CFO – 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.

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.

Finding the Right Senior Executive

Recruiting talent is probably one of the most important jobs of a management team. Unfortunately it is a pain. Deciding who to hire takes time and requires a lot of thought. The consequences of the decision are great, which causes risk adverse executives to procrastinate and delegate the decision making to a committee.

Hiring a senior team member is even more complicated. Frequently there is a contract that needs to be negotiated, options, bonuses, other perq’s and job responsibilities to be decided. A new member of the senior management team has to work within their functional group (e.g. marketing or finance) and within a senior management group. So a lot of executives have say about the process.

I won’t rehash a bunch of techniques for getting the right person. I recommend “Who: The A Method for Hiring” by Smart & Street. There are a lot of books on how to hire although relatively few about hiring a senior executive.

The root problem is simple. We are all trying to hire someone who can do the job and and fit in with the culture. There is a lot of focus on limiting the risk of hiring which perversely can increase the chance you won’t find the right candidate.

The Downside of Minimizing Hiring Risk

There are several pitfalls in this risk oriented approach. A common way to minimize risk is to find someone who has already done the task in the same industry for another larger and hopefully smarter company. This approach has big drawbacks. First, you can’t assume that the challenges you have today will be the same in two years. Hiring a CIO with experience handling a crumbling systems infrastructure makes sense when you have a crumbling infrastructure. But are they the right candidate after it’s fixed?

Secondly, hiring from bigger, hopefully smarter firms doesn’t guarantee that the candidate knows how to succeed in your environment. A firm I was with wanted to jump start their internet initiatives and hired a head of the internet division from a big company that had a successful web site . The candidate interviewed well, was smart and knew the technology. However after joining, we found they were a caretaker manager, focused on maintaining a well functioning department that they’d inherited. The new hire didn’t know how to grow a business and left after six months having made very little progress. I see this all the time, growth firms hiring the executives from industry leaders such as Intel, Microsoft, Home Depot or Wal-Mart and being surprised to find out they’ve never actually dealt with much growth.

Another risk management technique is to hire someone you’ve worked with in the past. This is pretty common in Silicon Valley and it does limit some risks. However, the chance that someone you’ve worked for in the past is perfect for a position is remote. The risk of not getting along declines but the risk of not getting the right skills and competence increases.

In addition, most executives don’t want to repeat their same experience over and over. A lot of CFO’s get tired of the numbers and seek to move into operations roles. Any work relationship you enter where the employer is hiring one thing and the employee wants to do something else is bound to be a problem. This in some ways explains the relatively short tenure for CIO, CFO positions. After a couple of years these executives are bored and are ready to move on.

The best way to minimize risk is to follow a good hiring process. Hire people that fit and have the skills you need.

Determining Fit

Fit is a function of shared values. Defining a firm’s values takes some time and the result isn’t a black or white. I’ve successfully hired formal executives into relatively informal firms. Sometimes you can open up the values of the organization by hiring someone on the edge of the company’s comfort zone. This can be difficult for the executive (and the company) if it is too far a stretch.

I recently worked with a senior executive who lasted six months on a new position. The company is very loose, with no procedures, budgets, plans or structure. The senior management team wears jeans or shorts and the decision process is very consensus oriented. The new executive was a much more formal, process oriented executive, who worked more “top-down”. The fit issues were an issue early and they only got resolved when the new executive was ejected from the business. Failures like this are both costly and painful for the participants.

Identifying values in senior executives is a lot about understanding the stories that make up their lives. How they tell that story will help the interviewer identify the values of the candidate.

The CTO of Looker, Lloyd Tabb, commented in a recent interview on his secret question for hiring. Lloyd says he looks for “we” rather than “I” in the interview conversation. This is good advice as word choice often reflects values (although be careful, word choice can also be driven by culture and social groups). The culture at Looker is very customer and team focused and “we” oriented.

Interviews don’t often include much time for free ranging values discussions but they should. The interview process should include a meal, time away from the office and be a sufficiently long process to allow the candidate to open up about goals, plans and dreams. This is sometimes called the “open kimono” approach and it requires an equal amount of sharing from the company.

