, 2016 @ 11:55:00 AM by Paul Meagher

I am halfway through Philip Tetlock and Dan Gardner's book Superforecasting: The Art & Science of Prediction (2015). Bloomberg suggest that this is the third most important book for investors to read over the spring break. With all due respect to Elon Musk and the Originals, I would probably rank this book #1 because of its' timeliness.

One current event that makes the book timely is the US Presidential elections and the race to predict who will be the next US President as well as the outcome of all the skirmishes along the way. A new group of people who will be given credibility in predicting these results will be the people that Philip Tetlock's research program has identified, through testing, as superforecasters. These are people who come from different backgrounds but who share the feature that they are significantly above average in predicting the outcome of world events.

The superforecaster club appears to be an elite group of prediction experts. Philip and Dan analyze what makes them tick in the hopes of helping us all become better at predicting the future. Many of the questions that Philip and Dan ask them are the types of geopolitical questions security intelligence agencies want to have answers to so that they can properly prepare for the future. Much of the research that is reported comes from research sponsored by intelligence agencies. Intelligence involves alot of prediction work so this makes sense.

The second reason why this book is timely is because this is tax time for many people and there is probably no better time of year to figure out a financial forecast for next year. You have your financial performance from last year clear in your mind and your are now 2 months into 2016 and have some current data to integrate into your forecast for 2016. So around now is a good time to exercise your prediction muscle and come up with a 2016 financial forecast. If you don't seriously exercise your prediction muscle don't expect your prediction abilities to get any better.

One prediction that small businesses are required to make each year is their expected income in order to make appropriate quarterly income tax payments. One reason superforecasters are good at predicting the future is because they are good at breaking down complex prediction problems, like yearly financial forecasts, into smaller and easier prediction problems. If asked to evaluate whether Hillary or Trump will win, they don't try to predict the question as it stands. They break it down into all the things that would have to be true in order for the Hillary or Trump presidential outcome to happen and evaluate the likelihood of those component outcomes. Similarly, to come up with a good financial forecast for next year you need to break your prediction down into expense and income buckets and try to estimate how full those different buckets will be.

One business expense that I claim are the books I purchase for educational or blogging purposes. How much will I spend on books in 2016? If I can nail this down fairly well and then nail down how much I'll spend on keeping my vehicle on the road and so on, then I should come up with a better forecast of my expenses for 2016 than if I just used my overall expenses from 2015 as my guide to forecasting my 2016 expenses. One way to improve your tax season experience is to look at it as an opportunity to improve your forecasting skills in a domain where you can get good feedback on your forecasting accuracy. To be become better at forecasting it is not enough to simply make forecasts, you also have to evaluate how well your forecasts did and this is relatively easy in the case of financial forecasting (next year's income taxes will tell you how accurate you were).

So back to forecasting my book expenses for 2016. Superforecasters are good at taking an outside view of the prediction problem before taking an inside view. The outside view is the objective view of the situation. They ask what might be the relevant numbers, statistics, and base rates upon which I can base my forecast. In my case, I can log into Amazon and see how many books I have purchased so far from them in 2016 and use the amount spent so far to project what I'm likely to spend this year. Once I have these numbers than I can take the inside view and ask whether my rate of reading is likely to persist for the rest of the year. As spring and summer approaches, and I spend more time at the farm, I expect my reading to go down. Even though my reading rate may go down, I nevertheless expect to keep investing at that rate of 1 book a week because my new years resolution was to read a book a week.

So one book a week at an average price of around $30 per book leads me to make an exact prediction of $1,560 (52 weeks x $30 per book) as the expected total for my 2016 book expenses category.

Another feature of superforecasters is that they are not afraid to do a little math. It is hard to assimilate forecast feedback if you don't compare forecasted and actual numbers. Comparing forecasted and actual numbers is trickier than just comparing two single numbers. It is at this point, however, that I want to conclude this blog because I think it will take another blog to address the issue of specifying and evaluating forecasts. I also have the second half of the book to read :-)

To conclude, the Superforecaster book is a timely book to read. Financial forecasting is arguably one of the best arenas in which to develop forecasting skill as it involves breaking down a complex prediction problem into simpler prediction problems and the opportunity to gather feedback regarding your forecasting accuracy. Financial forecasting is also a very useful skill so it is a good arena in which to hone forecasting superpowers.

In my next blog on this book/topic I'll address some of the math associated with specifying and evaluating forecasts.


Production Aggregation [Finance
Posted on February 10, 2016 @ 08:25:00 AM by Paul Meagher

Mark Shepard is the author of Restoration Agriculture (2013). He is a no-nonsense ecological farmer and a business mentor to many Permaculture startups. I listened to a recent podcast featuring him called Permaculture Demand, Starting Up & Organic Valley. This blog was inspired by some of what he had to say.

One topic that Mark Shepard discussed in this podcast is some of his positive experiences as producer number 40 (of 1,800 producers) for the Organic Valley Cooperative.

The Wikipedia page for Organic Valley provides these key details on the cooperative:

Organic Valley (OV) is an independent cooperative of organic farmers based in La Farge, Wisconsin, United States near La Crosse, Wisconsin. Founded in 1988, it is the largest organic farmer-owned cooperative in the world with over 1,800 farmer-owners across the United States, Canada, and Australia. Organic Valley markets its products in all 50 states and exports to 25 countries. In 2014, growing annual sales neared $1 billion.

