Stan Leopard's Notebook

Economic Forces Look Choppy Ahead

In my view, global economic drifts are currently being shaped primarily by 3 situations:

• US GDP growth is close to stall speed, and Current US policies are not pro growth (GDP growth: 2011 1.7%, 2012 YTD 1.75%)
• China's slowing growth (year over year June 7.6%, lowest growth since 2009)
• The Euro zone challenges, particularly Spain and Italy, producing a breakdown in the Euro

I am an optimist. I think the coming US election will improve policies. I think the Euro zone will continue to muddle through. I think China will navigate its economic transition and at a minimum stay above stall speed.

 However, I anticipate the real economy (the one we operate our businesses in vs. the stock market) can do no better than remain just above stall speed for about another 12 months. Additionally there's a more than nominal a risk of falling below stall speed triggered by one or more of...

• Euro zone chaos
• China's failure to manage a smooth transition from decades of high growth to slower or negative real growth (real growth is nominal growth minus inflation)
• Military conflict with Iran
• US failure to sufficiently deal with its increasing fiscal pressures
• Another unspecified Black Swan

If you share my view, you will see this as a time to be very conservative in business and capital strategies. Some ideas that come to mind...

• Minimize or eliminate short-term and/or variable rate debt
• Minimize inventory levels
• Reduce receivable days outstanding
• Adjust staffing to be at or even slightly below what you think you must have
• Focus on new offers, practices, narratives and strategies that produce competitive advantages for your enterprise
• Dialogue with your trusted advisors on your specific situation
• Execute sales agreements with your customers through at least mid-2013 if possible
• Keep commitments to your suppliers short-term

Turbulence is life force. It is opportunity. Let's love turbulence and use it for change. Ramsey Clark

I continue to anticipate a period of great opportunity (US) for knowledgeable business owners who are situated to move with the positive forces. Now is a time to be as prudent as you can be to preserve and, if possible, increase power.

Supported by my key advisors, I will be dialoguing with those in our configuration on the coming Joseki View conference call–our periodic practice of reading the world, or anticipating the drifts of the key forces of economics, politics, technology, demographics and competition we see most consequential for private enterprises.

Related Posts

This is a Time to be On the Numbers

Anticipating the Coming Expansion

Photo: Flickr User/finalRiddler

How do You Think About Risk?

Dealing effectively with risks–anticipating, managing and avoiding risks–is a key element of the CEO's role. When/if you have investors or outside board members, they normally share the risk management responsibility. However, if potential investors and key allies judge you incompetent or unreliable at risk management, they are unlikely to join your configuration. 

The capacity to recover from negative consequences is correlated to the power and resources of the enterprise–the less robust the enterprise, the greater the danger posed by risks. In my experience, risk management can be a very challenging domain for entrepreneurs. Without some tolerance for risk, ambiguity and uncertainty you would never have launched the enterprise you now lead. Usually the CEO is the chief promoter of the company, and developing rigorous narratives of risks differs from developing narratives of strengths and opportunity.

What is Risk?

Risk comes from not knowing what you are doing.  Warren Buffet

I remember Warren saying at one of the annual Berkshire meetings, "If you're writing insurance and you don't know what you're doing, you can be in a rowboat in the North Atlantic and customers will find you."

Risk is an assessment or interpretation we make in a domain of concern or action. Risks are situations–present or anticipated, that threaten accomplishment of your ambitions and intentions; risks are sources of harm and/or thwarted intention.

As an investor, I seek to develop 3 key narratives regarding risk:

• People: 
  • Is the CEO sufficiently capable and trustworthy to source and lead a team and culture to compete successfully in the marketplace?
  • Are any other key individuals–executives, investors, founders, etc.–sufficiently capable and trustworthy to follow, contribute and do their best to have the enterprise succeed? (I am always surprised to find key individuals with much to gain from the success of the business acting in ways that thwart the CEO, the strategy and the operating plan.)
• The industry or market:
  • What interpretation of the forces of the industry do I accept?
  • Does the CEO have a market analysis?
  • What is the market in which the company can be a leader?
  • What is the company's competitive advantage in this market?
  • How stable and robust is this competitive advantage?
• The investment:
  • Does the pre-money valuation compensate me for the risks I assess?
  • How and when will I get my capital back?
  • Do I accept the narrative of how the company will increase value? Is the narrative complete, or is it high concept?
  • What help does the CEO have to develop the enterprise? Do I assess this configuration as sufficient and satisfactory?

