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I read Michael Gerber’s eMyth Revisited in 2003, the same year I started my consulting practice. I felt that it gave me a roadmap to success as a consultant. The book opens by describing a woman who loves to bake, and her friends all suggest “you should be running a bakery.” So off she goes. However, she soon becomes overwhelmed by the managerial responsibilities that come with owning a bakery, taking her away from her true love and passion: baking pies.
“Simple,” I thought, “I’ll help resolve this disconnect by assisting my clients on the managerial side of the business so they can continue to ‘bake the pies.’ And there will be an educational piece to my practice too: I will teach these bakers enough about finance so they are better equipped to manage their businesses.”
But as the years have gone by, and I have gained experience as a consultant, I have come to realize there is something deficient about this model; some of my clients have a real aversion to learning how to manage the financial side of the business. Some even avoid hiring anyone to do it for them! There was the entrepreneur who did not file tax returns for numerous consecutive years, with the thin justification that these were loss years so they didn’t owe any money; but he put himself at risk of losing valuable tax-loss carry forwards. Then there was the maker of high quality organic desserts who couldn’t persuade her partner to create a “bill of materials,” and consequently did not know if some products were being sold below cost. And there have been numerous instances of people thinking about starting, or actually starting, businesses without having a clear idea of how much capital it would take them to get to positive cash flow. This systemic avoidance went well beyond what was described in eMyth.
Fortunately, Margaret Heffernan has written Willful Blindness and I believe it provides a deeper psychological/sociological explanation for why business owners are blinding themselves from the positive results of proper financial management. Figuring out whether the business is going to make a profit, what to do if it isn’t going to make a profit, where to find money to pay quarterly estimated taxes, etc. is not likely on the top of any business owners “to-do” list. Avoiding these and other similar activities for a day or a week may seem acceptable behavior, but as Heffernan writes, “All of us want to bury our heads in the sand when taxes are due, but in trying to pretend the threat doesn’t exist, and we don’t have to change, we are… trying hard to avoid conflict.”
I’ve also recently had the chance to do join up with Richard Magid and his team at Soundboard for some important client work and to witness firsthand how effective they are in the areas of coaching, training and cultural assessments. Their wide range of successful client work has made them highly sensitive to the discussions that are not taking place – but should be. If you are looking for consultants who can help get your employees more engaged, you should give them a call.
Client education will continue to be an important aspect of what I do, and I will continue to ask myself whether individual clients are truly coachable in financial literacy or not. I’m at a point when I can no longer keep my head in the sand when it comes to business owners who are not willing to get into the financials, because your business is too important not to look at the financials, and mine is too.
On March 9th of this year, Senator Mark Udall of Colorado introduced Senate Bill 509, the Small Business Enhancement Lending Act, a bill that would raise the permissible amount of Member Business Loans from the current cap of 12.25% to 27.5% of a Credit Union’s assets.
In aggregate, Credit Unions ‘ Member Business Loans equaled 4.2% of assets in 2010. While only a tiny fraction of Credit Unions are being held back by the current 12.25% limit, which was put into effect in 1998, and some have called arbitrary, National Credit Union Association survey data shows that nearly 70% of Credit Unions do not make Member Business Loans in the first place, perhaps held back by the perception that these loans were too risky.
The proposed legislation is supported by the Obama administration, and by the Credit Union National Association, which projects that the bill’s passage could result in $13 billion of new lending to small businesses, which would in turn stimulate 140,000 new jobs, all at no cost to taxpayers. The American Banking Association is vigorously lobbying against Udall’s bill, contending that the proposed legislation is intended to support “large, aggressive, growth-oriented credit unions who have abandoned their mission of serving people of modest means.”
Personally, I hope the Senate can move bill 509 quickly through committee, debate, and to an affirmative vote. While it is true that only a small minority of Credit Unions are currently constrained by the 12.25%-of-assets lending limit for Member Business Loans, in addition to freeing these Credit Unions to lend more, the bill’s passage might also stimulate other more conservative Credit Unions to think about originating Member Business Loans for the first time. To have this bill stifled by Big Banking as it attempts to protect its turf against encroachment from not-for-profit Credit Unions would be ironic, especially as this country attempts to pull out of a recession that was made worse by the reckless and unregulated actions of some of this nation’s largest banks.