Mark frequently refers to Organic Valley as a "production aggregator" meaning it aggregates production across farmers so that farmers can access larger and more diverse markets. The need for a production aggregator, according to Mark, can arise because there is a failing market for your commodity or service when you are acting alone in the marketplace. If you are at a farmers market with local grower competition and you can't sell your cucumbers or you can't get your price, then the solution may be for cucumber growers to aggregate production and sell the combined product into the same or bigger market that can absorb it at a price that is acceptable. The market feedback you get when you operate alone may be negative but when you cooperate with other producers the market feedback can be strongly positive and encourage you to grow more cucumbers.

If you combine all your cucumbers together and sell them to a grocery chain then you might be paying a fee to a broker who distributes on your behalf. What if you replace that broker with members of your coop so that any fees you pay are going back into your production cooperative? The fees might allow you to make more income or receive additional benefits (i.e., pension, dividends, internal jobs) and would help finance the evolution of the production cooperative. Note that this is a different model than Uber, AirBnB and other popular "sharing economy" business models that offers a production aggregator service and collects a brokerage fee but without many additional benefits provided. The alternative to the "sharing economy" business model may be something along the lines of Organic Valley or the very successful John Lewis Partnership in the UK. These companies may not be as "explosive" in their growth as Uber but they are showing high levels of growth and considerable growth potential.

There may be significant costs to setting up a production aggregator (e.g., legal, accounting, software, storage facilities, equipment, transportation, dedicated staff, etc...) and the production aggregator might seek investment to cover these costs. The production aggregator might offer to return investors money (plus interest) over a period of time but could also sweeten the deal with a coop membership that allows the investor to enjoy some of the benefits of the venture. Ideally, the investor's skillset would be useful to the company and an investor might end up paying themselves some of the money invested to carry out the required setup and ongoing work.

Setting up a production aggregator would entail some legal work on the company structure. Often they are setup using a legal trust as the formal business structure but some type of partnership structure might also work and be less legally complex to start out with. I do not pretend to be a lawyer or accountant so don't quote me on any of this.

I'm not necessarily endorsing the view that cooperatives are the end-all and be-all. I'm mostly interested in examining what the motivation for production aggregation might be, how the startup phase of a production aggregation service might be financed, and what types of benefits private investors might receive from their startup investment (i.e., payback with interest, membership benefits, payment for worktime invested).

Also worth considering is what types of objects can a production aggregation business model be applied to that it isn't being applied to today? Examples might be timber production, water production, carbon sequestration and other products or services that might be less tangible.


What Is An Earnout? [Finance
Posted on January 27, 2016 @ 10:28:00 AM by Paul Meagher

If you are selling your business (or some percentage of it) and you think it is worth $X but your buyer thinks it is worth $X-$diff, then you might still reach an agreement if you agree to the $X-$diff valuation today and the seller agrees to an "earnout" for the remaining $diff if the company performs to a certain standard over an agreed upon time frame. You as the seller get an immediate payoff less than your valuation, but you earn the rest of your valuation if your company performs as well or better than it has in the past.

An earnout seems to be a clever way to potentially reach an agreement between the buyer and seller of a business when there is a valuation disagreement. There are hazards, however, to cutting such deals. Mark Mcleod came out strongly against them arguing that earnouts almost never work due to alignment issues they can cause between the buyer (who doesn't want to pay the earnout) and seller (who wants the earnout). Mark suggests you treat an earnout provision like a lottery ticket with no strong expections that you will receive it.

Two other issues with earnouts have to do with potential litigation and negative tax consequences. Litigation often arises because there is a dispute as to whether the relevant earnout milestones were achieved and the seller may object that they were blocked in some way from achieving their earnout targets because of the buyers actions. One also has to consider whether the money paid as earnout money is treated the same as the capital gains arising from selling your business or part of it. Often earnout money is subject to higher taxes. These issues are discussed in more detail in lawyer Roger Royse's article The Problem with Earnouts.

So while earnouts would appear to be a clever bargaining technique in arriving at an agreement between a buyer and seller of a business, there are some negative consequences that all parties should be aware of and make allowances for if they still want to use an earnout to resolve valuation disagreements.

The purpose of this blog was to raise awareness of the concept of an earnout and some of the concerns that cause bloggers and lawyers to often speak poorly of this bargaining technique.


Highest Use of Capital [Finance
Posted on January 22, 2016 @ 10:02:00 AM by Paul Meagher

In my last blog on the principle of highest use, I wondered whether we might apply the highest use principle to investment capital. The basic idea is that we would want investment capital to serve its highest use first but also subsequently enjoy other uses that our investment capital might have. The purposes of this blog is simply to explore how we might apply the highest use principle to investment capital. I think it is an idea worth exploring and hope this blog encourages you to come up with your own views on the highest use of capital.

We might begin by listing all the uses of investment capital. When I googled "uses of capital" one result that was helpful was the Uses of Capital page on the Virginia Capital Partners' website. They list 8 uses for their investment capital. These uses are listed below (visit this page for details on each use):

  • Growth Capital
  • Acquisition Capital
  • Geographic Expansion
  • Startup Capital
  • Public Company Assistance
  • Restructuring
  • Shareholder Liquidity
  • Recapitalizations
  • Management Buyouts

This is a good list of uses for a venture capital firm's investment capital. Many of the businesses that use this website to raise capital seek capital for one or more of these these reasons. Unfortunately it is difficult to order this list and say that one use is higher than the rest. It is also difficult to see how employing capital for one use leaves you with the ability to enjoy other uses for the capital unless you derive a return on your investment that leaves you free to invest in other desired uses. For example, if you invest in helping a company grow, the return from that investment might in turn be sufficient to finance the acquisition of a company or geographical expansion for the company. The highest use principle might suggest the best initial use for your investment capital.

