Posts from MBA Mondays

Today on MBA Mondays we are going to talk about another form of costs; Sunk Costs.

Sunk Costs are time and money (and other resources) you have already spent on a project, investment, or some other effort. They have been sunk into the effort and most likely you cannot get them back.

The important thing about sunk costs is when it comes time to make a decision about the project or investment, you should NOT factor in the sunk costs in that decision. You should treat them as gone already and make the decision based on what is in front of you in terms of costs and opportunities.

Let's make this a bit more tangible. Let's say you have been funding a new product effort at your company. To date, you've spent six months of effort, the full-time costs of three software developers, one product manager, and much of your time and your senior team's time. Let's say all-in, you've spent $300,000 on this new product. Those costs are sunk. You've spent them and there is no easy way to get that cash back in your bank account.

Now let's say this product effort is troubled. You aren't happy with the product in its current incarnation. You don't think it will work as currently constructed and envisioned. You think you can fix it, but that will take another six months with the same team and same effort of the senior team. In making the decision about going forward or killing this effort, you should not consider the $300,000 you have already sunk into the project. You should only consider the additional $300,000 you are thinking about spending going forward. The reason is that first $300,000 has been spent whether or not you kill the project. It is immaterial to the going forward decision.

This is a hard thing to do. It is human nature to want to recover the sunk costs. We face this all the time in our business. When we have invested $500,000 or $5mm into a company, it is really easy to get into the mindset that we need to stick with the investment so we can get our money back. If we stop funding, then we write off the investment almost all of the time. If we keep putting money in, there is a chance the investment will work out and we'll get our money back or even a return on it.

Even though I was taught about sunk costs in business school twenty-five years ago, I have had to learn this lesson the hard way. Most of the time that we make a follow-on investment defensively, to protect the capital we have already invested, that follow-on investment is marginal or outright bad. I have seen this again and again. And so we try really hard to look at every investment based on the return on the new money and not include the capital we have already invested in the decision.

This ties back to the discussion about seed investing and treating seed investments as "options." Every investor, if they are rational, will look at the follow-on round on its own merits and not based on the capital they already have invested. But the venture capital business is a relatively small world and reputation matters as well. Those investors who make one follow-on for every ten seeds they make will get a reputation and may not see many high quality seed opportunities going forward. Our firm has followed every single seed investment we have made with another round. In most cases, those investments have been good ones. But we have made a few marginal or outright bad follow-ons. We do that for reputation value as much as anything else. We measure that value and understand that is what we are doing and we keep those reputation driven follow-ons small on purpose.

When it is time to commit additional capital to an ongoing project or investment, you need to isolate the incremental investment and assess the return on that capital investment. You should not include the costs you have already sunk into the project in your math. When you do that, you make bad investment decisions.

We are going to turn our attention on MBA Mondays to some costs that are important to recognize in business. First up is Opportunity Cost.

Opportunity Cost is the cost of not being able to do something because you are doing something else. These costs don’t end up on your income statement but they are expensive, particularly in a small business where you have very few resources.

Let’s use an example. Assume you have three software engineers on your team and you commit to building a new product that ties all three of them up completely for six months. Not only do you commit to build that product, but you sell it in advance and take a deposit from your customer to fund the development.  And then an even bigger opportunity comes your way. You have been invited to build a version of your product that will ship in a hot new device that a major computer company is making a big bet on. But you can’t take on that project because your team is tied up on the first project.

So the cost of the first project is not only the time and salaries of the three software engineers who are working on it. It is also the lost revenues and market share you might have gotten if you had been able to work on the partnership on the new device. That is your opportunity cost.

The problem with opportunity costs is that you can’t predict or measure them very well. They become painfully obvious in hindsight but not at the decision point when you need to know their magnitude.

So what do you do about opportunity costs that are out there but you can't see or measure? That's a tough one. I like what my friend Gretchen Rubin said on the subject:

I also try to ignore opportunity costs. I can become paralyzed
if I think that way too much. Someone once told me, of my alma mater,
“The curse of Yale Law School is to die with your options open” –
meaning, if you try to preserve every opportunity, you can’t move
forward.

