BERKONOMICS

Growing companies usually require more working capital during their periods of rapid growth.  In past insights we have calculated the amount of additional capital needed for a business as it grows, and the additional capital required is often surprisingly large.  In this insight, we need to speak of the sources of working capital and the implications to the future financial health of the choices made when selecting one financial resource.

Venture or angel-financed companies with plenty of working capital sometimes are immune to this need for some time into their growth, but at some point it will become clear that the cheapest form of finance is not equity in a growing enterprise.  If the equity value of a company is growing at the same rate as the company, say 40% per year, almost any form of debt financing may be preferable as a way of preventing further dilution from issuing additional equity.

The problem is that few small, growing companies seem to be attractive to most banks for traditional unsecured or asset-backed loans.  The exception is for those venture-backed companies with a significant cash balance remaining in the bank, which ironically make the most attractive customers for banks to offer loans.  The banks want to maintain their venture relationships and of course, want to use the existing company cash in their bank as collateral for – you guessed it – their loans to the company.  The term of art is “compensating balances,” and certainly using existing cash to leverage new loans makes the company more liquid, but at a price, as the compensating balances cannot be touched and are essentially frozen for the duration of the bank loan.

[Email readers, continue here…]  There are asset-based lenders of every size willing to take more risk and finance the growth of young companies without requiring compensating balances.  Using the company’s receivables and inventories as collateral, such lenders often also ask for a uniform commercial code (UCC) filing, perfecting their first interest in all of the remaining assets of the company – including intellectual property, the latter often being by far the most valuable asset the company has to protect.

Loan covenants are always required that clearly state how much net equity, the minimum current ratio, and other minimum financial requirements must be maintained to be compliant, and state the penalties for non-compliance – which are always severe, often threatening to call or cancel the loan in its entirety.

One of the important items in a calculation of amounts available to be borrowed is the amount of qualifying collateral, defined usually as the amount of net accounts receivable less than 60 days old, after deducting government billing – and all receivables from companies with some balances over 60 days.  To this net number, the lender will then apply a percentage, from 50% to 80% as the amount available for borrowing under the agreement.

It is important to calculate the true cost of such money.  It is typical to charge an interest rate that is higher than a normal bank loan for asset-based loans.  Also tacked on is a “float period,” typically two to five days, amounting to additional interest as if the money paid back is still outstanding for that time as compensation for the time to clear checks paid into the lender either by your customers directly (lock box method) or by you.  A five day float increases the actual interest rate by up to an additional 2% over the stated rate. Then there is the loan audit fee, often more than $4,000 a year, to pay for the lender’s auditor to make sure the collateral and company are compliant with the covenants of the loan. Lenders sometime add a charge for loan oversight, called a consulting fee, and very often make warrants (a promise to later sell the lender stock at a fixed price) a part of the deal.  When calculating the true cost of a working capital loan, after adding all of these elements and estimating the value of the warrants in dilution to the shareholders, you may be shocked at the number when expressed as an annual percentage rate.

And yet, such a loan does rise and fall with need.  And it is often cheaper than the cost in dilution of issuing additional stock to obtain working capital.  These decisions require knowledge by management, help from accountants and or attorneys, and an understanding at the start of such a relationship that borrowing from asset-based lenders is like entering a marriage where the other partner has all the power to ensure success in the event that anything goes wrong with the original plans.

At the MIT Center of Collective Intelligence, professors and graduate students are wrestling with an important opportunity – and gaining ground.  With new collaborative tools available for use in the cloud,   people are no longer isolated in their creative endeavors. Some label this “crowdsourcing,” a term used to describe one form of this new empowerment.

How do you use the new tools for collaboration to enable people and computers to be connected so that collectively they act more intelligently than any individual?  MIT has come a long way in identifying tools and techniques.

[Email readers, continue here…]  You can do the same.  First, realize that no individual in your organization, including yourself, is as effective alone as with collaborative help from peers.  Then find ways to build concepts, plans, documents, and actions through the collective collaboration of your key group.  Explore and implement one of the many collaborative environments available through cloud computing, products from Microsoft, Google, IBM, and others.

Test the system. Create a document with your basic plan or idea for action.  Post the document using one of these common tools and invite members of your group to add to or comment upon this beginning effort.  Respond and build upon the result.  You will note that within a short time, you will have created a plan or document usually far better than if you had worked alone.  And the added benefit is that the group will feel ownership in the result, a powerful step toward a successful outcome.

There are a number of key performance indicators that help new generation company management see more clearly their progress and corporate health.  The old measures, including return on investment, percentage of profit against revenue or employee count, and more, obviously are still relevant.   But businesses that expose their story to tens of millions of potential customers through the Internet need additional tools.  Some of these are also applicable to non-Internet businesses.