Another way to think about the highest use of capital is to reflect upon your own experiences investing in your business. You definitely want your capital to satisfy as may uses as possible. If you had the choice between purchasing a tractor or a piece of land, what is the highest use of capital? That might be determined by the number of uses I have for the purchased object and whether those uses can return capital that would allow me to re-invest into other uses. The highest use of capital in this case might be a tractor because having the land alone without a machine to work it is not likely to return capital back to me as quickly as having a tractor that can be used for many revenue generating activities and also to develop the land. The revenue generated from using the tractor might allow me to subsequently buy the land and have a tractor to work it which preserves my wealth and potentially allows me to re-invest my capital again. So the highest use principle might help us figure out which of several potential investments is the best use of our capital based on whether one of those investments is more likely to allow us to invest in the other uses for our capital.

Another way to think about the highest use of capital is in terms of maximizing positive impact while preserving wealth. Some call this social impact investing. In this case you look beyond just the monetary returns of you investment to how the investment impacts the lives of workers, the community, and the environment. Henry Ford, for example, said "The highest use of capital is not to make more money, but to make money do more for the betterment of life." Henry Ford may not have been totally philanthropic when he used his capital to raise workers wages as it lead to his workers being able to afford to buy the cars he was producing. Using capital for "the betterment of life" can feedback and create a virtuous cycle of investing that ensures your money enjoys many uses in other hands before it is finally exported from the community for some commodity that cannot be purchased locally. Ford's capital investments had significant social impact while also preserving his wealth. Some might say the preservation of capital is not required in social impact investing. If not, then we have to ask whether this is the highest use for our capital because once it is used up there may no longer be capital available for other uses.

Anytime we invest money we are concerned with making the best use of our investment capital. The highest use principle encourages us to look beyond the initial use of investment capital to anticipate how the investment might lead to other uses of capital either in your hands or in the hands of others. Ideally you want your investment capital to be preserved so it can be used again for the next best use of capital.

Social impact investing is another way to frame the highest use of capital and the highest use principle might be even more applicable to this form of investing. If you are an investor considering a social impact investment you might want to invest in a project that represents the highest positive use of your capital while also ensuring that your capital will be preserved for the next highest use in the future. Entrepreneurs receiving such funds should realize that the objective of the investor may not be to simply to spend their money on a good cause, but to create enough revenue from their investment to preserve their wealth for the next best use and to create the maximum number of uses in the community where the money is being invested.


Price to Earnings Ratio [Finance
Posted on January 8, 2016 @ 11:40:00 AM by Paul Meagher

The price to earnings ratio, or P/E, is a important investment concept.

One reason it is important is because it provides a way to think about how to value the worth of a company. If your company is generating profits then you can use those profits to establish a value for your company. The value of your company is some multiple of those profits. The size of the multiple is the tricky part to figure out.

One factor that determines the size of the multiple is whether you are a private or publicly listed company. The economist Paul Samuelson calculated that, in a bull market, the multiple for a private company was 3 and a public company was 5. He used gross revenues as his measure of "earnings" instead of "profits".

Not all revenue streams are created equal. A profit in one industry might be worth more than the same amount of profit in another industry which would be reflected in higher Price/Earnings ratio in the former industry than the latter. Investors may see more potential for earnings growth in the former industry than the latter.

Yahoo Business publishes an Industry Summary that gives you a rough idea on the P/E for various industries. The "Catalog & Mail Order Houses" industry has an astounding P/E ratio of 955.60 (on Jan 11/2016) which, if you dig deeper, you see mostly reflects the value of Amazon in that industry segment.

The P/E value for different industry segments might tell you something about how to value your revenue stream. Shop around for what might be the best estimate of P/E for your industry. Again, using industry level P/E is only one way to guesstimate what your P/E might be.

My interest in P/E ratios was spurred by reading Marjorie Kelly's analysis of how public companies of the "extractive" type work (see my last blog on Generative Versus Exractive Ownership Design). In particular, I've been studying her systems diagram on some of the main factors influencing profit in a public company and the role that P/E plays.

In this diagram she illustrates how public company Profits can be increased by adjusting the factors in the bottom loop which can be magnified by the factors in upper loop. If Amazon increases it's profit by 1 million then this gets multiplied by a P/E of 955 which results in a 955 million increase in the valuation of the company. One can see that when Amazon declares a profit it has a bigger effect on company valuation than most companies in the world.

I think it is worth studying Marjorie's diagram for awhile to see if you agree or disagree with her analysis of how Profits in (extractive) public companies are determined - what she calls "the secret of the magic". I also think it is worth studying Marjorie's diagram because it will give you a richer understanding of the P/E ratio by relating it to other economic factors. A definition of the P/E ratio gives you one type of understanding, but seeing how it might work in a systems diagram gives you another type of understanding.

I do want to conclude, however, by pointing out that the P/E ratio is one tool you might use for the purposes of thinking about company valuation.


Definition of Money [Finance
Posted on November 23, 2015 @ 08:37:00 AM by Paul Meagher

I'm currently reading a book by Lars Tvede called The Creative Society (2015).

I'll probably have occasion to blog about the contents of this quirky and wide-ranging book in the future, but today I want to discuss Lars' definition of money which I found interesting:

Money is an information technology that informs us about the value of experiments and rewards those who performed them. ~p. 57

In an earlier section, he elaborates upon this definition as follows:

Money is often described as "a unit of accounting, a store of value, and a medium of exchange", but is also an essential information technology which describes to us the value of a voluntary win-win transaction. Win-win, yes. But win-win how much? The money provides the answer in a simple, common code. Two camels. 20 seashells. One million dollars. Any blabbermouth can fantasize about how much he did for others, but if he does it in a marketplace, we can make a decent estimate of its value by counting the money people gave him for his effort (of course, there are exceptions to that). ~ p. 54.