Executives searching for positions can similarly learn about the company by focusing on the process, people and surroundings as they go through the interview cycle.

Skills and Competence

Senior executives have the dual role of functional head and senior executive group member. As I noted earlier, we try to minimize risk by choosing executives from the industry. This avoids functional risk but the real risk of failure is outside the functional area.

Executives fail because they can’t effect change. It isn’t functional knowledge but the ability to get things done within the organization that makes a difference. Actual industry expertise isn’t all that helpful, as is expertise in the particular software or the particular systems the firm uses. If you are planning on turning over your management team every two years, it makes sense to hire from the industry. If you are looking to build a management team for five to ten years, then look for executives who have experience getting things done successfully.

One of the most effective firms I have worked with have the majority of senior executives from outside the industry. The new perspectives have allowed them to move a lot faster and smarter than hiring from bigger, slower moving competitors. Viewpoint diversity is valuable and new perspectives bring new ideas and fresh approaches.

Some of the worst hires are candidates with industry experience in weak firms with “it was someone else’s fault” stories. Every career has a clunker or two in it, but senior executives have to be responsible for where they go to work. If an executive has been forced out of three or four firms and can’t give a reference from any of them, it’s a red flag.

A senior executive has to be open to new approaches, but have standards they will always keep. Hiring a senior executive that won’t say no to the CEO is a waste of company resources and a disservice to the firm and the shareholders. As a hedge fund analyst, if I saw a CEO that dominated the management team, it was usually an excellent short.

A rule of thumb is that every senior executive should have the skills and abilities that could result in them serving as a CEO, either with this company or with another company. If I don’t see that ability, I pass. I am sure most of these executives will not serve as CEO’s, the opportunities may not come up, they won’t want to put in the time and effort or it isn’t a good fit personally. But having the communication skills, the curiosity, the optimism and the leadership that CEO’s have will make them better members of the senior management team. And that is the best way to minimize risk.

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Dr. John Zott is the CFO for Carlson Wireless Technologies, and 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 a former student, colleague or would just like to connect – reach out.

Sales Forecasting, Budgeting and Igor’s model

As a CFO I have struggled with sales forecasts and budgets. Either I am presented with a list of sales initiatives that add up to a multiple of the sales plan (I call it the “whatever sticks” method) or I get a sales plan that lacks any detail at all besides a growth rate which is similar to previous years rates (the same as last year method). Both outcomes leave me unsatisfied.

The “whatever sticks” method usually is a brainstormed list of ideas that haven’t been resourced or have an effective plan of action. Because the total ideas add up to a big number everyone goes into the new year excited for results, only to be surprised by the end of the first quarter when the numbers don’t turn out. The estimates for sales were often the “seven sunny days” types, which counted on a lot of luck.

I used to call this the church potluck dinner problem. Every one brings a wonderful dish to the potluck. When you begin loading up the cheap paper plate, the salad gets mushed in with the beans and the jello ends up leaking into your chicken. As the line goes on, you realize you’ve run out of room for other attractive dishes and you build a second level of food. And the plate bends as it gets wet creating more unattractive mashups and nothing tastes right.

The “same as last year” method does a better job of focusing on the current business but it generated few new ideas. Projects that needed resources weren’t identified and budgeting was based on history. If any portion of the current business was changing the plan wouldn’t be accurate and we’d be playing catch up. The sales plan should include a list of action items that are assigned, have deadlines and are likely to increase sales. Otherwise the “same as last year” plan is based on hope and not action.

I used to teach a class where we’d use a linear regression equation to forecast sales of public companies. It works. The CFO/CEO should have a separate statistical model for sales. Sometimes it is more accurate than budgeting and it always provides insights when reviewing the plans.

Sales and profits are a function of taking a chance. Risk-less profits don’t exist and all sales efforts entail investment with an expectation of a return. I’ve written before about Frank Knight’s comments about risk and uncertainty (see here). Sales efforts are generally uncertain – we don’t know what will work and what won’t, but we need a method to organize and prioritize actions. If we develop a list of sales initiatives, how are we to sort through and assign probabilities or guesstimates of effectiveness? When will we know we have enough quality, resourced initiatives? I’ve found a simple insight by Igor Ansoff that can provide some help overcoming this problem. Igor Ansoff was a management theorist who laid out a simple 2×2 matrix, on one axis markets on the other products.