Other Sources of Risk

A post by Tom Tunguz of Redpoint Ventures specified 11 risks VCs evaluate. I think he's speaking to start-ups, however, for the established private company, I highlight these:

Business model risk –Is there a clear business model? Do the unit economics seem to work? If not, what are the assumptions required to achieve [maintain] profitability?

Execution risk – Does the team have the right skills and passion to reach their goals? If not, are they amenable to finding others to complement their skills?

Capitalization structure risk – Does the company have enough room in the cap table to take more investment necessary to grow while still ensuring employees and executives are well compensated?

Legal risk – Does the company have a high likelihood or lawsuit for patent or copyright infringement? Does the company have outstanding complaints with early employees or founders? Are their regulatory challenges involved in this sector?

A Practice for Risk Assessment

If you're thinking of raising outside capital, or just intrigued by reflecting on risks, I recommend a project for assessing your business as a prospective investor would. I suggest the criteria and standards for assessing a business specified in Venture Investing by David and Laura Gladstone.

Relevant Prior Posts

Attend to the Details

 Good Thinking is Real Work

Photo Credit: Flicr user/Kristen Becker

Do You Pay Yourself at Market?

If you own all or most of your company, it's easy to think, "What's the big deal? At the end of the day whatever the business produces is mine."

You are both an executive and investor in your enterprise. Compensating yourself at a rate other than market–pay based on the role you hold, the skills you have and the marketplace you're in–sets up several breakdowns, both for you and for the business. 

Design the Enterprise as an Investor

How you think about your compensation affects how you think about the compensation of others. Reflect on your actions to reveal your philosophy. Given that compensation has a significant impact on the organization, know and be consistent with a philosophy and practices for designing compensation. My philosophy: pay base salaries slightly above market median and provide strong rewards for performance above standard, at both the individual and team levels; share company successes broadly in some manner. When we win, we win together. Establish and build a culture that provides satisfaction beyond the financial domain.

When you aren't rigorous in making assessments of the market value of your expertise for your present situation, it's unlikely you will be rigorous in making these assessments of others. Overpaying is a negative for investors, as excess returns to management come at the cost of returns to investors. Excess compensation produces a culture of entitlement and resentment. Underpaying also produces resentment, at least from top performers, and increases the likelihood of a culture of incompetence, dissatisfaction and higher turnover. In a competitive marketplace we compete for employees just as we compete for customers. A driver of Apple's success is their commitment to positioning "A" players only for to key roles and teams.

An Approach to Designing Management Compensation

• Constitute your philosophy for compensation. You can get help from other CEOs, your board, and your network of professional help. Do not hire compensation consultants–the incentives are misaligned.
• Develop a standard practice to determine the base salary range for each role in your market and for the size of your company. Possible resources include your CPA, industry and geographic compensation surveys, and professional investors in your space. This practice is then performed periodically to keep your knowledge of compensation aligned with market changes.
• Rigorously specify what results are specific to each role. What are the outcomes that each individual or team produces? Specify the standards for acceptable performance. Reward performance exceeding satisfaction. A starting place is the individual/team gets 10% to 20% of the results produced beyond standard. 
• If you have a board or investor as a customer for your performance, establish your own compensation to be base plus performance bonus as well. If you are your own customer, have only a base salary for yourself, closer to the top of the range.
• Constitute a minimum profit standard for the enterprise. Share profits achieved above this standard. 10% of excess profits is a starting point.
• Design all performance rewards and profit sharing to have a 3 year time horizon. Rewarding annually provides incentives to "game" the system.
• Adjust base salaries up or down as the market changes. Success with this practice requires it be part of your culture and you make your team aware of the philosophy when they join and ongoingly. The fact is no single company can stand against the marketplace. To be effective, strategic and competitive we must always be responding to market forces, adjusting our design as these forces change.

Different companies have fundamentally different cultures. In some situations everyone employed may be a real team member (this is often the case in very small enterprises and professional service firms. In others, there are builders and mercenaries. I prefer (where possible) to work to have an enterprise where everyone is committed to our competing successfully to fulfill our mission. However, I have learned to be rigorous in making these interpretations. If you have mercenaries or laborers, design their compensation appropriate to their roles.