In perceptual psychology, we might call money a measurement scale where the amount of value in a product or service can be assessed according to the price we assign to it. So when we see that a product has a certain price, we assume it has a certain value. If we don't perceive the product or service as having that actual value then we don't buy it. We might view branding as a way to manage the measurement scale so that the price we assign a product or service has the perceived and experienced value associated with that price.

Ultimately what I like about Lars' definition is that is a definition entrepreneurs might find useful. Money informs us about the value of our experiments and rewards those who perform them.


Future of Banking [Finance
Posted on October 7, 2015 @ 08:37:00 AM by Paul Meagher

In the begining of the last recession in 2008 when taxpayers bailed out the too-big-to-fail banks, there were some banks that did not suffer similar mortgage default rates as these big banks. These were the community-owned banks, state-owned banks, credit unions and some other financial institutions with a cooperative, mutual, local, or mission-driven focus.

In her book, Owning Our Future (2013), Margorie Kelly points out that one common feature of these alternative banks was that they were not profit maximizing entities and had an ownership design that precluded them from simply wanting to generate more mortgage loans so they could maximize profits by selling them off to bigger banks who were creating mortgage-derived securities from them. If the loan went bad for these alternative banks it often meant they weren't serving their community or their mandate. The care and consideration these banks put into their loans was apparently greater than the first and second tier banks that were geared towards generating mortgage loans to maximize profits.

Profit maximization, it turns out, may be a good strategy for banks in the short run but it can lead to its own demise when it becomes predatory, impersonal, and purely financially driven. In the long run banks with an ownership design that represents the community it operates in and which has a mission beyond profit maximization tend to do better. Consider that many of the larger banks probably wouldn't be around today if they were not bailed out and that many of these alternative banks were not experiencing anywhere near the same level of defaults during the 2008 meltdown.

Ironically, the government fix was to increase the federal deposit insurance requirements, reporting requirements, and auditing requirements for all banks which tended to differentially affect the financial viability of these smaller alternative banks. The regulators apparently did not see, or allow that, the ownership design and community-based mandate of these alternative banks were the controls that prevented them from experiencing the crisis to the same degree as the profit maximizing banks.

The story behind the crisis is obviously more complex than this but the point of this short blog is to draw attention to the issue of whether banks that are profit maximizing are systemically problematic and whether we can correct this simply through regulatory improvement. Or, does it require an ownership design change coupled with a mandate change to create real systemic changes in banking? Regardless of whether you agree with Margorie's analysis and assessment of the banking crisis, I think Margorie's book (which I also referred to in a previous blog) is useful in helping us to see that there is room for innovation on the issues of who owns a bank and what their mandate is. The design of future banks will hinge fundamentally on these two issues.


Rent-Backed Securities [Finance
Posted on October 20, 2014 @ 05:11:00 PM by Paul Meagher

Mark Dotzour from the Texas A & M Real Estate Centre wrote a blog called Wall Street Landlords in which he discusses how Wall Street investment firms are buying large numbers of distressed single family homes that are in various stages of foreclosure. Mark published a useful table that lists the investment firms owning the largest number of such single family homes:

What many of these firms are doing with these properties is fixing them up and renting them out for income. Some may sell them when the housing market appreciates again but many of them are happy with the combination of a discounted purchase price and higher than average rental fees so will likely remain landlords for the foreseeable future.

The biggest player by quite a margin is the Blackstone Group, a huge NY-based investment firm with $248 billion in assets under management. The Blackstone Group is leading the way in devising a new financial product, rent-backed securities, based upon the rental income from these properties.

According to Brian Lynch, "Under this business model, the equity present in rental agreements will be aggregated into tranches based on confidence in the financial ability of the tenants pay their rent. The collateralized security instruments from these tranches will have various rates of return based on risk factors from the underlying leases. Should these rent-backed securities default, the security owners may even have an ownership stake in the properties to fall back on". The reason Blackstone is offering these rent-backed securities to investors is to "allow them to free up equity in these properties to purchase even more distressed homes". Investors apparently are quite excited to buy them so other large investment firms in this market are considering similar offerings.

These rent-backed securities setup an obvious positive feedback loop that will lead to Blackstone becoming an even bigger player in the single family home rental market. While institutional investors and pension funds are apparently quite happy to invest in such securities, Occupy Our Homes Atlanta is not so thrilled. They reported that:

  • Tenants wishing to stay in their homes can face automatic rent increases as much as 20% annually.
  • Survey participants living in Invitation Homes [Blackstone's brand for single family home rental properties] pay nearly $300 more in rent than the Metro Atlanta median.
  • 45% of survey participants pay more than 30% of their income on rent, by definition making the rent unaffordable.
  • Tenants face high fees, including a $200 late fee for rental payments.
  • 78% of the surveyed tenants do not have consistent or reliable access to the landlord or property manager.

It will be interesting to see how the rent-backed securities market plays out. Will the relentless profit-maximization of the Blackstone Group lead to ever more complex leveraging of the rental income and home collateral they own (e.g., rental default swaps)? Will blow back from main street put limits on the positive feedback loop that firms offering rent-backed securities can enjoy? Could there be a market failure involving large losses in rental income and investors wanting their money back - or would they end up owning all or part of the distressed homes backing these securities?

I don't have any answers but I expect that the Blackstone Group will be the company to watch in this evolving market for rent-backed securities.

I also wrote this blog in part because I'm interested in learning more about the Blackstone Group holdings in order to understand why they are the largest alternative investment firm in the world. I seem to be running into their name more frequently as a result of the many companies they have acquired or have a controlling interest in.