Last Sunday evening’s broadcast of the CBS news show “60 Minutes” raised some important questions about “Three Cups of Tea” author Greg Mortenson and the governance of the charity he founded, the Central Asia Institute (CAI). I watched the episode, reviewed the Central Asia Institute’s latest 990 form, and also read the CAI’s response to 60 Minute questions, which is now posted on their website.
 Both CBS and the Central Asia Institute agree that only 41% of the Central Asia Institute’s spending actually went to build schools in Afghanistan and Pakistan. Furthermore, while the CAI spent $1.7 million for book related expenses (i.e., advertising, events, film, publications, and travel) what is much murkier is how much of Mr. Mortenson’s royalties from sales of “Three Cups of Tea” have been donated back to the charity, raising the very reasonable question of whether Mr. Mortenson is deriving excess benefits from the charity he founded.
I personally felt the 60 Minutes segment was the product of some outstanding investigative journalism while I did not find the responses posted on the CAI website very reassuring. Read them both, decide for yourself, and add a comment here, or on the 60 Minutes website, which has 379 viewer comments, and counting.
Loans outstanding to small businesses hit a four year low of $652 billion in 2010, down 6.2% from the $695 billion outstanding at the end of 2009, according to a Small Business Administration study published in February, 2011 titled “Small Business Lending in the United States 2009-2010.” For purposes of the study, the SBA defines small business loans as business loans under $1 million.
Of the $43 billion decline in loans outstanding to small businesses, so called “mega-lenders” (i.e., institutions with assets exceeding $50 billion) accounted for an aggregate reduction of $18 billion, or 6.7%, as their collective small business lending dropped from $270 to $252 billion. By way of comparison, lenders with assets in the $100 to $500 million range saw their loans outstanding to small businesses drop by only 3.7% in 2010, from $130 to $125 billion.
A variety of reasons were given for the overall drop in small business lending, ranging from tightened credit standards, weakened lending institutions, and also weaker loan demand from healthy, established institutions concerned about the strength of the economic recovery.
The SBA report states that the recession has not pitted large borrowers vs. small borrowers, and that loans outstanding to large borrowers dropped by an even larger percentage, declining by 8.9% from the end of 2009 to the end of 2010.
 Sbarro Inc. filed for chapter 11 bankruptcy protection on Monday, April 4th, joining a growing number of restaurant chains that have done the same, such as Uno Holdings, Claim Jumper Restaurants and the parent company of Charlie Brown’s Steakhouse., the “Nation’s Restaurant News” reported. If approved by the bankruptcy court, the company would be able to cut its $486.6 million in debt by $195 million. (By way of comparison, competitor Papa John’s, which has grown to three times the size of Sbarro, and is not in financial difficulty, is carrying only $95 million of long term debt on its balance sheet)
Since the founding Sbarro family immigrated from Naples and opened their first Salumeria in Brooklyn in 1956, Sbarro has alternated between public and private ownership, going public in 1985, and then being taken private again by the Sbarro family in 1999, perhaps due to their dissatisfaction with the company’s sluggish stock price.
The “Wall Street Journal” reporteed that “much of the pizza chain’s troubles go back to debt taken on in 2007 to back a buyout by private -equity firm MidOcean Partners” while in fact, the Italian quick-service operator had been under-capitalized and over-leveraged ever since 1999. As reported in Sbarro’s 10-k reports, the company’s ratio of earnings to fixed charges dropped from 4.1x in 1997, two years before the 1999 buyout, to 0.7x in 2001, two years after.
After its acquisition by MidOcean Partners in 2007, the company was walloped by the recent recession, as foot traffic at malls dropped off, while flour and cheese prices climbed. Sbarro is the only restaurant company in MidOcean Partners’ portfolio, which includes Freshpet, LA Fitness, Bushnell (fans) and Isotoner. Sbarro had indicated in an SEC filing in late 2010 that there was substantial doubt it would be able to continue as a “going concern.”
The Sbarro company website says, “there will be no impact on our ability to deliver the great food and excellent service our customer’s have come to expect.” Since I had never eaten at a Sbarro, I stopped in to their location at 46th and 5th Avenue, to sample a slice of their tomato and onion pizza, and can truthfully report that it looks great, with lighting that would make Julie Taymor proud, but tastes just average, with an unexceptional bread-like crust, and uninteresting sauce and cheese.
