Finance – Bates Creek Consulting

How do you avoid a crisis?

I have been tracking the Coronavirus for about a month and a half, my first email on the subject was back on February 14^th. At that time, it looked like it was going to fizzle. It hasn’t.

“How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually and then suddenly.” – Ernest Hemingway

Firms fail all the time. They survive when the sun is out and the environment is consistent, but when change comes, even if expected, they can’t adapt and failure results. During a bankruptcy meeting at the court I overheard the case before ours. The owner had lost a significant portion of his business but failed to downsize staff, equipment and space and in a couple of years was in bankruptcy court. I commented to our attorney that if the owner had just recognized and taken some action he wouldn’t be in this mess. The attorney commented that was true for everyone in bankruptcy. The challenge is recognizing the need for change and the development and execution of actions to solve the problem.

Start-ups are generally dealing with crisis every day and they good at solving the problem. What used to work, doesn’t. Procedures and processes are revamped shortly after development. The management team is having strategic planning sessions every month laying out a new course. As a firm grows, it becomes less flexible and processes are written, reviewed and put into a book. The firm achieves a level of effectiveness, so efficiency becomes more important and redundant staff which provided flexibility is removed from the company. This process works great in a static market. Unfortunately we are not in a static environment. Here are my four steps to keeping the start-up mindset going as you grow.

Keep your head up. Too many management teams are inward focused. They care about what goes on in the next office more than the next building and even less about what is happening across the world. When I started out we had a news service curated by the company librarian. We would receive via a buck slip (names of the relevant executives to be checked off as read) a package of the most relevant articles that affected our firm, our competitors and market. Today that may be your RSS feeds. Management meetings would include time to discuss what we learned. Understanding and wisdom was shared through the team. Black swan events happen all the time, especially if you are not paying attention. Cut down on surprises, make sure your team is looking outside the firm.

Build multiple redundant plans. A plan is a decision on what you are going to do to achieve some goal. If you have only one plan, any change will mean you have no plan. All plans are about an uncertain and possibly unfriendly future. Good plans think through contingencies and outline potential options. Bad plans reflect the present circumstances. Charlie Munger talks a lot about decision trees and thinking about options and choices. Most schools don’t do a good job of teaching this skill. Learn it. Thinking through what could happen along with what actions could be taken will make your plan more robust.

Build a diverse team. “None of us is as smart as all of us” – Ken Blanchard. Recent research talks about the decision-making advantage of a diverse team. History proves this true. Good teams work together but also bring experience and perspective. We’ve all worked with the executive who has 10 years’ experience which is really 1 years’ experience 10 times. Different perspectives help make everyone smarter. Seven people you went to grad school will be a great party, but your shared viewpoints hide rather than illuminate options. I’ve worked with a lot of executives: both great ones and a few not-so-great. Great ones don’t always fit, but they always add value. Organizations are quick to exit the “poor fit” team members who don’t share similar viewpoints. Fit works great when the environment is static. When the environment changes “fit” drops in relevance and competence rises.

Only the Paranoid Survive is more than a book by Andy Grove. I don’t wish you to be truly paranoid. Paranoia is a symptom of illness. But I’ve now worked with too many businesses which when successful consider themselves brilliant and special, and when difficult times come they shatter. In the stock market we used to say, don’t confuse brains with a bull market. It is easy to make money when everything is up and to the right. Don’t drink the lemonade, keep humble. This section is likely wasted at this time. By now you‘ve figured out that the tide has gone out as Warren Buffet says, and who is naked. This crisis will pass but don’t forget – there will always be crises.

Ramp or Steps?

I once implemented SAP over the top of Quickbooks. We were on a fast growth trajectory and the venture funds wanted a solid system that we could use while we grew. The SAP ERP system was selected before I joined. The system wasn’t as mature as it is today and for our $1,000,000 check we received a lot of “Achtung” error screens. The one positive was that we used their system exactly as designed. Our processes didn’t exist, so there was no need for customization.

Managing growth is about managing the many changes that occur when you turn a small business into a big business. Start-ups lose money before they achieve scale. This is because costs aren’t perfectly variable. If you open a frozen yogurt shop, you’ve got to rent space, buy fixtures, yogurt machines and train a staff. All of this cost occurs before you bring in any revenue. These investments are a part of your fixed costs. Costs that vary with sales are called variable costs. A perfect variable business would not have any costs until revenue is achieved. Unfortunately, there are no perfectly variable businesses.

Costs grow in “steps” because the cost increases are not smooth, they increase in a bunch. For instance, you could start out renting a small space with a fixed rent, which is a step up from working on the kitchen table. A year later you pay the same rent but the staff has grown and people have to crawl under their desks to get to their chairs. A new space is located and rent increases, another step. Shared space operations like WeWork, Regus and Carr and hope to minimize the steps by allowing you to add space as needed.