So my advice is to understand the concept of opportunity costs, build them into you mental map, but don't focus too much on them. If you can, try to build some flexibility into your organization so you aren't completely resource constrained. That will reduce opportunity costs. But at the end of the day, you need to "move forward" in Gretchen's words and that is first and foremost what all great entrepreneurs do.

Related articles by Zemanta

• Opportunity Cost (gregmankiw.blogspot.com)
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Continuing the international theme, we are going to talk about Purchasing Power Parity today on MBA Mondays. I learned about purchasing power parity in business school and it has always helped think about international exchange rates. The theory is far from perfect and fails miserably in many situations, but I still think the basic construct of purchasing power parity is something everyone in business should understand.

The basic concept is this: a basket of goods that are traded between markets should cost the same in different markets. My favorite example is the "Big Mac Index" which is calculated and published annually by The Economist. If a Big Mac costs $4 in the US and 3 pounds in the UK, then the proper exchange rate between the two currencies should be four dollars to three pounds which works out to be 1.33 dollars per pound.

The reason I like the Big Mac index is it is simple to understand. A Big Mac is not a "basket of goods" however and a more comprehensive basket of goods is normally used to calculate purchasing power parity of different countries.

That said, I will use the Big Mac index one more time to explain how purchasing power parity can be used to determine of a currency is overvalued or undervalued. This example comes from wikipedia:

Using figures in July 2008:

• the price of a Big Mac was $3.57 in the US
• the price of a Big Mac was £2.29 in the United Kingdom (Britain) (Varies by region)
• the implied purchasing power parity was $1.56 to £1, that is $3.57/£2.29 = 1.56
• this compares with an actual exchange rate of $2.00 to £1 at the time

• [(1.56-2.00)/2.00]*100= -22%

• the pound was thus overvalued against the dollar by 22%

This is important to understand. If two baskets of goods should cost the same in different markets and they don't, then the implication is that one currency is overvalued relative to another and that difference will eventually unwind itself.

Let's look at China versus the US. The International Monetary Fund (IMF) estimated in 2008 that one US dollar was worth 3.8 yuan using purchasing power parity. And yet the official exchange rate at that time was one dollar for 7 yuan. That situation has not changed much. The yuan dollar exchange rate is now one dollar of 6.8 yuan.

What this means is that US made goods are more expensive in China than they should be using purchasing power parity as a guide. And Chinese goods are less expensive in the US than they should be using purchasing power parity as a guide. If the dollar yuan exchange rate was allowed to move entirely with market forces, the theory of purchasing power parity says that the exchange rate should move to around 4 yuan to the dollar. Until that happens, this price discrepancy will remain.

There are all sorts of problems with purchasing power parity but I will not go into them here. The basic concept makes sense to me and is used widely in international economics. It is worth understanding as it provides a basic framework for how currencies can and should move relatively to each other.

Related articles by Zemanta

• China lowers U.S. dollar parity to 6.7980 yuan (marketwatch.com)
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I'm in europe this week, using euros for everything instead of dollars. So I thought it would be an appropriate time to talk about currency risk in a business.

When you have a business that only generates revenues in your local currency, you don't have to concern yourself with the fluctuations of one currency versus another. But if you start generating revenues in other currencies, or if you open an office outside of your country and start generating expenses in other currencies, you will have to start thinking about currency risk.

First, let's talk a little about currencies and how they fluctuate against each other. Since I'm spending euros this week, let's look at the past 120 days of price action in dollar/euro:

So let's say that 20% of your company's revenues are euro denominated. And let's say that your business is doing $10mm a year in revenues. So about $2mm in US dollars of your revenue is in euros. And let's say that was the case at the beginning of the year. At that time, the exchange rate was about .7 euros to 1 dollar. So your business was generating 1.4mm euros in revenues. Since the start of the year, the euro has dropped and now you get .8 euros for every dollar. So if your business is still generating 1.4mm euros in revenues, that is now only $1.75mm dollars of revenue per year. You are still selling just as much in euros, but your annual revenues in dollars has dropped $250,000 in six months. That is how currency fluctuations can impact a business.