 Harry & David Holdings Inc. filed for a pre-arranged chapter 11 bankruptcy on March 28th, 2011 after having skipped a $7 million interest payment to bondholders on March 1st. Harry & David’s sales had declined in recent years, as recession-strapped consumers and corporations cut back on discretionary gift purchases, and new competitors such as Amazon and Edible Arrangements entered the fruit basket business, competing with free/discounted shipping and innovative new fruit basket arrangements respectively.
Harry & David arguably would have been able to ride out the recession without the need for a bankruptcy if its balance sheet had not been weakened earlier in the decade. Specifically, the acquisition of Harry & David by investment bank Wasserstein in 2004 for $254 million weighed down the company with $250 million of debt, as Wasserstein hastened to pay itself back for the capital it had used to make the acquisition, recouping 1.25x its original investment. The founding Holmes family had sold Harry & David to RJR Nabisco in 1986, a previous peak period for leveraged buyouts, and ownership of the company had changed hands additional times before Wasserstein’s acquisition in 2004.
The company’s bondholders, including Wells Fargo, will become the new owners, as they convert their debt into equity, the “Los Angeles Times” reported. The company is continuing normal operations on the internet and its 70 remaining retail stores, under the leadership of Kay Hong, chief restructuring officer and interim CEO. Harry & David’s previous CEO, Steve Heyer, former CEO of Starwood Hotels, was appointed Chairman and CEO of Harry & David in March, 2010 by Wasserstein, and never moved to Oregon, choosing instead to run the Oregon-based company from his office in Atlanta, Georgia. In February 2011, Heyer was replaced by Hong, the former CEO of turnaround firm Alvarez and Marsal, when it became clear, after a disappointing Christmas selling season for Harry & David, that some sort of financial restructuring was unavoidable for the century-old firm.
 3M Company published the game Stocks and Bonds in 1964. It is a stimulated stock market played out over a 10-year period, where the stock prices of fictional companies such as Metro Properties, Growth Corp., and Stryker Drilling oscillate up and down, determined by the roll of two dice, and the special events described by 36 playing cards. I was overjoyed when the game showed up as my birthday present when I turned 14, and was content playing it for a year or two, choosing the stocks more or less at random, but finally, I spent an entire afternoon doing the math to find out exactly which of the ten stocks provided the highest expected returns. Fortunately, it was a pretty close horse race between three different stocks, as far as which one provided the best return, so the game wasn’t ruined, and I still had many enjoyable hours ahead playing Stocks and Bonds with children, once they became teenagers.
Although I am no longer playing Stocks and Bonds, I do from time to time help entrepreneurs seeking funding from angel investors, and I’m often asked what kind of returns these angels will want on their investment. So you can imagine my delight in learning of a study done by Ramon DeGennaro and Gerald Dwyer, (and this took a lot more than one afternoon to complete) that analyzed the investment returns of 588 angel-funded companies, spanning the 1972-2007 period.
Their study, titled “Expected Returns to Stock Investments by Angel Investors in Groups” drives home the relationship between type of exit and investor returns. Out of the 588 angel-funded companies in their data set, 408 companies had lasted at least a year, and then reached some sort of exit. Of these 408, the 56 that went IPO, (i.e., issued stock to the public through an Initial Public Offering) were the stars, with average annual return to investors of 93%. Another 180 companies were bought out privately, and their investors did almost as well, with an average annual return of 84%. However, 114 companies in the study ceased operating, and their investors were nearly wiped out, with a negative annual return of 93%. The blended Internal Rate of Return to investors in all 408 companies was 33.7%, but importantly, this did not include the results from the 180 companies that never reached any kind of exit, and were probably under-performers.
This terrific study helps explain why astute investors will always probe concerning exit strategy, and why they are also always concerned about the risk of the entrepreneur running out of cash before reaching break even, two things that weren’t concerns when playing my old childhood Stocks and Bonds game. It also explains why entrepreneurs seeking angel funds need to be able to demonstrate that their company has the potential to yield an internal rate of return to investors of 35% or hopefully even more: because investors need that kind of return on the winners to offset the losses from the ones that inevitably fail.
Crumbs Bake Shop, which was founded in 2003 by wife-and-husband team Mia and Jason Bauer, hopes to see their company stock soon listed on the NASDAQ exchange – quite an achievement coming at the tail end of the recent recession.
The 2/8/11 Crumbs investor presentation is as nicely laid out as the Crumbs store I visited earlier this week, and a must-see document for any would-be restaurant owner who is thinking about writing a business plan. At first glance, I was amazed by the degree of disclosure of their business strategy, and key metrics.