A big change in business in the last 25 years has been the decline in the size of the steps and the ability to ramp a small business. We used to call the growth infrastructure problem “the tunnel”. Before you entered the tunnel you could make money – the business is small, not much investment in space or people, there was little structure and no overhead. You entered the tunnel when a step up in investment was required. Maybe you needed a larger office, or a new system or a warehouse. But whatever it was, until you grew sales sufficiently to cover the cost of investment, you had high costs and lower profits.

Years ago there were many, many large steps. Renting an office space used to mean a 5 or 10 year lease with guarantees by the founder. Not so anymore. You will pay a more per square foot for shared space, but you aren’t committed in the long term. Systems used to run six figures, while today I’ve worked with businesses with sales more than $40m a year running on a $400 copy of Quickbooks.

Financing can sometimes help make those steps smaller, too. You may only need to put down 10% on that frozen yogurt machine, so you pay the loan with money you’ve made selling frozen yogurt. The risk remains (after all you have to pay the loan), but you better match income with outflow.

These steps happen with staff, space, equipment and systems. Managing the growth is a lot about making the steps as small as possible while keeping your attention on the target. My SAP install turned out to be a bust. After losing $50m the company pivoted and we returned to Quickbooks.

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Dr. John Zott is the Principal consultant at Bates Creek Consulting and works as a CFO. John is a senior adjunct professor at Golden Gate University and comments regularly on issues that affect growth companies. If you are a former student, colleague or would just like to connect – reach out.

Why we spend our time on what we spend our time on

I attended Armanino’s annual conference last week. Matt Armanino went through their CFO Evolution Survey which talked a lot about CFO’s and business transformation. The survey has been going on for 8 years and it benchmarks what CFO’s do and what they should be focused on. The survey refers to three main focuses of the CFO, accountant, protector and business leader. According to the survey, accountant and protector roles chew up 75% of the time, while the ratio they suggest, should be more 50/50 with business leader being a much more important role. The actual conference material was focused on the accountant and protector, which is where most of the attendee’s currently spend their time.

CFO’s spend their time where the needs are, not where they’d like to work. Allocating time has to be done in the field based on the challenge the company faces.

When I work with CEO’s I often use the metaphor of operating a car.

Getting the Car Running

The first level is the accounting figures, the controls, audit and compliance are about getting the car working, and telling you where you have been. To do this well you need a great understanding of GAAP, compliance and tax. In big firms this is often a senior level job that doesn’t necessarily lead to a CFO role. At a medium or small firm this level is “table stakes” for CFO’s and Controllers. If you can’t do this, you have to find a different career choice.

Having correct accounting figures is like driving by looking out the rear view mirror, because this is reporting on what has already happened. CFO’s that fail

here do so because they have a weakness in a core skill (planning, reporting, managing). In a bigger firm, that weakness can be covered by strength in the staff. Getting compliance, process and controls right can be a big job. Although Armanino suggests that the CFO spend less time in this area and focus on automation of routine functions, successful CFO’s in a new situation can spend years getting this right. If this isn’t right, being the best business leader in the world won’t help, you have to get the numbers right.

Drive the Car

The second level is the use of metrics and tools to identify how the business is operating. It is like driving the car. The use of key performance indicators (kpi’s), development of dashboards to manage the business and reduce risk is like looking out the front window of the car. More real time data allows you to make changes as circumstances change. Forecasting and planning become relevant. Executives who are uncomfortable with building metrics on the management of the business become compliance “bean counters”. A great deal of firms in the small, middle market haven’t developed a good set of KPI’s which help drive the business. They are often happy just having accurate financials.

The main time focus of the second level is the next 3-6 months. CFO’s that excel here use technology and reporting to drive change. The challenge is to maintain balance in reporting – too much focus on financial numbers will pull attention away from customer and staff oriented metrics.

Many, many businesses survive with minimal KPI’s and really no long-term planning. Reactive management styles can be successful. In a fast moving market, sometimes all you can do is drive fast and aim in the general direction of success.

Plan the Route

The final level is the transformative level, where the CFO plans the trip and picks the stops. At this level the CFO becomes a business partner to the CEO and helps create the circumstances and changes needed to keep the business successful. The business model becomes relevant, exit strategies, market changes and management development are important. This is the level that Armanino suggests CFO’s should be working at.

I don’t think every financial executive should work their way to the final level. There are lots of companies without a good level one reporting system or without good KPI’s or metrics. When hiring, CEO’s and Boards should think more conceptually about the current challenge of the business and stop worrying about industry knowledge. Wal-Mart and Dolce & Gabbana are both retailers, but they aren’t the same.