If you pick the right people, give them the opportunity to spread their wings and put compensation as a carrier behind it, you almost don't have to manage them.  Jack Welch

There's more to culture than compensation, and we must always do our best to have compensation fit our environment and mission. One of the 10 fundamentals of economics is that people respond to incentives. Though fraught with a myriad of negative consequences when badly designed, compensation is a very powerful incentive. 

Other Resources

How Much Should you Pay Yourself? Entrepreneur April 18. 2012

 Relevant Prior Posts

A Firm's Culture is an Essential Element for Success

Good Thinking is Real Work

This is a Time to be "On the Numbers"

Image credit: iStockphoto/tattywelshie

Reconstitute To Return to Profitability

When we are ready to act to stop losses, we are thrown to think about cutting expenses. In this post I offer an alternative I see is more powerful for restoring profitability–one that can produce benefit from having encountered losses.

Profits are the lifeblood of the enterprise, and are especially critical to the small to medium private company. Profits provide growth capital as well as power for the business to survive the unanticipated, unavoidable breakdowns that are inherent in the nature of building companies.

Once we emerge from the start-up phase–that period where we're evolving our core offer, producing the organization and getting to breakeven–it is essential to sustain or recover profitability. Every month. Every quarter. Every year.

I don't want to do business with those who don't make a profit, because they can't give the best service.  Richard Bach

The natural pattern of behavior for us as CEOs when we begin to lose money includes...

• Assuming its a one month aberration
• Finding ourselves in the narrative that we can't afford to reduce expenses
• Being upset at external causes–customers, the economy, competitors, etc.
• Being pulled to take care of the individuals who are part of our organization
• Being stopped from acting by our negative moods
• "Hoping" that revenues will increase to return us to profitability
• Avoiding taking action

The 5 stages of grief articulated by Elizabeth Kubler-Ross come to mind...

• Denial
• Anger
• Bargaining
• Depression
• Acceptance

When we do act–usually after several months of losses and when all other options are exhausted–most of us think about what expenses we can cut and what individuals we can layoff. We focus on the current design of commitments as the starting point for our response. 

A More Effective Response

Making profits is a fundamental and essential purpose of a business and one of the commitments of the role of CEO. When we anticipate or experience breaking even or losing money, it is a call to immediate action–to notice, observe and assess the cause. Sometimes a loss in one month has a unique cause that will not recur, however, this is the anomaly rather than the norm. Most often a loss reveals a change in market conditions that must be addressed.

Think about what you would do to recover profitability. The normal response is to think about cutting expenses. We look at the present set of expenses we have and ask, "Which of these can I reduce or eliminate"? This approach constrains our thinking inside the structure of commitments that have evolved for the roles and other committed expenses of our business. Many people think in terms of fixed expenses, forgetting that all expenses are commitments which can be stopped or modified. Of course some commitments take more work and time to change than others, such as moving facilities, but all expenses are just commitments and we can make different ones for a different situation.

My strategy for returning a business to profitability:

• Accept the situation immediately and design, prepare to act and act to restore profitability; move with alacrity; take care of your mood and your team's
• Assess anticipated future revenues you are confident of and total funds available after external expenditures such as materials or external services) ; this is the amount you have to spend on production, sales, G&A, and other costs
• Draw or write the current structure of financial commitments–staff, rents, outside services, professional fees, etc.; work to see the commitments as an integrated whole rather than in divisions such as departments or functions
• Look for waste or opportunities for decreased costs in the current design, calculate the gain from eliminating expenses you now say are unnecessary
• If this does not produce satisfactory profitability, analyze the costs you can afford for the level of future revenues you are confident you can produce to produce a minimum level of profitability (I recommend never lower then 5%)
• With this budget for all committed expenses, produce a new organizational design that you can accomplish with this budget; think about roles rather than current individuals; design the workflows required to sell and produce your offers
• Refine and evolve this design at least once after completion (in another design session with your key team)
• Design and craft the narrative for the organization of why we must take this action to cope with the threats, fulfill the obligations and exploit the opportunities of our present situation, and what new situation we are committed to producing
• Act with maximum velocity to implement and settle the organization in the new design

Embrace a Philosophy of Profitability

I never lost money by turning a profit.  Bernard Baruch

Profits are a derivative of revenues, minus costs and expenses. We manage those elements to produce profitability. I hear people speak of profits like they just happen, like the weather. Without profits a business is weak, vulnerable and losing power. The "game" of business is to produce, maintain and increase power, and business power is best assessed by net cash flow produced. 