Let's do the same analysis, but this time with expenses. If at the start of the year, you had $2mm in annual expenses in a euros because you have an office in europe with employees, rent, etc, then you had 1.4mm euros in annual expenses. By June of this year, those expenses have dropped to $1.75mm, saving your company $250,000 in annual expenses.

What this example shows is the primary lesson of currency risk in business. It is ideal to have your foreign currency denominated expenses and revenues be as close to each other as possible. Because if you can do that, they are a natural hedge. If our examples are combined, and you have $2mm of revenues and $2mm of expenses in euros (a breakeven business in euros), then your profits will not be impacted by currency fluctuations. Your revenues might go up or down, but your profits will be immune.

If you cannot match foreign currency denominated revenues and expenses, then you will have risk to your business. If the foreign currency revenues and/or expenses are small (measured in the millions or less), then you should not do anything about this risk. Just understand that you have the risk and live with it.

But if your unmatched foreign currency denominated revenues and/or expenses are in the tens of millions of dollars or more, then you can hedge the risk. As I explained in last week's post, there are a number of hedging strategies that you can put in place to manage this risk. There are currency desks at the major money center banks and global brokerage firms that specialize in hedging currency risk for companies and they will be happy to put in place currency hedges for you. Hedging currency risk can get expensive, which is why I don't recommend it for small companies, but for large companies with significant currency risk, it is standard business practice and it is very common.

For many entrepreneurs, currency risks are not going to be something to worry at the start of the business. But we see most of our portfolio companies start thinking about international expansion about five years into the development of their business. They open an office outside the US and start generating non dollar denominated expenses. In time, they start generating non dollar denominated revenues. At some point, these amounts become significant and the CFO has to start thinking about currency risk. If you get to that point in your business, think of it as a good sign. Something to manage for sure, but a sign that the business is on the right trajectory.

This is the third in a series of MBA Mondays posts about risk and return. Last week we talked about diversification, my favorite form of risk mitigation. This week we are going to talk about another favorite risk mitigation method of mine – hedging.

There are different types of investors in any highly developed and liquid market. There are speculators who are looking to make risky bets and you can use them to reduce your risk by taking the opposite side of those bets. Doing this is called hedging.

Let's go through some real world examples. The simplest one is shorting a stock that you own. Let's say you own 1,000 shares of Apple that you bought during the 2008 market break at $75/share. The Apple shares are now at $267/share and you are worried that the iPhone 4 reception problems are going to hurt the stock in the short term. You could sell the stock, but you really don't want to. So you can short 1,000 shares of Apple for as long as you are nervous. 

The way shorting a stock works is someone who also owns the stock loans you the shares and you sell them. You promise to give them back the stock at some future date. You pocket the $267,000 you get from selling the Apple stock but you have a liability which is you have to give the stock back to the person or institution who loaned it to you. Fortunately, you still own the stock you originally purchased so you can always pay back the loan in the stock you own. If the stock goes down, you can use some of the $267,000 you got in the sale of stock to buy back the Apple stock at a lower price and use that to repay the loan. If the stock goes up, you are losing money on your short, but making exactly the same amount on the stock you originally bought.

In this scenario, you have hedged your risk of the stock going down, but you are also not going to make any money if the stock goes up. It is like you sold the stock except that you still have your original stock in your possession. You are perfectly hedged except for counterparty risk, which are risks brought on by the other party to your hedging transaction. In this case, counterparty risk is pretty low.

Another form of hedging involves options. There are two primary forms of options, puts and calls. A put option gives you the option of "putting" your stock to someone else at a specific price. A call option gives you the option of "calling" a stock from someone else at a specific price.

Let's continue this example of Apple stock at $267/share. Instead of shorting the stock you can use options to hedge your position. The simplest form of a hedge is to buy a put to protect your downside. Let's say you want to make sure you get $250/share for your Apple stock no matter what. You can buy a put that allows you to "put" your Apple stock for $250/share until August 10th (a little more than 5 weeks) for $27. If that happens, you actually are getting $223/share because you'll get $250/share but you had to pay $27 for the call. That is the purest form of downside protection. It is expensive, but you get to keep all of the upside on the stock. And there is counterparty risk because if the person selling you the put goes out of business, they won't be there to honor the call.