Here are some of these measures, and how to calculate them. You will recognize the value of these for any business, even if they have not been in common use in the past.

CHURN   (% customer cancelling each month)

This is calculated by dividing the number of cancellations by the total number of customers before cancellations and multiplying by 100.

CMRR      (Contracted Monthly recurring Revenue)

A simple statistic which can be derived from a good general ledger using GAAP accounting procedures.  Revenues are recorded as earned, not paid, especially when paid in advance.  This number is increasingly used by appraisers and buyers in valuing a business, with some multiple of this number being one measure of the value of the enterprise.

LPC          (Lifetime Profit per Customer)

[Email readers, continue here…]  This is the total expected revenue for a customer (usually calculated with a five year life no matter what the type of business) less the cost of acquisition (see below) less the recurring direct costs of serving the customer or of product estimated to be sent to the customer over the lifetime relationship.

CACR       (Customer Acquisition Cost Ratio)

This is a measure of capital efficiency, focusing upon the cost of acquisition of the customer (including direct sales, commission payable, direct marketing and other direct costs) divided by the expected gross revenues over the customer’s estimated lifetime of purchases.  The lower the ratio, the more successful the customer acquisition campaign.

CPA          (Cost per Acquisition)

This is simply the sum of the month’s direct costs for sales and marketing divided by the number of new customers acquired, yielding a dollar cost per average new customer. The lower, the better.

MBE      (Months to breakeven)

A better measure of capital efficiency.  Total new customers this month times the average expected revenue – divided by total direct sales and marketing cost together with the cost of product or service for those customers for the month. The result will yield the number of months the average account takes to be profitable for the company.  The lower the number, the more efficient the marketing and sales campaign, and the more efficient the use of financial capital in customer acquisition.

Surely some of these measures would, if used by your organization, shed additional light on the efficiency of the operation and over time the trends related to efficiency.

We all know that the world of marketing has turned upside down these past years through the power of the Internet.  College professors teaching marketing must be having a real challenge keeping up with the new channels of communication, the relative values of advertising buys in this new world, and explaining how to make the most out of these cheaper and more powerful channels.

Although there is still a place for display advertising in this new world, increasingly small businesses are discovering that creating buzz and engaging their audiences through social media are more powerful and cost effective.

Marketing texts and college professors say that it takes at least seven impressions – exposures – before a person recognizes and acts upon the message.  That’s an expensive proposition for small companies.  On the other hand, your target audience is already talking to their friends and associates about products and services they like and use.  Plugging into those conversations gives you the power to multiply your message many times over, often at no cost at all.

[Email readers, continue here…]  How do you engage your customers in a conversation instead of merely broadcasting your message again and again in hope that some one remembers it?  The answer comes in a number of forms, but centers around your finding the thought leaders within circles of influence, attracting the “influencers” that people follow.  To do this, your message must resonate in a way that it appears unique.

If you cannot incorporate social content into your product, surround your product with social content.  Create groups in Facebook, followers on Twitter, a comments section on your blog or website, and more.  Identify a number of influencers, and then offer to let them use your product or service at low or no cost if they will join your informal advisory group on the ‘net.  Ask for endorsements when appropriate.

Above all, make every outreach an attempt to engage your customers, listening to their responses and responding one-to-one wherever possible.  Make each customer feel important and valued.  In this new world of engagement marketing, the customer has a voice much earlier and much louder than ever before.

Substitute the word “money” for “water” and we have an explanation for most all of the reasons why successful products move from concept through early adopters through mass market.

Money flows to the cheapest effective solution to a problem.  Fighting this fact will just extend the misery of accepting a product or marketing failure in the marketplace.

Take for example, adoption of solar panels or hybrid vehicles in the mass market.   Most of us want to do well for the environment, but are willing to do so only if we do well for ourselves when measuring alternative costs.  Solar panel installations break even only after over years of use, even with subsidies offered by electric companies or governmental organizations. And adoption of solar technology for home and business has been relatively slow as a result.

[Email readers, continue here…]  As solar panel efficiency increases from 20% to 40% and more, and as electricity prices rise, the net breakeven for solar panels should decrease dramatically.  Even when subsidies stop, the economic breakeven will decrease to a few years as mass acceptance becomes real.  And the reason for the delays, as well as the later successes, will surely be in the money saved, not just in “doing well by doing good.”

Hybrid cars become attractive investments when the extra cost can be amortized over a year or two of savings in fuel.  Yes, in both cases cited, the cost of fuel is a factor as it rises over time, reducing the time to breakeven.

Whenever someone asks why a product or service has taken so long to succeed in the marketplace – when so obviously a success with early adopters – why not try using the water flowing downhill analogy.  It provides a proper insight almost every time.