I learned to continuously design the business with a commitment to a percentage of profitability. Over my career I have learned to enter or remain in businesses where I can commit to and produce a net operating margin of at least 10%. The higher net operating margin we can produce, the more valuable the enterprise. A businesses with higher profit margins commands higher premiums or multiples of earnings when raising capital or monetizing.

Related Posts

Produce a Profit Every Month 

Attend to the Details

Image Credit: Flicr user/stevendepolo

This is a Time to be "On the Numbers"

The global economic drift has increased in volatility during the past month. Greece appears to be in denial about an inevitabile reduction in it's government size, entitlement culture and restoration of integrity to it's marketplace. I anticipate widespread consequences if Greece leaves the Euro (I personally hold as the most likely outcome), specifically severe tightening of capital availability in Europe with moderate tightening in the U.S. The other major factor I see affecting global economic growth is a slowing of China's economy. While we can't trust that we have complete information as China does not have a free press, data does indicate deceleration in several sectors of the economy. Additionally, this week's U.S. tariff on Chinese solar panels could be the beginning of trade skirmishes between the U.S. and China. China contributes approximately 31% to global economic growth for the past year. A significant decrease in Chinese economic growth, coupled with the Eurozone's current disruptions, will likely cause U.S. economic growth to slow and global growth to possibly go negative.

What Does This Mean for a Private Enterprise

I learned to specify a P & L framework for my business as one of the fundamental constitutive declarations. For example:

Net Revenues                              100%

Costs of Fulfillment (CoGS)            50%

Gross Margin                                 50%

Marketing & Sales                          15%

Offer (Product) Development          10%

G&A                                                8%

Enterprise Development                  2%

Net Operating Income                    15%

First specify NOI, and then design the remainder of the P & L structure to produce that NOI. This is essential. If we do not have an intention for profit at a specified level, we will never be profitable to that level. A key commitment for the CEO is to hold the profit intention, and to always be designing and acting to produce and maintain the committed NOI. I have advised several dozen companies for over 25 years, and I continuously find that a firm commitment to achieving and sustaining a the specified profit level is missing in the constitution of the enterprise.

It's easy to justify to losses, but losses can never be sustained without sufficient capital to fund them. We tell ourselves we can't afford to lose any of the capabilities we currently have. We tell ourselves that we're going to get that big order that will return us to profitability. We tell ourselves that the costs of reducing expenses are greater than the benefit. If you're losing money, what narrative do you have to justify its continuation? How well grounded is this narrative? For example, what is the source of capital to fund the losses and is it available at satisfactory costs for ample time to invest through losses and remain viable? Running a loss intentionally is sometimes a necessary strategy. However, the money-losing enterprise is fragile and becomes increasingly more vulnerable to negative perturbations the scarcer capital becomes.

When capital tightens, private companies have decreased access to capital other than what they internally generate. Every dollar of losses is a dollar of capital that must be replaced from some other source. Every dollar of (after-tax) profit is a dollar of additional capital to be utilized to to increase enterprise value. 15% NOI will fund enterprise growth of slightly better than 20% annually. 

Possible New Actions

To be prepared for a tightening in capital availability, I suggest:

• Review/refine your company values to make profitability a value if it isn't currently; profits are required to produce increases in capital which are required for growth and enhanced stability
• Specify or refine your intended P & L structure for your company; communicate the commitment to your team and throughout the company
• Assess the current committed expenses and redesign as required to have a level of committed expenses with which you can produce the revenues to meet the NOI commitment every month; organize production/fulfillment to scale with temporary costs for revenues in excess of the baseline
• Review current external capital sources to assess continued availability and stability of costs of capital; constitute strategies to strengthen the capital structures as required for competing in a more volatile marketplace
• Assess your practices for communicating and continually seducing any external capital sources, e.g. your bank(s), investors, etc.
• Review/revise your vendor terms to match payments to vendors with payments from customers as best you can; I have always worked with my suppliers to create being connected in the production system to serve our mutual customer

Although I think this is a time to be very prudent in managing a private company, I remain optimistic about the U.S. turning away from the fiscal cliff that looms ahead. I've spoken to may people in my network recently who think we will not stop before we "hit the wall". I currently foresee the probability of a shift to policies supporting growth at around 50%. I remain pragmatically optimistic about our future.

Related Posts

Produce a Profit Every Month

 

Anticipating the Coming Expansion

 

I invite your comments and questions.