If you are willing to give up some upside, then a better approach is the "collar". In this trade you buy a put and sell a call. The August 10th Apple put at $250 is trading at $27 right now. To finance that cost, you can sell an Aug 10th Apple $280 call for $24. You are still out $3/share but it is must less expensive insurance. However, if the stock goes up to $280, it can get called from you.

I got all these option prices from the CBOE's website. These are the current prices as of Monday morning before the markets open. These prices will move around a lot, reflecting both the price of Apple stock, the remaining time until expiration of the option, and the volatility of the stock.

If you think about the collar, it is a lot like shorting a stock you already own. You are protected if the stock goes down but you aren't going to make much if the stock goes up.

When our venture capital firm finds itself with a lot of public stock that we cannot sell for one or more reasons and we want to protect ourself from downside risk, we like to use a collar. You can use traded options, like the ones I am quoting from the CBOE. Or you can get a trading desk at a major brokerage firm to create synthetic options for you. No matter what you do with collars, it is going to cost something. You are purchasing insurance and insurance has a cost.

It is important to remember the counterparty risk when you are hedging. No hedge is any good if the other party to the transaction is not there to settle up. It is like buying insurance. You want to buy insurance from a highly rated carrier and you want to do hedging transactions with financially secure and stable counterparties. What constitutes that these days is another issue.

In summary, when you have a large gain on your hands, think about taking some of that gain off the table by selling it and diversifying. If you can't do that for one reason or another (taxes is a common one), think about a hedging transaction.

I was talking to a friend over the weekend and he told me a story about a person he knows who made hundreds of millions of dollars of net worth in his career and then lost it all. I asked my friend how that could happen. He said "he made a lot of risky bets and none of them worked out."

I don't get how anyone could do that to be honest. I don't understand how someone gives Madoff all of their money to manage for them. When someone has very little to lose, I totally get betting it all and going for it. But when you have accumulated a nest egg or more, you must be diversified in your investments and assets. You cannot put all of your eggs in one basket.

Last week on MBA Mondays, we talked about Risk and Return. I made the point that risk and return are correlated. If you want to make higher returns, you must take on higher risk. But you can mitigate that risk by diversification. And this post is about that strategy.

One of the things most everyone learns in business school is portfolio theory (that's a wikipedia link if you want to learn more). Portfolio theory says that you can maximize return and minimize risk by building a portfolio of assets whose returns are not correlated with each other.

Let's use some real life examples. Let's say you have a portfolio of stocks and all of them are tech companies. To some degree, they are all correlated. When the tech bubble blew up in March of 2000, every tech stock went down. So if you had that portfolio, your portfolio went down big. Let's say you have a portfolio that has some tech stocks, some oil stocks, some packaged goods stocks, some real estate, some bonds, and some cash in it. When the tech bubble bursts, you get hit, but your portfolio does not "blow up." That is the power of diversification at work.

I have my own tech bubble story that is similar to that example. When the Gotham Gal and I moved back to NYC in the late 90s, we bought a large piece of real estate in lower manhattan from NYU. We sold a big slug of Yahoo stock that we got in the sale of Geocities to fund the purchase. And then we sold another big slug of Yahoo stock to fund a complete renovation of that real estate. Beyond those two sales, we did not get liquid on most of our internet and tech stocks because our funds were locked up on almost everything else.

When the bubble burst, our net worth dropped 80% to 90%. But it could have dropped 100%. That real estate did not drop in price. It actually increased by 2.5x over the eight years we owned it. That is the power of diversification at work.

Of course, we learned our lesson from that experience. We now have a fairly diversified portfolio of assets that includes venture capital investments, real estate investments, hedge funds, and municipal bonds. I am not suggesting that our mix is a good mix. I suspect we could be much more conservative and more "efficient" with our asset allocation if we hired a professional financial planner to do this work for us.

But this post is not really about our portfolio construction or even about asset allocation. It is about the power of diversification as a risk mitigator. 

Let's talk about diversification in venture capital funds. Making "one off" early stage venture capital investments is a bad idea. The chance that you will pick a winner in early stage venture capital is about one in three. I've said many times on this blog that one third of our investments will not work out at all, one third will work but will not be interesting investments. And all of our returns will come from the one third that actually work out. If you are making "one off" early stage investments and make five or six investments over the course of a few years, you do not have enough diversification. You could easily pick five or six investments and not once get to the one third that work.