Crumbs’ business model may wind up being just as delicious for investors as their cupcakes are for consumers. By baking their cupcakes off-premises, the average build-out cost of a Crumbs location is held to $300,000, while their average ticket (i.e., sales per transaction) of $18-20 translates to average sales per location of $1.1 million, for an average 16-month cash payback on each new location. And with an average EBITDA per store of $231,000, their cash-on-cash return on that $300,000 build-out cost is a tasty 77%.
The vehicle for taking Crumbs public is 57th Street Acquisition Corp, which already trades over-the-counter, and in January announced plans to acquire Crumbs as soon as this month, which would be the final step of a reverse merger. The Crumbs investor document projects that at closing, 55% of Crumbs stock will be owned by the public, 40% by current Crumbs management, and 5% by 57th Street sponsors. The deal structure is less easy to understand than the store economics, and I noticed from the investor document that a considerable number of contingent shares are being created which would be issued once the stock price reaches certain future targets, which could serve to dilute public investors’ returns. And at $31 million of (unaudited) 2010 revenue, Crumbs is on the small size to be a publicly traded company, although it projects it will be at $85-90 million of revenue by 2012, and be at 200 units by 2014.
So with cupcakes coming in three different sizes: “taste”, “classic” and “signature”, hopefully there will be enough Crumbs to go around on a post-IPO basis to make everybody satisfied.
Borders’ February 16th, 2011 bankruptcy filing was the result of bad timing and bad decisions, as reported by the “Wall Street Journal” and others. The recession that started in 2008 cut a swath through the ranks of bricks and mortar retailers, as consumers cut out discretionary purchases, taking out such big names as Linens ‘N Things, Circuit City, Mervyn’s, The Sharper Image and Wickes Furniture. And Borders was slow to diversify to on-line sales, having turned over its internet operations to Amazon in 2001, and only taking back its Borders.com website in 2008.
One truly poor bad decision that has been just a minor mention in most press coverage of its recent bankruptcy filing was Borders’ heavy stock repurchases: nearly $600 million dollars worth over for the three fiscal year period ending 2/3/2007. For perspective, the share repurchases over these three fiscal years is nearly three times the amount it owed in aggregate to its top ten unsecured creditors at the time of its recent bankruptcy filing.
Companies typically choose to repurchase their stock to accentuate the growth of their earnings per share, anticipating that they can reduce the number of shares more than the added interest expense reduces their net income. And if that happens, the reasoning goes, then stock holders will be rewarded with a higher stock price, and in a very tax efficient way.
This sometimes works beautifully, and an example that I have used in my Introductory Finance class is Coca-Cola’s share repurchases for the ten year period from 1987 to 1997. Over that stretch Coca-Cola’s net income increased an average of 16.3%, and due to an ongoing program of share repurchases, its earnings per share increased an average of 18.7%. Better yet, Coca-Cola’s stock price had average annual gains of 30.2% over those ten years, as institutional and individual shareholders clamored for a decreasing supply of Coca-Cola shares. (For more about the Coca-Cola share repurchase, go to http://www.rudofskyassociates.com/finance.html and press on the widget to hear a 4:30 voice recording)
The difference between Coca-Cola and Borders is that Coca-Cola was consistently profitable over that stretch, and it also had a well-defined and winning strategy in place, which meant no surprise alternative uses for all that cash. The share repurchase algebra fell apart for Borders because it ran a $151 million loss in fiscal 2007, and reducing the number of shares can’t accelerate your earnings per share growth, if your earnings per share isn’t positive to begin with.
In conclusion, if all the cash that was used to repurchase shares in the middle of this past decade had instead been used to somehow strengthen or restructure the company on a more proactive basis – perhaps by either launching a more competitive eBook reader or by closing some of their many unprofitable stores earlier – Borders’ creditors, employees and shareholders all probably would have been better served.
Just before writing this blog posting I noticed an email from LinkedIn with small thumbnail photos of my 40 LinkedIn contacts that changed jobs in 2010, described by “Fortune” as “the best networking email that I will receive all year.” I totally agree with Fortune magazine’s assessment, and it really underscores to me the value of being a long-term LinkedIn user.
All of this technology has a price tag, and now that LinkedIn has announced its intentions to sell its stock to the public for the first time, through their S-1 Report, which is available on EDGAR, the U.S. Government repository of public company financial filings.