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Dr. John Zott is the Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are looking for a CFO for your e-commerce/retail/consumer company, or are a former student, colleague or would just like to connect – reach out.

Simple, Better Decisions

Although I prefer to help businesses grow, sometimes growth goes bad and the company becomes a turnaround. I worked with a firm that went through a very rapid growth phase, was hit with an unexpected event, and ended up declaring bankruptcy. I joined shortly before the bankruptcy and saw them through the money raise and bankruptcy exit. It is a valuable experience that is way under appreciated by hiring managers.

One day early on in the process, the outside corporate counsel (a close friend) and I were sitting in the back of the court room waiting for our turn. Several smaller cases were being heard by the judge. After listening to a few of the facts, I noted to my friend that if these firms made a few relatively small decisions six months earlier they could have avoided the whole bankruptcy proceeding. The lawyer turned to me and said “every case in bankruptcy court could have been avoided by making a few better decisions earlier.” Although this doesn’t sound that profound now, it did to me then.

Decisions have consequences, and bad decisions lead to bad outcomes. Although it can be personally satisfying to blame one person or one decision for a bad outcome, there are often multiple decision points and multiple people involved and plenty of opportunities to take another path. The downward spiral of performance is often accompanied by a closed mind. You can’t fix a problem you won’t see.

Management teams repeat their core message to the staff, which communicates strategies and values. This repetition helps solidify the culture and keep the company on track. Unfortunately, as circumstances change, sometimes the strategies must change. Repeating the company line when it is no longer relevant is like dancing for rain. The only winner is the guy getting paid to dance.

Worse yet management teams that don’t recognize change become further out of touch with the front-line staff that faces the market and the changes. Respect declines when your boss is telling you to focus on “a” when you can clearly see the problem is “b”.

The first rule of holes is “when you find yourself in one, stop digging.” Management teams need a method of tracking performance that tells you when you are in a hole, an open mind to recognize that circumstances have changed and the fortitude to go and fix the problem.

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The Elusive Nature of Sustainable Growth

Sprinkler test for fire supression system installed two months before massive 39,000 acre Lake Chelan fire.

The upward trajectory of growth is exciting, challenging and at times mystifying and elusive. Growth happens due to a group of factors, some of which are dependent on timing and luck. You can put all the pieces in place for a growth strategy and execute well and still not achieve the planned growth. At other times, the simplest adjustment in color, price or promotion generates significant new sales. If you are embarking on a growth strategy the odds of success are in favor of assembling the pieces, hiring well, executing well and a bit of luck. However in a pinch, just luck can work.

Growing fast is like catching lightening in a bottle, it is not easy and is risky. But once growth has begun it is imperative that you don’t screw it up. Like Bull Durham’s Nuke LaLoosh, a superstitious baseball pitcher, you must respect the streak. You must respect the thing that is bringing the customers to your business. Too often managers will want to implement changes without regard to how that effects the very thing that drives customer acceptance. I get that the lead engineer wants to tweak the product for more performance and the head of operations wants to reorganize (again) and the stores team wants to update the prototype. All of these things will eventually get done, but don’t let them come before sales.

I once worked with a company posting solid 6% comps in an industry that was lucky to get 2%. Overall sales growth was high teens. The management team kept trying to change the formula, seeking to compete against bigger companies. What they didn’t see is that the strength of the business was the very product and service lines they were de-emphasizing. At another company the culture was very gung ho and entrepreneurial, which had been a big part of the strategy. The new CEO saw his role as professionalizing the team, which mostly consisted of adding bureaucracy and purging the company of all managers who weren’t loyal to the new CEO. Disaster ensued.

Although it is seems hard to believe, management teams often do not understand what drives incremental growth or short term sales slumps. They speculate, hypothesize and test, but often don’t know if the change in trend is short term or long term. Management teams are paid to take action, and often they take action prior to diagnosis. Tom Peters used the term “ready-fire-aim” to coach big businesses to move faster. For small business this is a bad strategy. You already pull the trigger plenty fast, you just don’t hit many targets.

John Tukey put it “Far better an approximate answer to the right question, which is often vague, than an exact answer to the wrong question, which can always be made precise.” A great strategy based on the wrong question is far worse than an ok strategy to the right question. Doing nothing is a better result than doing something wrong. Doctors take an oath to “first do no harm” as the cure can be worse than the disease. Managers should take the same oath. Before messing with a product line that is working or with a company that is killing it, make sure that your changes don’t impact the reason that customers are choosing you over your competitors. And when in doubt, test and test again.

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We love our Guru’s but they aren’t helping

I have been saying for many years that we are using the word ‘guru’ only because ‘charlatan’ is too long to fit into a headline. Peter F. Drucker.