Green Bonds are Taking Off [Finance
Posted on September 4, 2014 @ 10:31:00 AM by Paul Meagher

Green Bonds are ways for Governments, Municipalities, Financial Institutions, and Corporations to raise money to support a broad range of green initiatives from erecting wind turbines, to reclaiming brownfield sites, to addressing issues related to climate change, etc... The promise of Green Bonds, like any bond, is that you will get an assured return on your investment after a certain term by providing debt capital to these organizations.

The issuance of Green Bonds has been growing rapidly over the last few years with many financial institutions and corporations getting into the game at a rapid rate. The climatebonds.net website keeps a tally of how many green bonds have been issued to date and this year is set to break new records again for the amount of green bonds issued - going from approximately $11 Billion last year to an estimated $40 Billion this year.

Table showing Green Bond issuance by month

One reason why Green Bonds are taking off is because, according to this economist article, "55% of pension-fund assets are exposed to climate risks (including heavier regulation of dirty industries); buying green bonds helps offset such risks". So pension funds want to buy into Green Bonds to hedge against climate risks that other companies in their portfolio might be subject to.

Another reason would include the fact that "US Green Bonds" as issued by the US Treasury are tax-exempt investments to incentivize investors to buy into them.

Another reason is that corporations see them as a useful way to raise money for certain types of projects. Because green bonds are growing in popularity it is getting easier to raise capital quickly by issuing "Green Bonds" for their green projects.

Finally, many of the projects that these green bonds are being used to finance are simply good investments. Many green energy projects, for example, have relatively low risk with stable long terms returns so why not invest in them.

The story on what green bonds are and how they work is just beginning. Many see a bright future for Green Bonds in helping solve a host of environmental problems. As with anything with the label "Green" attached to it, one must be skeptical of how "green" the projects are that are being funded via "Green Bonds". There is some work to standardize the criteria used for a bond to qualify as "green" but I doubt that everyone will buy into one published set of standards. It is nevertheless worth keeping an eye on how the whole area of Green Bonds evolves in the near term as more governments, large financial organizations, and large corporations throw their hat into the ring by releasing more Green Bonds. It should mean more money to finance green projects in the near term if the rate of release and subscription to these bonds stays at its present level of growth.


Financial Statements for Investors [Finance
Posted on February 11, 2014 @ 03:31:00 PM by Paul Meagher

You have a good idea but need capital to make it happen. You decide to pitch your idea to investors and see if you can find interested investors. You have a good idea and impress some investors who want to do some follow up with you. They want to know more information about your business. This is where many attempts to raise funds potentially break down. Why? Because some entrepreneurs think fund raising is all about the idea and haven't invested time into generating some basic financial information investors might want to know as part of their due diligence.

What financial information might that be? Most business plans are expected to include the following financial statements:

Income Statement

Balance Sheet Statement

Cash Flow Statement

If you are an existing business seeking funds, then you might be expected to have historical and projected versions of these financial statements. Your projected financial statements will be assessed for realism by your historical financial statements. If you are a startup, then you can only provide projected financial statements and these projections will be based upon industry and market research. Most banks will ask for these three statements when deciding whether to provide a commercial loan so it is reasonable to expect that a private investor might enforce a similar level of due diligence when deciding whether to invest in a business or not.

Now that you know what basic statements you might be expected to have on hand for business investors, you can do some research so that you are prepared in the event that potential investors ask you for them. The bottom line is that entrepreneurs should at least be familiar with these types of financial statements when seeking funding in case you are asked to produce them.


Next Worry Date Formula [Finance
Posted on November 25, 2013 @ 07:29:00 AM by Paul Meagher

Scanning a book by Micheal Janda called "Burn Your Portfolio: Stuff They Don't Teach You in Design School, But Should", 2013, Peachpit Press. I came across an interesting financial nugget that he calls the "Next Worry Date Formula" that I will share with you today.

Janda manages a successful design firm and came up with the idea of the "Next Worry Date" because alot of money was coming into and out of his business and he had generalized anxiety about the financial situation of his company. To resolve his anxiety, he made some calculations in his head to figure out if he should be worried about money. Eventually, he realized that he should write these calculations down and use them as a basis for figuring out when he needed to start worrying about the cashflow situation in his business. The result is the Next Worry Date formula which looks like this:

Total cash in the bank
+ Total receivables
+ Total remaining billings for current month
- Tax money (money set aside to pay quarterly taxes)
- Emergency fund (money set aside for absolute emergencies)
= Total Cash Flow
/ Monthly overhead cost (divide by monthly costs)
= Number of months of cash flow coverage
- One month
= Next Worry Date (that is one month before money runs out)

To illustrate how the formula is used, Janda uses the example of a freelancer working from home doing the Next Worry Date calculation on August 1st. Here is what the numbers look like:

$12,300 Total cash in bank
+ $6400 Total receivables
+ $5300 Total remaining billings for current month
+ $3500 Total remaining billings for next month
- $3000 Tax money - since it is August 1st, you have two $1500 quarterly payments remaining for the year
= $14,000 Total Cash Flow
/ $6000 Monthly overhead cost - let's say you pay yourself $5000 per month and have 1000 in additional business expenses
= 2.4 months Number of months of cash flow coverage
- 1 month
= 1.4 months Next worry date is one month before money runs out.
= Sept 30th Next Worry Date

One quibble I have with this calculation is that, by my figuring, 1.4 months from August 1 would be approximately the middle of September, not the end of September. This could be an error or it could be intentional. After going over another example calculation below I'll give one possible rationale for assigning a Next Worry Date in this manner.