Photo Credit: Flicr User Ambersky235

Produce and Maintain a Margin of Safety

My major learning from attending the Berkshire Hathaway annual meeting this weekend was a new insight on the significant value of focusing on a margin of safety in all forms of investing. I give great thanks to Warren Buffet and Charlie Munger for generously sharing their interpretations and philosophies. Their fundamental thinking on investing and producing returns is relevant and valuable for those of us working to produce, maintain and increase enterprise value in private companies.

I heard Warren's philosophy of always having a margin of safety newly, and see the importance of this commitment in our work.

I've never believed in risking what my family and friends have and need for that which they don't have and don't need.

Warren Buffet

Margin of safety is a distinction from Graham and Dodd's Security Analysis–first published in 1934. The term means the difference between the intrinsic value of an investment and it's price. Graham and Dodd were writing about the purchase of securities in the public market. When we make new commitments in any of the capital structures of the enterprise we can act to maintain or increase our margin of safety. From the learning this weekend, I intend to have a satisfactory answer to the question, "Is there sufficient margin of safety", for all new significant and/or long-term commitments in our enterprise. 

Some ideas for each of the 5 fundamental capital structures:

Human Capital

• Work to increase staff capability and improve practices to maintain and increase your margin of safety
• Add staff only when there is a satisfactory return on costs
• Consider the all-in costs of new staff (training, selection, management, effects on current staff, etc.) when analyzing hiring vs. alternatives
• Make periodic well-grounded assessments of the value of each staff member and team, and ensure they are appropriately compensated
• Design compensation systems that reward adding long-term value to the enterprise 

Operating Capital

• Use leverage (debt) sparingly, if at all
• Know the cost of debt over a 5 year time horizon and consider the effects on the economic returns of the business to owners
• Secure fixed rates and repayment terms that provide a margin of safety sufficient to withstand negative/unfavorable conditions
• Consider a range of scenarios, including everything that can go wrong and how you can respond
• Do not tolerate operating losses; commit to producing profits every month

Capital Equipment

• Fully consider margin of safety in selecting vendors, an item's capabilities and specific selection; often the best investment is not the lowest price
• Think about the whole enterprise and processes; reconfigure to make new equipment acquisition unnecessary and to maximize returns on new investments 

Capital Inventories

• Have rigorous assessments of the current marginal utilities of your offers
• Constitute and continuously improve practices for designing and executing new products and services with high marginal utility
• Increase your firm's value to customers and your network in ways that increase your intrinsic value and thereby your margin of safety

Financial Capital

• Have a rigorous assessment of the intrinsic value of your enterprise; do not entertain fantasies in this domain
• Work to produce a surplus so the enterprise can acquire products, services and/or other businesses to build intrinsic value
• Only use your equity (acquisitions, capital raises, etc.) when you are receiving commensurate or better value
• Do not have stock options; these are always sales of small parts of the enterprise at less than full value; there are less costly and more effective ways to reward staff
• Do not grant streategy-setting authority to people not fully at-risk with you

 

We are business owners in order to fulfill our ultimate ambition to earn, save and invest enough to survive, be free and live a good life during our working career and the years of old age. We accomplish this ultimate ambition by fulfilling strategic objectives to create superior value and competitive advantages. We reduce our probabilities of failure by creating and sustaining a margin of safety in our enterprises. Buffet's first rule of investing–don't lose capital. Producing, maintaining and increasing our margin of safety applies to both our human and financial capital.

 

Recommended

 

Buffet discusses how to think about intrinsic value in the Berhshire Hathaway Owner's Manual. 

Related post: Attend to the Details

Image: Diesel e-Books

What is your Company Worth?

A private company has different values in different situations and for different purposes. I often hear value spoken of as if it's an assertion, or a fact, and that there is "a" value for a business. We say that enterprise value is an assessment–an interpretation made by an observer for the purpose of action–based on the concerns and background relevant to the investor. Different investors will assess different values for an enterprise based on their situation and strategies. Strategic investors are working to execute or improve their strategies, and to make new strategies possible. Financial investors are concerned with producing satisfactory monetary returns. Regardless of the concerns of the investor, the greater the owner earnings or free cash flow the business can produce in the future, the greater its value. When you think about a capital transaction for your business, start with the purpose and the ultimate outcome(s) you're committed to producing.

What is your purpose?