We put 21 investments into our 2004 fund and I believe we will put between 20 and 25 investments into our 2008 fund. With that number of investments, we have a good chance of finding one investment that will be good enough to return the entire fund. And we have a good chance of finding another four or five investments that will return the fund again. We can handle a complete wipe out on between five and ten investments and still produce excellent returns. That is how diversification helps to manage risk in an early stage venture portfolio.

So if you are building a portfolio of anything, be it financial assets or anything, make sure to fill it with things that are not too similar and not too correlated with each other. To do otherwise is not prudent.

One of the most fundamental concepts in finance is that risk and return are correlated. We touched on this a tiny bit in one of the early MBA Mondays posts. But I'd like to dig a bit deeper on this concept today.

Here's a chart I found on the Internet (where else?) that shows a bunch of portfolios of financial assets plotted on chart.

 

As you can see portfolio 4 has the lowest risk and the lowest return. Portfolio 10 has the highest risk and the highest return. While you can't draw a straight line between all of them, meaning that risk and return aren't always perfectly correlated, you can see that there is a direct relationship between risk and return.

This makes sense if you think about it. We don't expect to make much interest on bank deposits that are guaranteed by the federal government (although maybe we should). But we do expect to make a big return on an investment in a startup company.

There is a formula well known to finance students called the Capital Asset Pricing Model which describes the relationship between risk and return. This model says that:

Expected Return On An Asset = Risk Free Rate + Beta (Expect Market Return – Risk Free Rate)

I don't want to dig too deeply into this model, click on the link on the model above to go to WIkipedia for a deeper dive. But I do want to talk a bit about the formula to extract the notion of risk and return.

The formula says your expected return on an asset (bank account, bond, stock, venture deal, real estate deal) is equal to the risk free rate (treasury bills or an insured bank account) plus a coefficient (called Beta) times the "market premium." Basically the formula says the more risk you take (Beta) the more return you will get.

You may have heard this term Beta in popular speak. "That's a high beta stock" is a common refrain. It means that it is a risky asset. Beta (another Wikipedia link) is a quantitative measure of risk. It's formula is:

Covariance (asset, portfolio)/Variance (portfolio)

I've probably lost most everyone who isn't a math/stats geek by now. In an attempt to get you all back, Beta is a measure of volatility. The more an asset's returns move around in ways that are driven by the underlying market (the covariance), the higher the Beta and the risk will be.

So, when you think about returns, think about them in the context of risk. You can get to higher returns by taking on higher risk. And to some degree we should. It doesn't make sense for a young person to put all of their savings in a bank account unless they will need them soon. Because they can make a greater return by putting them into something where there is more risk. But we must also understand that risk means risk of loss, either partial or in some cases total loss.

Markets get out of whack sometimes. The tech stock market got out of whack in the late 90s. The subprime mortgage market got out of whack in the middle of the last decade. When you invest in those kinds of markets, you are taking on a lot of risk. Markets that go up will at some point come down. So if you go out on the risk/reward curve in search of higher returns, understand that you are taking on more risk. That means risk of loss.

Next week we will talk about diversification. One of my favorite risk mitigation strategies.

This is the final post in a long MBA Mondays series on projections, budgets, and forecasts. Today we will talk about what happens when reality starts to differ from what you've budgeted – you re-forecast.

Let's go back to the framework I laid out at the start of this series. Projections are long-term high level efforts to establish the scope of the opportunity. Budgets are an effort to establish an operating framework for the coming year. And forecasts are done intra-year to establish what is likely to happen. As someone said in the comments, it's "long term, short term, and real-time."

Forecasts are typically done mid-year but they can and should be done whenever the actual performance differs significantly from what was budgeted. Forecasts are not an attempt to throw out the budget. The company should continue to measure itself and report against the budget. The forecast should exist beside the budget and show what management thinks is likely to happen.