I usually draw this using the axis: Same/New Customers and Same/New Products. The list of sales initiatives are assigned to one of the four boxes. For example, opening new units for a retailer is New Customers : Same Products and is shown as “Market Development” on the chart. Obtaining more of a key customers business is Current Customers/Current Products or Market Penetration as titled on the chart. Line extension or Product Development is adding additional product or services to the offering to our current customers. In the chart the Diversification strategy is in red, and that’s a good color for this approach. New Products/New Customer strategies are startups.

Using the Ansoff Matrix helps identify the uncertainties and the holes in your plans. The holes are identified as you assort the strategies into the boxes. The uncertainties can be estimated by box. Market Penetration strategies will tend to be cheaper, more numerous with small payoffs and high chance of success. Market and Product Development will have worse chance of success then Market Penetration but will have a high payoff. Diversification will have the lowest chance of success. As a CFO, I rarely include in a sales budget a diversification strategy, mostly because I’ve been burned. Many (most) diversification strategies fail and all should be tested thoroughly before counting on them for sales.

With the Ansoff Matrix you can assign a standard deviation and mean result to success for each of the initiatives and then simulate a 1000 trials of the expected strategies. Many strategies are one-tailed or are options, which can result in a positive payoff, but only if certain conditions occur. Summing the range of results for the strategies selected gives a more accurate representation of potential sales and can set expectations realistically.

Taking these extra steps focuses the management team on strategies that generate a difference, while still staying within the level of resources the company possesses. Realistically if you are a star and finish your sales objectives by mid-year, you can just generate a new set and begin again (or get back in line for seconds!)

The way to solve the church potluck problem is to focus on a few things to eat and to leave some room on your plate for later in the line. The way to solve sales budgeting conundrum is similar. Being picky is good for management teams and good for a potluck.

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Four thoughts on how to deal with Hedge Fund Investors

After being a public company CFO, I spent some time as hedge fund analyst. During that twelve years I spoke with a lot of management teams, watched hundreds of investor presentations and read a
roomful of disclosure documents.

The most interesting change in perspective was 1:1 meetings, when we’d be in a room with the CEO and CFO and we’d have an hour to ask questions. Sitting in those meetings on investor side of the table was a lot easier than being a CFO. However, the biggest difference in the two positions is time span.

When you run a company you are thinking about time differently than a hedge fund portfolio manager. Projects take years and to turn the ship is hard. Profitable business investments have to be identified, planned and implemented. If you are a hedge fund manager, you can reshape your portfolio in an afternoon, and exit your positions within a week.

Elliot Jacques wrote about the “time span of discretion” which dealt with the time frame where the executive was focused. Most senior managers are focused on the coming 6-12 months. Most fund managers are focused on the next 2-3 months. I’ve argued before that senior management needs to raise its focus from making this year to a process of making every years’ numbers. Thinking further out will not help your discussions with a short term investor. I’ve come up with four ideas for you to think about when dealing with professional investors and the hedgies.

1) Prepare your company presentation as a story.

Most stock analysts are intense, smart, educated and inexperienced. When they make mistakes it is usually based on relying too much on book learning and too much reliance on models. Most risk isn’t covered in an excel spreadsheet, and at best they generate a couple of point estimates for EPS based on simplistic assumptions. Their lack of experience makes them open to a good story. A well constructed narrative will sway an analyst, even if the story is simplistic and inaccurate. Good stories have a beginning, a middle and an end. There are characters. A good story has a coherent theme and is easy to remember.

2) Keep your messaging consistent.

Because analysts often lack the experience to tell if a management team can deliver, they simplify and judge on message consistency. If you separate a CFO and CEO at a stock conference and quiz them individually about recent events at the company, you will often hear two stories, which is a problem. If the words in the 10k don’t align with the slide deck then there is another inconsistency. Hedge fund analysts are a little more savvy, they are paid more and they have been burned a few times. They are less swayed by a story and are more tuned in to the results.