Assessments about enterprise value and the structure of a transaction depend on the purpose or objective. Is your purpose to...

• Monetize the value of the enterprise to have capital for another purpose, such as retirement or starting a new business?
• Strengthen the capital structure in order to reduce risk?
• Have financial capital to fund losses to be incurred in designing and preparing new offers?
• Have financial capital to fund growth beyond what profits support?
• Have financial capital to acquire another business or strategic assets?
• Gain strategic help required to build a significantly more valuable enterprise?
• Replace existing owners?

What is the best strategy?

 

The best strategy depends on purpose. My examples above represent three general purposes:

1. Growing the enterprise is ways in which you and your team are competent and able to accomplish
2. Adding expertise, network and money to the configuration in order to grow--in ways that are sufficiently greater than what's possible with the present constitution
3. Moving into the endgame of transitioning the business to new ownership

Having experience in all of these categories, both as entrepreneurs and investors, we find #2 above–adding expertise, networks and money–offers the greatest space of possibilities for creating extraordinary outcomes. This has resulted in our business strategy to invest our expertise, networks and money in those situations we encounter where we think that with our help the enterprise can shift to new strategies and operational structures that enable and produce an acceleration of growth such that a value 10X today's value is possible in a decade or less. 

Many entrepreneurs/business owners we encounter prefer the whole grape to a slice of the watermelon. It seems that one of their fundamental criteria for the constitution of their enterprise is that they rule absolutely. There's absolutely nothing wrong with that. I advise that you be clear about your ambition, and mindful that your choices of strategies and tactics are coherent with that ambition. As an entrepreneur, I have sought out powerful investors, advisors and mentors because to me that is the most powerful strategy for fulfilling my ambition. I perform best when I have powerful others to think with, to satisfy and to let me know when my thinking is incoherent, non-competitive or unworkable given the limitations and constraints of the present situation.

How do you select a strategic investor?

To produce a strategic partner to accelerate your firm's mission or constitute a more powerful mission, I recommend you think through your current situation and your criteria and standards for a partner before engaging in dialogue. Consider...

• What are your personal lifestyle, financial and business ambitions?
• What is the time horizon for accomplishing your ambitions?
• Are you on track with the configuration and constitution of the enterprise as it exists today?
• If you are on track, what would a partner need to provide to be worth making the connection?
• If you're not on track, what would a partner need to provide to be worth making the connection?
• How will you assess the trustworthiness and value of potential partners? 
• If you assess you can trust a prospective partner, and they bring the required resources, are you willing to give up (if applicable) sole control?

These last two questions are the most important. If you require strategic help, the best evidence for someone's trustworthiness and value is their past accomplishments. This is the criteria we use and what we recommend. We see that accomplishing extraordinary results requires a powerful configuration. We have succeeded thus far by being clear on our objectives and joining with others to produce powerful networks.

Image: iStockphoto/ymgerman

Produce a Profit Every Month

One of the basics I learned from my first mentor early was that in order to be profitable for the year, one must be profitable every month. Profitability is a fundamental element in my business philosophy. Profitability is the lifeblood of business–for every month we run a loss, we lose a degree of our freedom; for every month we run a loss we lose a multiple of that loss in our wealth.

I've found that without a commitment to monthly profitability, most businesses will perform far below their potential. Was I profitable every month? No, but I was continuously learning, designing and reorganizing to be profitable every month. Velocity in acting to achieve, restore and sustain profitability has a high return on investment.

What is Profitability?

In our businesses we are committed to economic profits–a surplus of revenues over expenses including accounting for the market rate for owners' compensation (whether being paid current or not) and for returns on invested capital. Many business owners I've encountered fail to distinguish between accounting profits and economic profits. Accounting profits are the surplus of revenues over expenses based on the book entries of revenues, costs and expenses, usually without accruing for any portion of owner compensation unpaid or for return on capital.

The greater the economic profits of a business, the greater the enterprise value.