The next example Janda uses is for a small design agency of 10 people or so (the numbers may be fairly realistic given that Janda manages a design firm). Again using August 1st as the date when the calculation is being performed, he computes the Next Worry Date as follows:

$87,300 Total cash in bank
+ $109,000 Total receivables
+ $72,500 Total remaining billings for current month
+ $58,400 Total remaining billings for next month
- $12000 Tax money - since it is August 1st, you have two $6000 quarterly payments remaining for the year
- $45,000 Emergency fund
= $270,200,000 Total Cash Flow
/ $65,000 Monthly overhead cost
= 4.16 months Number of months of cash flow coverage
- 1 month
= 3.16 months Next worry date is one month before money runs out.
= Oct 31th Next Worry Date

So, in this case, 3.16 months from Aug 1st is approximately Oct 31st. Perhaps Janda likes to assign a worry date to the most reasonable end-of-the-month timeslot when he thinks he should start to worry again about his finances. It is often the case that financial tracking is done on a month-by-month basis so putting a worry date in the middle of the month can make it trickier to figure out where you stand financially, so perhaps it makes sense to do the calculation at the beginning of each month and assign next worry dates to an end-of-the-month slot that seems most reasonable. What we are monitoring with the next worry date is whether you do in fact end up cashless on your next worry date. If you do, then you must react either by cutting costs or taking on new projects or both. You then need to start monitoring your financial situation on a more constant basis to know exactly where you are. Eventually, you want to move the next worry date back out into the future far enough that you don't have to keep monitoring it as much.

Most entrepreneur's don't have a steady pay cheque so it is easy to develop anxiety over finances. Generally the way to overcome that anxiety is to sit down and figure out your finances to determine where you actually stand. I offer up the Janda's Next Worry Date formula as one framework you might use to make your calculations and manage anxiety about finances. One aspect of this calculation that I find particularly interesting is that you won't find this formula or calculation in textbooks on finance or accounting perhaps because they are written for people who often end up doing the books, or advising for, a large company. The concept of a "next worry date" is not as real to them as it is to an entrepreneur with an uncertain cashflow. The concept of a worry date is not something they teach you in business school, but it becomes very real when you enter the working world as an entrepreneur. As an entrepreneur you need to manage your money effectively but also not obsess about it. The Next Worry Date formula is one tool you might use to help think about your finances more realistically, with the proper amount of anxiety, and at the appropriate times of the month.


Stages of Startup Funding [Finance
Posted on May 30, 2013 @ 01:33:00 PM by Paul Meagher

The One Minute MBA has a useful video on funding phases that successful startups often go though as they grow.


Tracking Expenses Better [Finance
Posted on May 2, 2013 @ 08:08:00 AM by Paul Meagher

Just finished up my taxes for another year. Every year it seems my taxes get more complex. As usual, I leave everything to the last minute and have to set aside 3-4 days to categorize all my invoices into the various expense categories.

This year I have decided to make some improvements to my accounting system. My invoicing system is ok. My problem is staying on top of my expenses. So, towards that end, I have created monthly expense folders (e.g., Jan 2013 Expenses, Feb 2013 Expenses, etc...) and have thrown all my relevant receipts into those folders. I usually sort my receipts into sorted piles when doing taxes (e.g., fuel, electrical, heating, small tools, planting, internet, etc...), but I will probably leave my receipts in my folders and maintain a separate journal of expenses sortable by date and expense category. I know a spreadsheet can do all this, but I'll probably hack up my own php-based application to do this because 1) I can, and 2) it might be useful to eventually interface it with my php-based invoicing system to create a business dashboard.

What I hope to get from my improved accounting system is a more up-to-date sense of my cumulative income and expenses. I'll be able to better calculate how much I need to pay the taxman in my quarterly income tax installments rather than relying upon an estimate based on last year's taxes. I should be able to figure out if I should be making business investments to keep my tax rate at a certain level. Rather than making those purchases towards the end of a tax season, I could be making them during the year with an eye to optimizing my taxes and cashflow better.

So far it looks like I'll need at least 3 database tables to track expenses: Expenses, ExpenseCategories, and Businesses. The latter table is required because I operate three businesses and expenses have to be assigned to the correct business. An expense will be tagged according the business it belongs to and the expense category it belongs to. Each business will have it owns set of expense categories (there is not much expense category overlap between my internet businesses and my farm business). I can export my banking and credit card data in Comma Separated Value which will make it easier to get a list of my expenses and input them into my expense tracking system. It will still require reviewing my downloaded expenses each month and getting them ready for input, but once they are ready, I should be able to develop a script to batch input my expenses for the month according to transaction date, description, and amount.

Hopefully this will be the year when my accounting system is finally mature enough to provide me with reports on year-to-date income and expenses along with monthly breakdowns of income and expenses. It should allow me to view these reports separately for my three businesses and also offer some ability to combine income and expenses across businesses as well.


Real estate investments and interest rates [Finance
Posted on January 30, 2013 @ 06:30:00 AM by Paul Meagher

At the end of march next year, my wife and I will have paid off our house mortgage.

My wife was looking over some financial statements and it looks like the total amount we will have paid for the house will consist of the original mortgage cost plus approximately 44% of that amount in interest costs.

We wondered whether purchasing real estate is a good investment or not.

My wife pointed out that this can't be answered in the abstract because it very much depends on what your interest rates are as you pay down your mortgage. We had higher interest rates at the beginning of our mortgage 12 years ago (approx 6%) but the last few years they have been in the 2.5% to 3% range. It would have been especially nice to have had the lower interest rates at the beginning of our mortage as we would have taken down the principal faster and paid less interest. Our interest rates have been fairly reasonable compared to borrowing in the 80's and 90's and compared to those with a poorer credit rating.