Off the cuff remarks and meetings at the bar are a danger to management teams. I once heard a senior executive announce that they had to work the weekend on the budget. It was April. What does “having to work the weekend on the budget” mean in April? It means you are off plan. Analysts are not your friends and there are no “off the record” conversations.

3) Be prepared.

A management team presents the strategy to the board, to executive management, to senior management, to the employees and to the investors. If the investor presentation doesn’t sound practiced, then how much has management communicated to the company? If your presentation isn’t crystal clear, clear enough that a person with a high school education can understand, then you probably haven’t presented it the 20+ times you need to if you are going to convince the employees. Repetition equals retention. Management teams that are not practiced fail. After valuation, this was my most reliable source of ideas. If I heard a management team stumble through the presentation of a complicated new strategy that would require thousands of employees to do something different (say make panini’s at Starbucks), I knew I had a winner short idea.

4) Don’t take it personally.

A hedge fund trades in and out of stocks a lot. Selling your stock doesn’t mean they hate your company. It just means that they’ve found something that will move more or sooner than your company. We shorted a lot of good companies because we have to hedge our other positions, that is what we are being paid to do. I went to a lot of meetings without a preconceived notion of whether a stock was a long or a short. We’d be short for an event or a tough quarter, and then would go long. Management teams that obsessed with whether the analyst is a “long” or a “short” wasted their efforts. Keep your ego out of it, manage what you can manage and make the company better.

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Retrospective Thinking and You!

*Santa Cruz Small Boat Harbor Lighthouse*

McKinsey recently published a survey about whether CFO’s are ready for tomorrow’s demands on finance. For the most part it is not terribly helpful. The additional roles include the “new” fields of risk management and compliance. These tasks have been with us for decades, but today there is a department with the title. My experience with big consulting firms is that they offer good input at a high price. (However, I read everything Tim Koller writes for McKinsey and you should too. I’d classify his insights as great ideas.)

The CFO survey had one question about capital expenditures which caught my attention. Only 30% of the CFO’s agreed that their company “has a formal process to review investments made 3-5 years ago.” This is a big problem as firms that don’t check on their performance don’t learn from their mistakes. Retrospection is hard and I get why you don’t want to do it. Ben Franklin said “Experience keeps a dear school, but fools will learn in no other”. When a management team makes a mistake and doesn’t learn from it then we even less smart than the fools.

I know that everyone cares about the stock price. Stock prices are driven by the return on investment in the projects the management team selects. Poor project selection means poor investment returns and poor stock price performance. Measuring returns informs future investments and identifies opportunities. It creates accountability. It is the difference between taking a class in investing and trading in the stock market for a living. Great investors track their wins and losses and try to learn from both, although the losses are always the most informative.

After being a CFO I took a turn as a hedge fund analyst. About 10 years ago I went to a stock presentation where Coldwater Creek was touting their secondary offering. The plan was to open new units that would generate great returns, earnings and a high stock price. The management team offered up very compelling ROI’s over their first three years of investment in a new unit. I got to ask one question: “how many of these stores have reached their three year anniversary and did they perform similarly to the forecast?” The answer was they had no units that had yet reached the three year life. I wanted a follow up question but the CEO wisely picked on another analyst. Simply put a pro-forma financial model is not the same as actual results. Coldwater Creek never achieved those planned returns and the $32 stock is now worth 2¢.

I worked with a major US bank and was told that the way to promotion was to make a lot of loans fast. When inquired about what happens when they inevitably go bad, I was told that the rotations typically lasted 24 months, and the problems didn’t show up until after you’d left the department. Credit problems were never tracked back to the initial bank officer, just assigned to the executive that then held the portfolio. The difficult job at the bank was in following one of these “fast-trackers” and constantly dealing with a crappy portfolio. This strategy worked until there was a slow down in growth and executives were stuck in the job for 48 months. As Warren Buffett says “ Only when the tide goes out do you discover who’s been swimming naked”.