How to Produce Profits

If you choose to commit to economic profitability, practices I've found useful include:

• Have management financial statements prepared and available for review by the 5th business day of each month (or sooner). The standard for management accounting is not absolute accuracy (often the accounting profession standard), but rather sufficiently accurate that management can make assessments to determine performance to minimum profitability standards and to the Operating Plan. I prefer some data in this report be presented graphically.
• Design the committed expenses to be at a level you are confident enable you to produce at least a break-even result, on an economic profits basis, each month. This begins with assessing the minimum revenue level you will commit to produce in the lowest month, then working with your team to invent a structure for fulfilling that level of revenues which allows the company to be viable. Start with a blank sheet and work with all expenses–including costs of goods sold, owners' compensation and return on capital–until you achieve a design that works. There are no "fixed expenses", meaning every expense is a commitment and you can reconstitute to achieve profitability.
• Design for fulfilling revenue beyond the minimum level with costs that are fully variable. I advise no committed, ongoing expenses other than what the business can afford in the minimum month.
• Review performance with your team every month early enough to modify practices to adjust to new interpretations, such as an increase in what we say is the minimum revenue we can produce, or new practices we produce to operate with greater efficiency and/or effectiveness.
• Share the game of profitability and the monthly results, in an appropriate form, with the entire company. Speak about your philosophy of profitability and why it's important to everyone in the company. Design and craft this business narrative to be complete and meaningful to everyone involved–staff, suppliers, advisors and other stakeholders who affect revenues and expenses.

Involve Everyone (appropriately)

If you've never read Jack Stack's The Great Game of Business, I recommend it for practical suggestions on involving the entire company in the "game" of building enterprise value. Stack is a successful practitioner of business, not merely a consultant/writer.

You may have and encounter many objections to this posture if it's new for you and your organization. Develop and continuously deepen your thinking and writing on the benefits gained from an absolute commitment to profitability. Your narrative about the importance, utility and worth of profitability makes fulfilling the commitment possible.

Why Consistent Profitability is Essential

Economic profitability gives an enterprise its value and freedom. We are all working to produce our survival (being able to transact for life's essentials), our freedom (capacity for choices such as not having bad customers or investing in new ideas) and our ability to live a good life. Companies that are robust are more satisfactory places to work, and have an increased space of possibilities for succeeding. It's extremely difficult, if not impossible, to create and innovate in survival. The discourse of business we study and practice emphasizes knowing your numbers, that is how much money you need to earn, save and invest to survive, be free and live a good life during your career and the 20-30 years of old age.

If you lose $100 thousand and the business earns 10% net pre-tax on revenues, it requires $1 million in additional revenues to recover the $100 thousand. Every month of losses has negative consequences for the present and the future.

If your goal is anything but profitability – if it's to be big, or to grow fast, or to become a technology leader – you'll hit problems.

Michael Porter

Image: iStockphoto/sodafish

Book: Seth Godin's Survival is Not Enough

One of the things Jeff and I say to our colleagues and followers is "The rules have changed." We see that to perform effectively, strategically and competitively in today's highly competitive and rapidly changing global marketplace we must be continuously learning strategic knowledge to better design and execute offers, practices and strategies that provide the best value we're capable of to our customers, employees, colleagues and networks.

I recently read Seth Godin's Survival is Not Enough: Zooming, Evolution and the Future of Your Company. Seth's writing, in his blog posts and books I've read, often provokes my thinking about refining enterprise design for increased effectiveness in our fast-changing world. We have prepared a book review that's a more complete description. If you are intrigued, I recommend you buy the book and read it. It offers fundamental thinking that's as sound today as when it was published in 2001.

In our reading and dialogue on Survival we focused on culture and capital assets as the two key domains in which to learn and increase our capabilities for acting with our enterprises.

Work to build a culture that's nimble, that's prepared to deal with the unexpected, that tolerates failure. Design projects and plans so that failures that do occur happen at non-catestrophic levels of investment. Increase the organizational learning that occurs between individuals in the same roles, such as your sales people, and between different functional units of the company, such as engineering and sales.

In not one of the presentations [for VC investment] has the entrepreneur walked in and said: "We've got really smart people, an excellent attitude and an organization that's designed to evolve and change.  We're not sure what the future brings, but we are sure that we've got the fast feedback loops and bias to evolve that we'll need to stay ahead of the competition."

Practice fast feedback and refinement. Continuously test, measure and implement. Launch new offers, practices and strategies with velocity and with just enough design, crafting and preparation. Don't work to have perfection in the plan, but rather start executing as soon as you're sufficiently prepared to not break trust. Design and refine more frequently to increase and sustain competitive advantages.