There is comfort knowing that someone knows what is going on and can help us by giving us their opinions about politics, stocks, how to live better and what to wear. All we have to do is to find the right guru – the right advice. We think we are reducing risk by following a guru, but we aren’t. But, at least we won’t look foolish alone.

There are not many physics guru’s because one important part of guru-ness is that the subject matter should be indeterminate, that is that it cannot have a single right answer. The stock market is prone to guru’s. There are no simple answers and what works one day, won’t work another. Investment shows on TV are about entertainment, not education.

By now hopefully you know that there are no stock market guru’s. It is simply not possible to forecast where the stock market is going in the short term. Most of what passes as forecasts are 20/20 hindsight or deal with relative valuation of the market. I think relative valuation is useful, you can buy the market at a discount. I know you will pay less for Christmas/Holiday cards in January (11 months early) than November. However, buying something at a discount doesn’t stop the chance that there will be a bigger discount later.

“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge. ” Lao Tzu

Politics is similar to the stock market. The guru’s in politics are no more accurate, and offer no more clarity than the stock market guru’s. Political forecast accuracy has been the subject of quite a few good books. Tetlock’s book “Expert Political Judgement” outlines his thoughts on why so many political forecasts go poorly. Philip Tetlock’s suggests that foxes are better than hedgehogs at forecasting. The fox knows many different things, hedgehogs know a few things well. His more recent book with Dan Gardner “SuperForecasting” offers examples of good and bad forecasts and includes some suggestions on how to do it better.

Forecasts are effected by circumstances and human behavior that in the short term can be identified, but in the long term (more than a year or so) have too many interactions to be of any use in forecasting. Like the weather forecasts which fall apart the further out you forecast, the longer the time frame the more human behavior and chance result in different outcomes.

“No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers.” – J. Scott Armstrong

There are a lot of guru’s in the business world. Harvard seems to grow them like tomatoes. The history of management includes a lot of ideas that turned out to be stinkers. Scientific management wasn’t a very good idea even when it came out. Re-engineering turned out to be another way of saying lay-off. I’ve spent hours debating core competencies which in the end, couldn’t be defined or implemented. Theories that can’t be tested are especially prone to guru-ness.

Trying to implement guru’s advice can be frustrating. I loved “In Search of Excellence” but the advice was general like “stay close to the customer”, which is almost perfect guru advice since you can always say you weren’t close enough. I call it Zott’s Law of Business Books. The more general, the easier to read, the less useful the advice. Kahneman’s “Thinking Fast and Slow” was a top business book of 2015 and is interesting and a good read. Again, not much useful advice.

J. Scott Armstrong also said, “If you can’t convince them, confuse them.” A lot of business guru’s wrap pretty simple ideas in complicated language.

The Principal Agent problem states that there are differences between principals and agents (owners and managers) and that making agents more like owners will solve the problem. I like Agency Theory, it explains a lot of behavior. We sought to fix this problem by giving executives stock options. Since then we’ve spent millions on stock options and it doesn’t appear that management is any more aligned now than before. The cure I think is worse than the disease.

We listen to these guru’s because we want an answer. The answers given aren’t necessarily right nor particular useful, but they are confident and we value that certainty. Guru’s use our need for certainty to sell us their opinions (and via advertisements, dish soap). In today’s world of fake facts, alternative news, spin and TV personalities who are selected and paid for their ability to speak confidently (without knowledge), our main defense is a healthy skepticism . Skepticism and an understanding that we live in an uncertain world.

Quidquid latine dictum sit altum videtur – Anything said in Latin sounds profound.

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The map is not the territory – Setting up a Chart of Accounts

Accounting is a numerical history of a business. We summarize the millions of transactions into a cogent one page document that tells the status of the business. The financial statements however, are not the same as the business. Alfred Korzybski said that “the map is not the territory”, referring to the object and its’ representation. A financial statement summarizes, and a summary leaves out details. Tracking which data goes where is the job of the general ledger and chart of accounts.

The core of reporting is the chart of accounts. Financial statements summarize sales into one line. Accounting might have half a dozen sales accounts and hundreds of departments, which all roll up to one single number – sales. These accounts are used to better understand the summarized information. Sales are reported net of returns, but accounting departments track the returns in a separate account so that department heads can see if return rate is trending up or down. If your ERP or sales software tracks returns, you probably don’t need a separate account for tracking that information.

However, accounts seem to proliferate. Charts of accounts grow over time – someone wants to know some summary fact of the business and the systems that generate that data don’t supply the summarized data to management. Commonly at retailers it is a POS (Point of Sale) system that runs the cash registers and reports summary data to a sales data warehouse or general ledger. Usually they only report data to the general ledger, so operating data is sourced from accounting records.