Recently I heard that the average Silicon Valley CFO lasts 28 months in a job. I’ve never seen a financial analysis on a public company that didn’t go back at least three years if the data is available. The analysis usually go back at least five years and I’ve seen some that go back ten years. We do that to get a sense of how capital has been deployed though the firm’s history. I’ve written here about how hard it is for senior executives to change a business model. Returns on investment are persistent with companies generally moving towards the mean return for the industry. Some of reversion is due to luck evening out, and some of the reversion is due to management teams responding to incentives, both bad and good. If the management team knows that they will be held accountable for capital investments, they have a big incentive to do a better job.

I get that everyone wants to focus on the future and no one wants to poke through past errors. As investors, we are relying on CEO’s and CFO’s to invest the assets of the company wisely. As executives, that means taking a hard look at how capital has been invested, what we did wrong, what we did right and what that teaches us.

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Why Your Staff Quits

Nothing gets done until someone does something. Those someone’s are your staff. Recently a friend quit her job for a new better position closer to home. I couldn’t help but thinking that part of the reason she left was due to how she was treated.

I am not a great “people” person. I am better than Christian Wolff from “The Accountant” as I don’t shoot people and I do have the reputation of being a decent boss. CFO’s in general tend to be quieter than other exec’s, more introspective, we do spend an inordinate amount of time analyzing information, have a large body of technical accounting knowledge and normally emotional intelligence isn’t a prerequisite for the job. Whether you are great at this or not, there are three things I’ve learned that a any senior executive can do to improve their relationships at work. And good relationships lead to lower turnover and higher work satisfaction.

1) Respect your staff. In the movie, Jerry Maguire, Rod Tidwell wanted “quan”. Quan is loosely translated as respect, admiration for skill and the money. Most professionals want their time and skills respected. I hated waiting outside my bosses office for a meeting to begin. I hated getting slide changes for the board meeting 30 minutes before the directors arrived. Respect your people’s efforts. Many senior executives feel more comfortable micro-managing and doing their employees work. Don’t be surprised if your staff doesn’t like it.

2) Talk to your staff. I believe in weekly one on one meetings. The purpose of the meeting is to go over current projects and planning, but you must leave time for the personal. I always started the meeting with a check in and if that was good proceeded to work related issues. Your staff doesn’t leave its humanity at the door when they come to work. Many of my meetings dealt with personal issues, smoothing out work disputes, and understanding more about my staff’s interests, goals and dreams. Unfortunately, a lot of what we do in modern corporations is repetitive and can be a bit dull. If there isn’t a pressing problem, I didn’t cancel the meeting but I’d cut it a little short and we’d focus on mutual interests. If there is a pressing problem the check in was usually cursory. Personal chat is distracting if you are on a deadline.

3) Listen to your staff. If they are dissatisfied it will come out. Usually you are told multiple times before an executive quits. Listening means quieting your voice and engaging with someone else’s story. Listening includes more than just the words. Word selection, intonation, facial expression, eye movements, body position are some of the elements of good listening. Listening takes an effort and your staff can sense when you are putting that effort out and when you aren’t.

Dale Carnegie was right, simply smiling and listening can make a difference in relationships. Often a simple thank you to the staff is all that is required. Turnover is a normal, but lots of turnover occurs because your staff doesn’t feel the quan.

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Becoming a more rational executive, five good techniques

I teach behavioral finance. That is the study of how people make financial decisions and how those decisions differ from the perfectly rational. We are currently in the part of the semester that deals with corporations and how they vary from perfect rationality.

I teach behavioral finance. This is the study of how people make financial decisions and how those decisions differ from the perfectly rational. We are currently in the part of the semester that deals with corporations and how they vary from perfect rationality.

Anyone who has spent any time in business knows that business life is not perfectly rational. There are big ego’s, incorrect incentives, limited analytical resources and group think. The hierarchical nature of large institutions also increases the likelihood that the organization won’t respond timely, which is also irrational.

When we do the class I collect stories of corporate irrationality from the students. There are many. We also brainstorm techniques for staying rational at work.

Here are five techniques for CFO’s to add rationality to decision making. Three of these approaches can be attempted prior to embarking on the strategy, the last two are ways to are for after you’ve taken a path and it isn’t working.

1) What is the base rate for success on this strategy? Why should our efforts be any different than the base rate?