In general, the degree to which a real estate investment is good or bad very much depends on how that investment is financed, in particular, the timing and size of interest rates on borrowed money. Current low interest rates make real estate investing fairly attractive right now. We are happy that we purchased a second farmstead property in our home town 3 years ago as the interest rate regime has been favorable (2.5% to 3% range). If the farmstead wasn't such a money pit, I'd be even happier :-)

Those wanting to list real-estate investments on Planet Dealflow are welcome to do so. Our premium service packages (Express Plus, Global Express Plus) offer you the ability to upload documents, images, and video to produce a professional real-estate opportunity for Canadian and international investors.


Tax implications of paying royalties versus dividends [Finance
Posted on January 25, 2013 @ 10:37:00 AM by Paul Meagher

Entrepreneurs can compensate investors in the form of dividends or royalties. There are significant tax advantages for entrepreneurs if they compensate investors in the form of royalties rather than dividends. To see why, lets first define these terms.

Wikipedia defines a Royalty as:

Royalties (sometimes, running royalties, or private sector taxes) are usage-based payments made by one party (the "licensee") to another (the "licensor") for the right to ongoing use of an asset, sometimes an intellectual property (IP). Royalties are typically agreed upon as a percentage of gross or net revenues derived from the use of an asset or a fixed price per unit sold of an item of such, but there are also other modes and metrics of compensation.

Wikipedia defines a Dividend as:

Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be distributed to shareholders. There are two ways to distribute cash to shareholders: share repurchases or dividends. Many corporations retain a portion of their earnings and pay the remainder as a dividend.

An eHow article entitled Income Statement Classification of Royalty Expense has this to say about classifying royalty expensies:

Since royalties fall under the overall heading of "Compensation" they can be written off as an expense for each tax period. Royalty payment rates are outlined in a contract between the company and the individual being paid, and are therefore determined based on sales figures for the applicable product. Necessary expenses, including any form of compensation, decrease a company's net income. Royalty payments are classified as current expenses on the income statement.

In contrast, Wikipedia says this about paying dividends:

For the joint stock company, paying dividends is not an expense; rather, it is the division of after tax profits among shareholders.

So entrepreneurs wanting to claim investor compensation as an expense might want to consider entering into a royalty arrangement rather than a dividend relationship with investors. Consult the above Wikipedia links for a wealth of information about royalties and dividends as methods of payment.


Engines of production [Finance
Posted on January 15, 2013 @ 07:58:00 AM by Paul Meagher

The more I read about Henry Ford the more impressed I am with him. He may rank as one of the all-time greatest business innovators and thinkers.

Henry Ford is best known for his innovations in mass-producing automobiles. The complexity of this undertaking required him to introduce a large array of technical, organizational and financial innovations.

Today I learned that the Model T had 4 buttons on the console. One set of buttons was to control whether the engine would run on gas or alcohol. Another set of related buttons would control spark plug calibration for igniting gas or alcohol. When Henry Ford launched the Model T, it was at a time when it was just as easy to supply a city with alcohol from surrounding farms as it was gasoline from longer distances away. Henry knew the marketplace and designed his vehicles accordingly. What is old could become new again if fuel prices continue to go up and our supply of oil dwindles. It would also require some loosening of laws around alcohol production. Conspiracy-minded people might note that it was during Rockefeller's presidency that prohibition was brought in and alcohol-based engines largely phased out. Rockefeller was an oil man. Anyway, the idea of supplying the motive power for engines from local biomass is an appealing idea in many ways and one that Henry Ford envisioned with the Model T.

Henry Ford also had some interesting ideas about the nature of investment that are worth considering:

I have never been able to understand on what theory the original investment of money can be charged against a business. Those men who call themselves financiers say that money is "worth" 6 percent, or 5 percent, or some other percent, and that if a business has one hundred thousand dollars invested in it, the man who made the investment is entitled to charge an interest payment on that money, because, if instead of putting that money into the business he had put it into a savings bank or into certain securities, he could have a certain fixed return. Therefore, they say that a proper charge against the operating expenses of a business is the interest on this money. This idea is at the root of many business failures and most service failures. Money is not worth a particular amount. As money is not worth anything, for it will do nothing of itself. The only use of money is to buy tools to work with or the product of tools. Therefore money is worth what it will help you to produce or buy and no more. If a man thinks that his money will earn 5 percent, or 6 percent, he ought to place it where he can get that return, but money placed in a business is not a charge on the business - or rather, should not be. It ceases to be money and becomes, or should become, an engine of production, and it is therefore worth what it produces - and not a fixed sum according to some scale that has no bearing upon the particular business in which the money has been placed. Any return should come after it has produced, not before.

The engines of production in our ecomony operate on many scales. Many internet businesses need "fast money" to capitalize upon emerging markets and investors in those businesses often expect quick returns on their investment (to the detriment of those businesses?). There is, however, an equally large array of businesses that require "slow money" because they can't quickly ramp up production. Farms, for example, do better if they get "slow money" to acquire the engines of production (literally) and the terms of re-payment are defined relative to when production happens, and not before. Many farm loan boards should arguably operate as slow-money lending facilities rather than fast-money lenders.

It is not yet time to consign Henry Ford to the dust pile of history. His ideas have a surprising longevity that make him worthy of study today.


Seed Money and Series A Financing [Finance
Posted on January 4, 2013 @ 09:45:00 AM by Paul Meagher

A couple of terms you might come across when searching for startup business capital are "Seed Money" and "Series A financing". Most entrepreneurs using this site to fund their startup will be looking for seed money. Generally after you have exhausted your credit line and tapped out any friends or family that might be willing to help out, you will seek out an angel investor or business investor for additional startup capital. The money these investors supply is called "Seed Money". Seed money is subject to a higher risk because often the business model is not proven or is not generating much revenue yet. The investor will generally be looking for ownership in the company in return for capital.