Forecasts are important for a variety of reasons but first and foremost you want to know where your cash balances will actually be. And you'll want to know where you will be on your revenue growth trajectory. If you are planning on doing a financing, forecasts are important because they will give you an indication of what the metrics investors will be using when they offer you terms for a financing.

The process of doing a forecast is not very hard. You simply take the model you used for budgeting and put new numbers in for revenues and costs. The way most forecasts go down is the revenues are taken down to reflect slower sales growth. Then management looks at the costs in the budget. In some cases, costs are not adjusted because management feels that they need to continue to invest in the business. But in many cases, costs are adjusted down somewhat to reflect a desire to conserve cash. Either way, you'll have a new set of numbers for the months ahead.

You combine these new sets of numbers for the coming months with the actual results for the months that have already happened and you have your forecast.

Once you do a forecast, it is a good idea to keep updating it as the year develops. If you do a forecast at mid-year and by the fall that forecast is off, do another forecast. The forecast is not another budget you have to try to meet. It is an attempt to estimate actual results. So keep adjusting the forecast in an attempt to nail it.

As you get into the fall, you will start budgeting for the next year. Use the learning that came from the forecasting exercise to make next year's budget better. Think of budgets and forecasts as agile financial management. The budget is the annual release and the forecasts are the iterations based on feedback.

So that's it. We are now done with projections, budgeting, and forecasting. Next week we'll tackle a new topic.

Last week we talked about budgeting in a growing company. I defined that as a company between 50 and 100 employees. Today we are going to wrap up the budgeting series by talking about what happens to the process when you get to be a "big company." The context for the whole of this MBA Mondays series of posts is the world of entrepreneurial startups so "big company" means 150 employees or more to me. The biggest companies that I actively work with are between 150 employees and 1000 employees. Once they get bigger than that, they are beyond my ability to comprehend them and help them.

The process of budgeting in a large company doesn't differ that much from a growing company. If you haven't read that post, please go back and read it.

The budgeting process is still led by the financial leader of the company (VP Finance or CFO but by this stage you are likely to have a CFO) and the CEO. But the team that runs the budgeting process now includes the entire senior team. That is because each senior team member has control over a meaningful team and piece of the business. So you have to get them all involved in the budgeting process.

It's also increasingly likely that your revenues are coming from a number of lines of business so you will want to do a more detailed revenue forecast with attention to each segment of revenue. Your sales leader will still be responsible for the revenue forecast, but he or she will need help from the finance leader and often from other senior team members to put the revenue forecast together.

You will continue to use KPIs as a bridge between the revenue budget and the cost budget, but the creation of the KPIs and the forecast of them is now driven by the entire senior team. As I said in last week's post, this is the most important part of the budgeting process so make sure to give the senior team ample time to get the KPIs right.

Cost budgeting in a large company is a much more exhaustive process. The cost budget has a lot more detail and input into it. It is an iterative process where each senior team member brings a cost budget from his or her team and the finance leader integrates it all together and then negotiates with the senior team members to get the numbers where they need to be. This is where entrepreneurial budgeting starts to feel like big company budgeting.

One thing that many companies start doing at this stage is benchmarking their budget numbers versus others in their industry sector. This is mostly done with public company numbers since getting detailed financials on privately held companies is difficult. It is helpful to look at what your competitors or similar companies are spending as a percent of revenues on the various parts of the business. And it is helpful to look at how profitable their businesses are versus yours.

As you can see, the primary difference between the budgeting process in a growing company and a large company is the amount of involvement, interaction, and iteration among the senior team. This all takes time. So start the budgeting process by labor day, if not a bit sooner. It will take three months to do this right. You'll want your budget ready for a board review in mid to late November so there is time to do one more iteration before year end if that is necessary.

The budgeting process is really critical in a large company. It forces the company to make highly informed decisions about investments and resource allocation and it creates company wide discipline around hitting goals. I have never seen a company of 150 employees or more operate functionally without a strong budget process.

I'd like to again thank Matt Blumberg and Jack Sinclair of our portfolio company Return Path for their help with these budgeting posts. I have watched them go through all of the various stages over the years and their planning and budgeting has been stellar. Their insights were invaluable to me in putting the "how to" parts of these posts together.

Next week we'll talk about what happens when the reality starts diverging from the budget – forecasting.