This technique is basically applying your circumstances to historical base rate stats, which is called Bayesian inference. A common application I’ve used this technique is estimating the likelihood of success for a new product. The base rate for product failure in the market is between 40-90%. For example, we’ve come up with a product concept that we feel is good, but faces several technical hurdles to reach the market. The chances of product success is then a function of the chances of success on each of the two steps: finishing the product and obtaining success in the market. Identifying the risks improves the planning process.

2) Conduct a pre-mortem. This is a concept that Gary Klein wrote about in the HBR, September 2007. The idea is to imagine that your project or strategy has failed spectacularly and then ask the question “Why did this happen?”. Hindsight is a powerful tool and it changes your perspective. Problems that were lurking in your subconscious get a chance to be aired. The resulting list of “reasons” for failure become improvements to the plan. Identifying timing, resource or scope issues prior to beginning the project results in cheaper and easier fixes. CFO’s are often the department of “no”. This technique allows you to get the whole team to think critically about a plan without being the wet blanket.

3) Stay intellectually and emotionally distant enough to use your judgement. Optimism and confidence in business are great. Being a part of a team that is conquering a market is a peak experience but that experience can blind CFO’s to reality. Denise Shull writes about using emotion to make better decisions. CFO’s and CEO’s, if good, live both inside the organization and outside. The outside perspective means that you are aware of the challenges within the business and secondly you can look at the business with a clear mind. Founders are, in general, terrible at this, but professional management can’t be.

Here are two techniques for after you are involved in a project that you think might be going bad.

4) If we knew then what we know now, would we still go ahead? This is a way of focusing on the sunk cost question. A full commitment to an ok strategy is better than a weak commitment to a great strategy. I’ve been in a lot of projects where significant investments of time and energy have been invested and then we find out a key fact that makes the project a lot less attractive. However, because we are all fully committed we ignore when key facts have changed.

5) “What would happen if somebody took us over, got rid of us — what would the new guy do?” asked Andy Grove of Gordon Moore in 1985, and this question is relevant for every senior executive. Firms get into ruts. Sometimes the answer is clear but because of institutional momentum management teams never think about the obvious choice.

5 Customer Perspective Questions for CFO’s

Great CEO’s and CFO’s see both the inside and outside of the firm. The inside perspective is natural, it is the default mode in corporate life. The outside viewpoint is harder but it offers a wealth of insights. Although there are many outside perspectives, a crucial one is the customer’s viewpoint. When I work with a company I am vitally interested on how customers perceive the product and the company. Here are five questions you can ask yourself about the customer’s perspective.

1) Do you respect the customer? The customer perspective doesn’t come easy to finance executives. I’ve heard senior executives refer to their customer base as stupid and cheap, and similar to cows. Although you don’t have to use your company’s products to be a good executive, it helps.

2) Do you get customer feedback? There is a saying “the best fertilizer is a farmers’ footsteps.” Great executives get in the field and see how customers react to the product. I hate business travel, but there is no substitution for getting great customer feedback. Although CFO’s can’t spend the same amount of time the CEO spends talking to customers it is an important part of the executive role. I know a lot of marketing execs swear by big data analytics. I love big data but stories drive passion and illuminate the data.

3) Are your customers thrilled or merely satisfied? Are we promising one thing and delivering another? Often the internal “story” we tell in the office is not connected to the reality in the field. My rule of thumb is to never give a customer something they don’t want and won’t pay for. Additional features increase price without increasing value. Engineering teams will design the ultimate product, management egos get wrapped up in featurism, and pretty soon that great little software tool bloats up. Be clear about what you are promising, make sure it is what the customer wants and then deliver on that commitment.

4) Are your operations streamlined to deliver on the promise you’ve made to the customer? The CFO has a key role in identifying where efforts (and costs) should be placed. Sometimes you centralize (and sometimes decentralize) but figuring out the best tradeoff in location, cost and service can increase profits significantly.

5) Is your business model congruent with what you’ve learned? Although the CEO owns the business model, the CFO is key in developing the strategic plan. I’ve always drafted the agenda for strategic planning sessions, including identifying the key strategic questions. Having a handle on the customer allows a CFO to ask the right questions, and shape the strategy so that the intersection between your company and the customer results in profits.