In the textbook account of startup funding, the next round of funding after the Seed Money round would be called Series A financing round. This round of funding involves larger amounts of money and generally involves venture capital organizations putting up the money. In this round of funding, the legal complexity of the contracts generally goes up and the level of scrutiny and involvement by the venture capital company also goes up. In this round of funding, the percentage of ownership you might have to sacrifice might be about the same as you sacrificed during the Seed Money round, but you will be asking for more money in the Series A financing round owing to the fact that there is less risk involved now and the business model might be starting to generate revenues.

If further rounds of funding are required, then those rounds will be called Series B, C, D, etc.... The letter lets the investor know where they fit in the hierarchy of company investors. If you intend to engage in multiple rounds of financing, then the worry for an investor is that their share of the company profits will be too small to make it worth their while investing in the company. Forward looking entrepreneurs will anticipate this dilution issue and will refrain from giving away too much of the company in the earlier rounds so that there is some left for later rounds of investment.

Image Source: http://en.wikipedia.org/wiki/File:Startup_financing_cycle.svg

We are talking here about rounds of investment that might required to turn a small company with a good idea into a large company with a profitable business model. These are not the only companies small business investors are interested in. Small business investors are also very interested in funding existing businesses that require capital to expand their business.


Business inputs and outputs [Finance
Posted on November 27, 2012 @ 08:39:00 AM by Paul Meagher

I recently attended a presentation by Dr. E. Ann Clark (retired U. of Guelph) on the future of framing at the Agriculture Campus of Dalhousie University in Truro. One of the main slides that she presented depicted the gross revenues from farming in Ontario steadily going up since 1920 while the net revenues went up until around 1950(?) and then started to go down. Presently, net revenues are slightly positive if you add government support, and negative if you don't. Of course there are farms in Ontario that do well, however, if we look at averages the farm sector in Ontario is not doing well. This was the starting point she used for her talk about what needs to change in order for Canadian farming to have a future.

So if gross revenues are steadily going up, where is all the money going? Basically, the cost of farming inputs (fertilizer, seeds, equipment, etc...) are going up faster than farm revenue, and, at the same time, because of extreme consolidation among buyers of farm products, farmers must be "price takers" rather than "price setters" for what they produce. In other words, the middlemen on the output side of farming are arguably getting more than their fair share of money as well.

There are lessons here for businesses of all types in terms of how to run your business. One lesson is not to believe much of the received wisdom about how to operate your business because farmers have been listening to the agricultural schools about the need to buy modern seed, fertilizer application rates, and the proper machinery to use. Much of this research has been sponsored by the seed companies, fertilizer companies and equipment manufacturers so there is some collusion in the advice provided. The advice certainly has worked out well for farming input suppliers. So, use your common sense and keep grounded and frugal when operating your business, and do not listen to the latest hype about how to run your business. In farming, this means, for example, using manure as your fertilizer and grass feeding your animals as much as possible instead of paying for these inputs. Also, there are benefits to including livestock with your cropping system (lowered fertilization costs, lowered soil preparation & weeding costs/time, enterprise-staking, etc...), rather than just operating a cropping system.

Another lesson is to keep an eye on your input costs and make sure they are in line with your net revenue, not your gross revenue. It is easy to believe that you need bigger and better equipment because you are producing more and bringing in more money; however, you may also be spending proportionally more to achieve that higher level of production so the net effect of these purchases can be negative on your bottom line.

Another lesson would be to eliminate as many middlemen as you can between you and the consumer so you can reap top dollar on the product that you produce.

So let the farming industry act as a cautionary tale for your business and the role of inputs and output costs in determining your bottom line. I have much of respect for farmers and their business acumen so don't take this as a criticism of farmers in that regards. Farming is a challenging industry to succeed in right now, but I'm optimistic that new structures of farming will emerge to coordinate farmers and consumers in more direct relationships.


Age of founder and life cycle patterns of consumption [Finance
Posted on June 26, 2012 @ 08:30:00 AM by Paul Meagher

Adeo Ressi has written an article in which he attacks the notion that there is a peak age for entrepreneurship, which some have claimed to be around 25 years old. He concludes his analysis with the following comment:

Age is only one factor among many to predict the success of entrepreneurs, and anybody at any age can break any molds put forward by “experts.” However, it’s clear that the stories of a few “college-dropout turned millionaire” (or billionaire) startup founders have clouded both the mass media and the tech industry from reality. We have romanticized the idea of a young founder because, well, it’s a great story, but these stories are not the norm. In the end, classic biases of gender, race, and age need to be discarded for a real science of success.

In general, I agree with Ressi that you can be a successful entrepreneur at any age, however, I don't think we should ignore the fact that there are some factors that might make it easier for an entrepreneur to succeed at an earlier age than a later age. One of these factors is our life cycle pattern of consumption. When we are younger there are fewer funding conflicts between our business and our household. As we age and our families grow, there is an increasing conflict between funding a new venture and funding the household with the household getting a larger share of available funds. Finally, as we near retirement the conflict weakens, but by then we might be ready to retire rather than wanting to invest in funding a new line of business.

Under this analysis, it is not the magic dust of youth that leads to startups being run by young founders, rather it is because there is less conflict between funding the startup and funding the household. This is not to say that older entrepreneurs cannot fund startups at a later age, but they need to be cognizant that this conflict potentially exists and they need to manage it appropriately. It would be nice to use the funds from a business you started at a younger age to buy your family all the good things in life, but you might be digging your own entrepreneurial grave by doing so. If you want to start a business later in life, and capital is scarce, you need to run a lean household in addition to a lean startup.




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