For the first nine months of 2010, LinkedIn had revenue of $161 million, with 73% of this coming from its Hiring Solutions and Marketing Solutions lines of business, as the vast majority of its 90 million individual members (including me) continued to take advantage of LinkedIn’s free basic service. Even with $161 million of revenue, LinkedIn had slightly negative free cash flow over this nine month period, as its $37 million of Cash Flow from Operations was offset by $40 million they invested back in the business, including investment to build out their data centers, technology hardware to support growth, and software to support website functionality development, which would include, I suppose, that email mentioned above.
To LinkedIn’s credit, they are flagging that their future growth will require substantial additional investment, and even have the courage to say in their S-1 that they do not expect to be profitable, on a GAAP basis, in 2011. Adding one new member every second does not come cheap! LinkedIn has a good lead in the professional networking space, but they may attract considerable competition from Facebook, Google, Microsoft, Twitter and others, all of which explains why they are going to the public markets for fresh equity investment, even thought they had nearly $90 million of cash on hand as of Sept. 30, 2010 – roughly equivalent to the amount of private investment they have taken in over the last few years.
By way of comparison to LinkedIn, Google was a cash cow even before their stock went public. For example, in 2001, Google has revenue of $86 million and Cash Flow from Operations of $31 million, of which only $13 million had to be invested in property and equipment to support the business, with the balance invested in “short term investments.” And Google maintained its positive cash flow characteristics even as its revenue exploded to $439 million in 2002 and exceeded $1.4 billion in 2003.
While LinkedIn is probably not the next Google from an investment standpoint, I do love being a member, and its management team appears to be the bringing the same degree of thoughtfulness to stewardship of the company, as they have in the past to evolution of LinkedIn’s functionality.
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Willful Blindness – A Consultant’s Take
I read Michael Gerber’s eMyth Revisited in 2003, the same year I started my consulting practice. I felt that it gave me a roadmap to success as a consultant. The book opens by describing a woman who loves to bake, and her friends all suggest “you should be running a bakery.” So off she goes. However, she soon becomes overwhelmed by the managerial responsibilities that come with owning a bakery, taking her away from her true love and passion: baking pies.
“Simple,” I thought, “I’ll help resolve this disconnect by assisting my clients on the managerial side of the business so they can continue to ‘bake the pies.’ And there will be an educational piece to my practice too: I will teach these bakers enough about finance so they are better equipped to manage their businesses.”
But as the years have gone by, and I have gained experience as a consultant, I have come to realize there is something deficient about this model; some of my clients have a real aversion to learning how to manage the financial side of the business. Some even avoid hiring anyone to do it for them! There was the entrepreneur who did not file tax returns for numerous consecutive years, with the thin justification that these were loss years so they didn’t owe any money; but he put himself at risk of losing valuable tax-loss carry forwards. Then there was the maker of high quality organic desserts who couldn’t persuade her partner to create a “bill of materials,” and consequently did not know if some products were being sold below cost. And there have been numerous instances of people thinking about starting, or actually starting, businesses without having a clear idea of how much capital it would take them to get to positive cash flow. This systemic avoidance went well beyond what was described in eMyth.
Fortunately, Margaret Heffernan has written Willful Blindness and I believe it provides a deeper psychological/sociological explanation for why business owners are blinding themselves from the positive results of proper financial management. Figuring out whether the business is going to make a profit, what to do if it isn’t going to make a profit, where to find money to pay quarterly estimated taxes, etc. is not likely on the top of any business owners “to-do” list. Avoiding these and other similar activities for a day or a week may seem acceptable behavior, but as Heffernan writes, “All of us want to bury our heads in the sand when taxes are due, but in trying to pretend the threat doesn’t exist, and we don’t have to change, we are… trying hard to avoid conflict.”
I’ve also recently had the chance to do join up with Richard Magid and his team at Soundboard for some important client work and to witness firsthand how effective they are in the areas of coaching, training and cultural assessments. Their wide range of successful client work has made them highly sensitive to the discussions that are not taking place – but should be. If you are looking for consultants who can help get your employees more engaged, you should give them a call.
Client education will continue to be an important aspect of what I do, and I will continue to ask myself whether individual clients are truly coachable in financial literacy or not. I’m at a point when I can no longer keep my head in the sand when it comes to business owners who are not willing to get into the financials, because your business is too important not to look at the financials, and mine is too.
Tags: client education, cultural assessment, employee engagement, fear of finance, financial literacy, financial training, small business financial management