Alan Kay said that “A change in perspective is worth 80 IQ points.” The fastest way to be smarter about a problem is to change your perspective.

CFO thoughts on Business Models

Fortune magazine reports that Warren Buffett stated in 1988, “With few exceptions, when a manager with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Bad business models often result in poor fundamental economics. Business models are hard to get right, and often very hard to change.

A 2014 survey of CFO’s asked about reporting and earnings quality. The Financial Analyst Journal reported the (Dichev, Graham, Harvey and Rajgopal) study in their Jan/Feb 2016 edition. The survey results are full of interesting details including the estimate of 1 in 5 financial statements being “cooked” with material (10% or better) adjustments. That information is worthwhile and it is bolstered by a list of ways CFO’s can tell there is a disconnect between reality and the financial statements. The survey also identified that a goal of financial reporting was about “conveying the long-run view of the profitability…of a bundle of assets”. As interesting as this is, I’d like to focus on another aspect of the article, the sense by the CFO’s of what drives earnings quality.

The survey inquired about factors that determine earnings quality – both internal and external. The top factor was the business model of the company. The other inputs included external factors such as the industry, accounting standards and macroeconomic conditions. Internal factors included internal controls and the aforementioned business model. Clearly, management teams are accountable for internal controls, but the argument for business model is not as certain.

Management teams are hired- they don’t create the business. They are brought in for their leadership, management, talent, knowledge and skills. Consequently, much of the business model is defined before the management team starts. Good business models require a good design in the beginning and careful nurturing. As markets change, business models grow obsolete and no longer fit their markets. Watching video has increased steadily in the last 20 years and yet the local Blockbuster is now a Dollar Tree.

I once joined a company that was earning <1% operating profits, and had no growth. In one year sales were up 10+%, and operating margins increased to 4%. In the next several years, we were never able to get operating profits much above 7%. In the years after I left, operating margins averaged less than 1%, until finally it went bankrupt.

The managers who followed me were a mix, some weak, some strong, some were tactical, some were strategic. When they took the position, they were confident about generating great results, but in the end none were able to solve the business model puzzle. Earnings were invested in a series of new initiatives which never resolved the core problem. Eventually weak profitability and lousy returns on capital resulted in a steady turnover in CEO’s and eventually it was sold to private equity who split out the good assets and bankrupted the rest.

This firm clearly had a business model issue. Flat market share, low returns on capital, little ability to innovate or compete in new segments. Low earnings quality is an outcome of the business model, and tinkering is not going fix it. So what do you do with a business that has poor fundamental economic performance? Here are a couple of strategies that can work.

One way is to get a break, either a technological change, industry change or strategic option which creates an opportunity that allows the firm to innovate. Richard Rummelt discusses this approach in his book “Good Strategy / Bad Strategy”. Blockbuster knew that digital streaming would hurt their business, but couldn’t come up with a strategy that was effective. Netflix, which was in the mail order DVD business, however, did. Searching, selecting and creating this opportunity takes time, resources and patience.

Another option is to pare the business down to the profitable core, and then build up from there. The focus here is on increasing the return on invested capital. A good business invests in projects that deliver a better than market return and prunes functions and divisions that do not. Will the business get smaller? Yes, it will, but the remaining business will provide a foundation for growth.

Both of these strategies have significant downsides for management. Few business leaders are strong enough or are far-sighted enough to risk the company on a technological change. Boards don’t like risk taking and the bigger the business the bigger the inertia. Paring down a business can often mean several years of declining sales. Even if you are adding to profits by subtracting a poorly performing operations, there will be concern by the Board, by investors and even by the management team. CEO and senior executive compensation is highly correlated with company size and declining company size means declining compensation. This is a lot of headwind, which explains why there are so many firms stuck in this state.

The bottom line is that it is a whole lot easier to keep a business model working well, then to fix it after it is broken.

Dichev, I., Graham, J., Harvey, C. R., & Rajgopal, S. (2016). The misrepresentation of earnings. Financial Analysts Journal, 72(1), 22-35. Retrieved from http://0-search.proquest.com.library.ggu.edu/docview/1762049797?accountid=25283