So what separated Sam Walton from the thousands of other people who opened little hardware stores in overlooked towns all over the country? One principle. Sam was obsessed with testing, measuring and implementing. He organized to evolve. Every day (sometimes every hour) Sam would try something new. He'd gather every bit of data he could about the test and then test something else. By testing and measuring, Sam discovered a pricing strategy that still works. By testing and measuring, Sam discovered a store location strategy that still works. Walmart now has a database with more than a billion [this was 2001] items of information in it. They've used it, for example, to discover that people who buy bananas frequently buy milk. By putting a display of high-profit bananas near the milk, they dramatically increased banana sales (and profit). For twenty years, Sam Walton tested and measured (then implemented) every principle he could. He built open systems that let his suppliers do the same thing. More than 98 percent of the items in a Walmart never see the inside of a Walmart warehouse. They go straight from the manufacturer to the store.

We see that our criteria and standards for making new capital expenditures must be nimble. There are many new offers in the marketplace for elements of design, for production, etc. We're becoming aware of resources we can utilize at far lower costs that internal investments.

Do we still need factories? Of course we do. How else are we going to make all this stuff. My point is that while the world still needs factories, that doesn't mean you have to own them. Owning a factory will probably become a profitable niche business, a way to make a nice living. But fast-moving, high-growth, zooming companies don't need to own them. Because factories are no longer local, because the ultimate provider is no longer the manufacturer, the model that was factory-centric is dead. Being factory-centric doesn't increase your profits, it decreases them. Being factory-centric doesn't decrease your time to market, it increases it.

Let me know what new actions you take. We accumulate new capacities to think and act in action, not by merely reading.

 Image: Flickr User/emmma peel

Our 2012 Anticipations for Refining Strategies

A key practice in our firm is to regularly utilize current data and the views of experts we respect on economics, politics, technology and demographics to think about what important shifts or new situations we can anticipate. We then think through how the changes we anticipate are relevant, meaningful and valuable to the small to medium private enterprises in our network and/or portfolio. 

Three times annually we produce The Joseki View, a participatory conference call, to present and dialogue on how to reassess and refine key strategies and plans taking into account the new realities we anticipate. Our most recent edition focused on the 2012 US economic outlook. Several CEOs and business owners reported they used the thinking generated by this call to make strategic choices that decreased current risk and will likely add to profitability for 2012.

The key claims from our recent Joseki View (information on receiving complete Notes & Guidance at the end of this post):

• We anticipate 2012 real growth for the US economy at 2% to 2.5%, exceeding the 1.7% of 2011. Our 2011 forecast for growth of 1.5% to 2%, below most other forecasters by 1% or more, turned out to be accurate.
• The US economy faces significant barriers to growth: monetary, fiscal, regulatory and tax policies.
• Fixed residential investment as a percentage of GDP is approximately 2%–the lowest lever since record keeping began in 1963. The economy cannot produce robust growth until residential investment returns to normal levels.
• Our forecast is a 60% to 80% liklihood of 2012 inflation above 3%, reaching 4% by Q1 2013. The opposing outlier possibilities of deflatiion or double digit inflation are higher than normal (in the range of 10% to 20%). These volatile times make long-term commitments of capital, debt or equity, an action to consider rigorously and prudently.
• We anticipate 3 major issues will determine the outcomes of the 2012 US elections:
  • A referendum on the view that deficit financed stimulus spending creates jobs and increases output
  • Taxes on "the rich"
  • Continued money printing by the Federal Reserve
• We anticipate that Republicans will retain control of the House, gain control of the Senate, and have the majority in states, both governorships and state houses. We are not confident in the outcome of the Presidential election.
• On "Obamacare", an area of immense impact to private enterprises, we anticipate the Supreme Court (hearing the case starting this week) will strike the Individual Mandate, which will cause guaranteed issue and community rating provisions to fall as well, and that the rest of the law will survive.

In addition to speaking about these claims in depth, we offered guidance and dialogued with participants on thinking about strategy for their enterprises in light of these possibilities. By the way, I use possibilities because I am clear that none of us "knows" the future. Ido know that the more skillfully we can anticipate shift in the marketplace forces (demographics, technology, politics and economics), the more successful we can be in designing and crafting competitive strategy. I never forget that there are literally billions of people in the world working constantly to best us in our industries and markets.

I have consolidated the offer of a complimentary copy of The Joseki View Notes & Guidance from our most recent call with an email subscription to the blog, notifications of new editions of The Joseki View and occasional other updates.  Please refer to the offer section sidebar at right of Stan Leopard's Notebook. 

As always, I welcome your comments and questions.

Image: iStockphoto/alexsl