In an e-commerce firm it is the order entry and fulfillment systems, which may not be connected with purchasing or payroll systems. In addition, management has come to rely on the controls put in place in a general ledger system. In the 1990s we used a lot of database query tools that would often give different answers based on query design, so one meeting might have three different set of numbers based on who’d written the query.

The use of data warehouses should decrease demand for general ledger detail. Sales splits can be done in more detail using a database with all the relevant sales data, rather than the general ledger which might contain only weekly summary data. However as the needs of the company change, often it is easier to just add an account number than reconfigure a reporting system. Data warehouses – an idea that dates back 20 years – still don’t function as well as they should. So the g/l becomes a stand in.

I’ve typically used a couple of hundred “natural” accounts for businesses from $5m to $500b in revenue. An account like “sales” or “payroll” are called natural accounts. These are modified by department code and sometimes other codes for cost accounting or for projects. This can result in thousands of combinations. In a typical retailer with 100 stores they would support 60-70 natural accounts, for 6-7,000 combinations. Add in district and regional codes you could reach another 1-2,000 combinations. Designed right that level of detail is easily handled by your accounting team. Designed wrong and you spend hours trying to reconcile the source systems to the general ledger. Which adds cost without benefit.

Manufacturers sometimes have additional codes for production cost allocations. If you are running the same line in two buildings, under one department, you might also use a location code. All these codes end up making a chart of accounts pretty complicated. This is worsened if you end up layering on the complexity as you go, rather than plan it in. Knowing going in you will likely need a location or a production line code and planning for it makes a big difference later.

Much of the complexity of the chart of accounts depends on what information you will want to retrieve. Simple natural accounts and department codes can get a business a long way. Accounting codes begin to change if you are running project-level or fund accounting. Sometimes you can keep the reporting structure out of the chart of accounts. For instance, if you have a district manager with 10 units, you likely don’t track the district code in each transaction, but roll up the district report by selecting which units are in a district when you summarize the data. This is the default mode for most firms who report with excel. Changing the unit roll-up when a district manager leaves the firm is not Excel’s strength. Excel’s data summarization and analytical tools have improved, but realistically, converting from a trial balance to report is an area ripe for errors.

If you have online reports, managing the access in an ERP system can be a hassle, unless you have some hierarchy built into the system. Imagine allocating 600 units amongst 60 district and 10 regional managers? If each of the units had an assigned district and regional code, the reporting would be much easier to manage and control. With the rise of reporting dashboards, this feature is almost always built in.

The general ledger and financial statements are summaries but useful ones, where similar data is grouped, analyzed and decisions can be made. Too big a chart of accounts and you will spend hours managing complexity rather than providing information. Too small a chart and you will your time breaking out the details you need. A map is a representation of a territory which can be held in your hand and used to navigate. Good design and a thought for the future of the business will help develop a solid organization for your accounting data so that it will supply you the information you need to navigate.

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Bad Growth vs. Good Growth

I believe there are two kinds of sales growth, good and bad. Bad sales growth is unsustainable, and in the end counterproductive. Bad growth maximizes sales growth over optimizing the factors which can lead to good sustainable growth.

Maximum sales growth seems great (who doesn’t want sales?) but it can lead to bad outcomes. A few examples, because the most instructive examples are the bad ones. I was working with a window covering manufacturing company that had a shot at landing a national big-box retailer. The CEO wanted the business and bid hard for the work. His company immediately increased by 50% but within 18 months went bankrupt. In his eagerness to get the business he bid below his fully loaded cost for the product and began to lose money quickly.

Under investing in systems and accounting kept the client from knowing their costs or how deeply they could cut prices. I met them about 8 months after the fateful bid, when I was brought in to purchase a high volume wood blind finisher to support their growth. While doing due diligence, I compared the costs for the target to the base company. Given that the target was specialized, 10x bigger and extensively automated, I was surprised that the target reported 15% higher costs than the base company. Digging into the internal cost data identified a problem in booking inventory that caused this discrepancy. The person in charge of inventory tracking (the owner’s sister) had no accounting training and wasn’t relieving inventory accurately. Her husband ran the manufacturing operation and he’d continually boasted about efficiency he’d gained. Those gains turned out to be spurious. It took only weeks to figure out that the base company inventory was overstated and that the new “big box” business had lost so much money that the equity was wiped out.

I once worked with an insurance company offering our customers the option of purchasing their product. The company was eager to grow the book of business quickly. They suffered adverse selection as the bad risks switched insurance to get the low introductory prices. Risk was significantly under-priced and profits, which were planned for year 2, ended up in year 4. Growing fast meant taking on unqualified and riskier clients. Bigness doesn’t overcome crappyness.

