Hello,

It’s back-to-school time, but this year feels different. The kids are getting older. Zach has been done with his Master’s degree for three years now. Emma just graduated from college (congrats to her!), leaving Zoe the only one left in school in far away Tel Aviv. My stepkids are moving along, too. Jacob just started freshman year in Chicago. Since Ollie is away at a boarding school, Eleanor and I have just Ruthie--a high school senior--left at home. I’ve very much enjoyed family life for over 25 years, and next year we’ll be empty nesters. After so many years with kids at home this is hard to contemplate. But life is change, and I’m excited to see what this next phase brings.

Hoping all is well with you.

Best regards,

David

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Business Plan Teardowns: The Perfect Hiding Place

It’s easier to destroy than to create.
I’m surprising nobody when I say that typically I’m building models. Often they are used to support a capital raise. However, I also evaluate models that other people build. Sometimes these are M&A situations where I’m asked to opine on management’s model.

Certainly any model depends on assumptions, and you can degrade favorable results by dialing back the assumptions. There’s certainly some art to understanding how sensitive a model is to key assumptions, and it’s valuable to understand what minimum set of assumptions you need to believe for the business to succeed.

But some models have deeper flaws, things that go beyond assumptions. And I love finding those flaws. Lately I’ve noticed these flaws cropping up in the same conceptual space.

The perfect hiding place is where no one will think to look.
I admit that working capital is a pretty geeky topic. It doesn’t have the flash of revenue, the solidity of the cost structure, or the fundamental importance of an equity raise. Its superpower is that most people ignore it, and that makes it a great place to hide things.

Many models ignore working capital altogether. They’ll show high volumes producing lots of revenue. Maybe they’ll detail some costs and forecast a few years of EBITDA. Then they’ll ask for capital to fund the early EBITDA losses.

This wasn’t the Marakon way back when I learned about corporate finance. Marakon emphasized seeing a full balance sheet so that you can calculate cash flow. Clearly, there’s much that’s left out of a forecast that ends with EBITDA: capital expenditures and debt, for example, in addition to working capital items such as AR, AP, inventory, etc. A simplified forecast certainly can work for many asset-light businesses. If you’re running a simple SaaS business where you’re collecting payments each month, running cloud servers, and not capitalizing development costs then EBITDA looks very similar to cash flow.

People want to hide their true cash needs.
But some businesses do have complexities beyond EBITDA. And others create complexity in their plans in order to make them look better than they actually are. I’m writing this because I’ve run across a few cases recently of people hiding their cash needs by manipulating working capital.

Now, my sense is that there are limited times when you want to do this. If you’re a startup CEO raising money and you successfully pull off this ruse, then all that will happen is that a year or two down the road you’ll find that you need more money and that your investors aren’t happy about it.

But the story is different if you are selling a business and wanted to put it in a good light. Then whatever happens in two years is someone else’s problem. Hence the incentive to fudge using working capital. In other cases I’m unsure if people are even aware that they are hiding their cash needs. They get lost in the complexity of their own work. Because it gives an answer they like (Hey, we don’t need as much cash as I thought we would!) they accept it and move on.

Seeing through the ruse.
Most plans are growth plans, and typically you need to spend ahead of the curve, i.e. you have high expenses before you get the higher revenues or there’s investment required to start something new. This is uncontroversial when the subject is product development. But when the subject is scaling, often people want to wish this problem away.

Some quick definitions:
–   working capital = current assets (excluding cash) less current liabilities.
–   Classic CA items include:
–   accounts receivable (AR), i.e. the money customers owe you after you’ve
delivered but before they’ve paid and
–   inventory - the stuff you have to keep on hand before you sell it to customers
–   And for CL, let’s for now just consider accounts payable, i.e. what you owe to
your suppliers.

If you’re scaling a typical company, you expect working capital to be positive, which means you’ve created an asset which needs to be financed, commonly in a startup with equity. When I see no or negative working capital I get suspicious.

One type of working capital shenanigan involved COGS, inventory, and accounts payable. The model set forth a complicated scheme about how different percentages of the cost would be paid at different times. However, when the dust settled, the Company-to-Supplier payment stream--instead of adding to Inventory--and reducing Cash, created a current asset labeled Inventory and a current liability labeled AP. It is a fundamental misunderstanding of GAAP to have a payment to a supplier increase AP. The net impact of this was that the company had no working capital need for all its inventory.

Another scheme involved prepaid services.Here I’m broadening the definition of working capital to include a non-current liability, deferred revenue liability (DRL). If my service costs $10/month but you prepay for two years, I put $240 in cash and $240 in a DRL. The trick in the management model was to assume that customers would prepay for FOUR years in advance! Now, it all looked ok on the income statement because you just saw the $10/mo for each customer. But behind the scenes on the balance sheet it looks like the company got a zero-interest loan from its customers. And clearly this reduced the cash needed to fund the business. This was relatively easy to find since the implications of management’s assumptions were that the recurring revenue business has negative AR days of hundreds of days. In the end, we found this assumption unlikely. Even most internet companies offer two mo/year free (a 17% discount) for upfront payment for one year’s worth of service.

Bottom line: do some quick checks on working capital. At least make sure it’s positive.