I was the lead auditor on a large auto company’s financing arm. At lunch one day, the top executive at the finance subsidiary said that the front office wanted more loans written and more cars sold. Since the financing division couldn’t access funds cheaply, the loans they offered had higher interest rates than average. Low risk borrowers weren’t interested in high cost loans as they had low cost options. Consequently the only way the company could increase loans was to take on riskier borrowers. Another example of adverse selection. I asked how this would play out. He said they’d write a lot of loans (and sell cars) but in a year a higher than average portion of the new loans would stop performing. Eventually the front office would ask that he clean up these delinquencies. He then would repossess enough cars to drop his delinquency rate to average. Repossessing cars is expensive and after the increase in losses due to the disposition of these vehicles he’d then be asked to limit these losses. If the scenario worked out as he’d foretold, he would likely obtain a bonus every year for achieving his objectives.

Creating growth like this is counter-productive. Yet lots of firms think it is as simple as the CEO ordering growth to happen. Smart growth is about balancing the factors of growth. People, resources, systems, processes, time and management must be balanced against sales growth. The factors must be optimized so that growth and profits continue. Optimization can be complicated, as there can be multiple successful solutions at varying levels of profitability. Some solutions are oriented to throwing bodies at the problem, other solutions might include implementing a computer system. Both ways will work, one way offers more flexibility and the other cheaper long term costs.

Most of the factors of growth can be quantified into costs, so there is a basic cost vs. profit model that needs to be managed, but time is the factor that determines the rate of growth. A firm that grows 10% and 9% in two years is roughly equal to a firm that grows 20% and 0%. The cost vs profit trade-off has to be seen over multiple years as costs often come as a steps. Investing in a new manufacturing facility or a new computer system is a step that will need to be cost justified over five or more years. Finding ways to minimize the height of the steps, planning on when to take the steps and grouping the steps into logical order are a big part of dealing with optimizing the growth rate.

It is easy to delay investment in these factors, but eventually the problem worsens which brings growth to a halt and sometimes worse. I am not suggesting that everything will be perfect before you can start growing – and growing fast. But as much as it is wanted or needed, when the car is doing 180 mph around Le Mans, you can’t change the tires. You can fix a foundation after the building is built, but it won’t be cheap or easy. Smart growth is about about balancing and managing these trade-offs.

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Dr. John Zott is the principal consultant at Bates Creek Research & Consulting.

I am the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and I comment regularly on issues that affect growth businesses. If you are looking for a CFO for your consumer company, or are a former student, colleague or would just like to connect – reach out.

Six Challenges for Investor Relations

Investor relations is broken. It isn’t the people, it is the process. Most senior executive see it as a department designed to help the company put their best foot forward. The skills needed are someone who is good with powerpoint, knows numbers and can talk to analysts all day long without going crazy. I think this definition misses six key challenges for Investor Relations.

Challenge #1 Investors have no time

Investors are limited by time and attention. Investing is based on financial reports which are both long and redundant, and the amounts of disclosure are not improving investor knowledge (read this). The SEC and the FASB have turned a simple financial statement into a career generating stack of paper. A typical 10k runs 100+ pages and is stuffed with disclosures, reconciliations and accruals.

A typical financial model will go back 10 years and ideally, all the 10k’s & q’s should be read from the entire history. Most are not. I bet that fewer than 50 people outside the company conceivably completely read any 10k document. Most analysts look at changed pages from the previous document, skim the management discussion and update the models with the key data. If you own 50 stocks, your reading load might be the same as knocking off three books a week in SEC filings alone, not including the other material you read to know what is going on in the economy.

Time pressure causes investors to look for shortcuts to the intellectual rigor of a complete and detailed review. Pattern recognition conserves time and brain power. Investments are selected that are similar to past successes. Investors classify stocks by lots of methods (growth, value, etc) to eliminate the time memorizing details about every company. The intellectual demands to obtaining, sorting and absorbing the material means that complicated stories are often ignored or missed. Complicated analysis, the use of a lot of jargon just make the analysts job harder, and therefore less likely to expend the energy to invest in your firm.

Clarity increases comprehension and makes the job of an investor easier. Easier means better analysis and better communication and a better stock price.

Investor relations has to recognize the time pressure and focus on a coherent set of facts that allow a potential investor to understand the business and make a prudent investment.

Challenge #2 It’s not just numbers

For the last fifty years we’ve been training executives in quantitative analysis, and today’s MBA’s know how to deconstruct a business. Because of our emphasis on numbers, today’s executives tend to manage rather than lead. CEO’s and CFO’s certify that the financial reports to the best of their knowledge do not include misstatements, or are misleading. Making both CEO’s and CFO’s more involved in the data and detail.

Investors do not have access to the details of the business, and realistically we can’t share them. Analysts are trying to make meaning out of disclosures, so they ask a lot of questions about management’s impressions or thoughts (or my least favorite “add some color to the numbers”). When analysts ask these questions, they are asking for help understanding the bigger picture and cannot tie in the numbers to a direction or theme.

Santa Cruz cows out standing in their field

They are looking for the story behind the numbers. When a senior management team that generates and lives on numbersis selling to someone who is looking for a story, there is a disconnect.

Humans like stories (see here for Paul Zak’s HBR article) and we remember them better than the numbers. The story provides structure to our understanding and helps add meaning and relevance.

Investor relations has to communicate a story that makes sense. It has to be reasonably based on history and explain a direction and purpose for the company. It is more than the just the numbers.

Challenge #3 An Outside Perspective

Investors have one huge advantage in valuing firms that senior managers lack. They have an outsider’s perspective. Working at a hedge fund meant sorting through 2-3 firms a week. You hear what the other firm’s have been saying, you can compare this quarters disclosure to the last 15 quarters, you aren’t sitting on half a million options that are underwater. The outside perspective is very valuable, I have written about it before (see here). Outsiders haven’t drunk the company Kool-aid, they aren’t convinced of the company’s invincibility and they aren’t incentivized to worship the company mission. This perspective is valuable to CEO’s and Boards, but the criticism is dismissed because the outside view often is working off of fewer facts and CEO’s reject criticism of their strategic plans.

In a capitalist system, the investment community is the owners of the business, and we should listen to the owner, even if they are sometimes wacky.

Investor relations needs to be a vital conduit about market perspectives on company strategy. That message has to come back to senior management the board and the CEO in actionable and understandable ways.

Challenge #4 It can’t be delegated.

Management gets a chance a couple of times a year to tell their stories to the investment audience. The simplest way to tell of a management team lacks a coherent strategy is if they can’t get the message across in the 25 minute talk they give before the break-out session. If in 25 minutes you can’t get the message across to the 40 or so MBA clones that make up the ranks of stock analysts, how did you get that message across to the 10,000 high school graduates that make up your workforce? Whenever I hear jargon and business-speak when a senior executive is discussing strategy, I know that strategy is dead on arrival when it gets to the front-line worker.

All presentations should be practiced prior to being given. If we work for the investors, what message do we send when we arrive at our meeting and our report is fumbled and ill prepared? I’ve never believed the stats about how much of meaning in a conversation is non-verbal, but I respect it is very high. Stumbling through a presentation reduces personal and firm credibility.

Investor relations is the responsibility of the CEO and CFO, and hiring a director or VP does not absolve you of the responsibility of being prepared, practiced and ready when reporting to the investors.

Challenge #5 – Authenticity = Credibility

George Burns was quoted “sincerity – if you can fake that you’ve got it made”. Senior executives think of IR as a something that can be faked. After reviewing 100+ companies a year for 12+ years, I’ve seen a lot of pitches. Figuring out what the management team does and doesn’t know is how we made money. If you state that you are #1 in something, you’d better be prepared for us to check.

Most Investor relations staff get the compliance problem. All the numbers are verified, everything is properly sourced. Then the CEO or CFO make an off-hand comment that will end up on a transcript and will be fact checked. I’ve written before about the average experience of stock analysts (see here). New analysts spend a lot of time reconciling cognitive dissonance, which is a fancy way of saying, does management “walk the talk”.

I’d rather a management team was perceived accurately, even if that perception was negative, for example as aloof or uncommunicative, rather than as something they are not.

Investor relations stands for authenticity and accuracy. Senior executives aren’t clones, and should be respected as individuals. Don’t write speeches full of bafflegab and resist the use of jargon.

Challenge #6 – Everyone is an Investor

Most companies incentivize with stock options and most stock option grants are small. Outside of a relatively small circle of high paid executives, most option grants hold little perceived value. They have a cost, but the perception is that they don’t have any value until they are vested and are deeply in the money. The staff needs to hear the story as much as the analysts do. Vendors may make million dollar commitments for a new product line and they need to hear your strategy. Customers, especially when they are making a commitment to a product, need to know whether the company is viable.

The reality of today’s connected society is that the number of people who “care” about what IR has to say is much greater than before, and those listeners have much more influence the firms success.

Investor relations material should be prepared for all the stakeholders, based on their needs. The delivery of employee oriented material may be through HR, but that disclosure should be focused on the key story and theme set by the strategic plan.

Conclusion

Investor Relations needs to play a bigger role within your firm. Helping develop the strategic plan, communicating a coherent story with numbers that provide clarity and understanding. It is time that IR is more than someone who talks to analysts and comes up with a quote.

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Dr. John Zott is the principal consultant at Bates Creek Research & Consulting. I am the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and I comment regularly on issues that affect growth businesses. If you are looking for a CFO for your consumer company, or are a former student, colleague or would just like to connect – reach out.

Three Thoughts on Balancing Profit and Uncertainty

Life is uncertain. Any entrepreneur knows that to start a business, you have to take a chance. You can calculate the risks, manage what factors you can, work as hard as you want, plan as extensively as possible, but there is always uncertainty and risk. Frank H. Knight defined risk as events that have a probability and a severity and are calculatable. Uncertainty is defined as those events without a probability and a severity. We face both uncertain outcomes and risk in our lives.

As a professional CFO, I’ve worked to limit uncertainty and manage risk. Eliminating risk and uncertainty however is impossible and will kill a business. The very nature of profit comes from taking a chance and offering a solution for a customer. A risk-free (and low uncertainty) business doesn’t exist. The closest we have to a risk-free return is a 10 year bond, which is trading today at about 2.2%. If you want to make more than 2.2% you are going to have to take on risk.

Running a business is about balancing all the factors: risk and uncertainty, the operations and the market so at the end there is a profit and a return on capital.

Profit comes from risk taking. The risk taking must be commensurate with the return, or it is foolish. Steven Crist wrote a chapter (see here) on value in the book: Bet with the Best: Strategies from America’s Leading Handicappers. Crist points out that even bets that are likely to lose (betting on a 4:1 horse, when the payoff is 12:1) can be a good investment.

Managing risk (and opportunity) sometimes means thinking about what could change. What assumptions are foundational to the business model which if changed would result in a serious impact to the firm? Although you think that there are relatively few of these, there are many, but thankfully they are relatively rare.

Many retailers were well aware of the impact of e-commerce, but few generated a capable response. Most dumped their catalogs and full product line on the internet and waited for customers. Worse yet, few planned for the inevitable loss of market share or the increase in new competitive business models (Stichfix, Frank + Oak, Thred-up) that might arise on-line.

Nassim Taleb talks about the four largest potential losses in Las Vegas, one of which became real: Siegfried and Roy’s magic and wild animal act was ended when a tiger attacked Roy. Roy later went on to say that he had high blood pressure and believed he had a stroke during the show and the tiger sensed that and was dragging him to safety. If Roy had died from the stroke and not the tiger attack, the result would have been the same, cancellation of the show. When a great deal of income depends on the health of one man, then there is a big assumption of risk.

Business decisions can increase or decrease risk and uncertainty.

Every decision we make creates new risks and uncertainty. Selecting a new ERP system? Hiring a new executive? Changing a key purchase policy? All will create both a primary effect and secondary effects that are unknown. Not making a decision, often called strategic dithering, creates additional uncertainties. Mark Fields was recently replaced as CEO of Ford, apparently because he wasn’t moving fast enough on self-driving cars (see here). I am not certain that a faster approach to self driving cars creates a lot more value than being second with a better product. But either way is uncertain.

Too often executive teams ignore risk and uncertainty factors in making their decisions. Anecdotes are easy to understand and are compelling although they are often sample sizes of 1. In the hedge fund business we used to say “beware the narrative” as we were afraid of being seduced by the simplicity of a good story. Balancing the trade-off between customers and operations without assessing the change in risk will likely lead to increased risky behavior and calamity.

Invert the decision making model – think about increasing risk.

Risk is necessary for profit, but risk as I’ve noted is calculable. Can you decrease risk for a customer and create greater sales and profits? Grouping uncertainty and risk can decrease overall risk. That is what insurance companies do. Offering a money back guarantee on products for a retailer is simple. If you realize you can return the product, you are more likely to buy, even if you are extremely unlikely to return the product. The highest margin item I’ve ever sold was warranties on electronics. Most are never used.

If you are a SaaS business, how can you lower the customer uncertainty and increase your payout? Most firms find buying a new system a major endeavor. They’d like to be married, without the process of getting married (which is a hassle). The risks are centered in the conversion, implementation, training and the first 90 days of the new system. Firms will pay to have implementation risk decreased.

Playing safe isn’t always a good option (see here). My local community has half a dozen businesses that are clever, deliver great value and could have a national presence. They don’t because the owners are happy enough with a small local business. Every couple of years change comes to the community or one of the owners and one of these businesses dies. I am not arguing all small businesses should become Staples, but as John Shedd wrote “A ship in harbor is safe — but that is not what ships are built for.”

Conclusion

I think a lot about balancing risk and returns. If you bet the long shot that is undervalued, you may win big, but you will most likely lose. Losing isn’t bad in this case, it is just one iteration of a process that brings a profit. Avoiding risk isn’t possible, but whatever approach you take, keep an eye on the tiger.

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