Digital Capital – new accounting approach needed.

Here a true eCFO topic – accounting! Before you stop reading –  this is really important – so stay with me. I first picked up on the topic when I started working with our Facebook agency on their generic group concept.  By now we have over 1 million fans in general Facebook groups that we “rent” out to clients in order to advertise to a specific target segment. I argued back and forth with our accountant that the capital we invested is in fact not a period expense in our P&L but that we are actually building a long-term asset that should show up on our balance sheet. I lost the argument but still know that I am right – just our accountings standards have not yet caught up with the “digital revolution”. Now McKinsey seems to agree – the consultancy published a new story that focuses on “digital capital” (LINK)

In their conclusion they highlight that even though accounting has not caught up – companies need to act now and explain to investors that they are building assets even if their balance sheet does not reflect it (yet). Capital allocation needs to be quickly adjusted in almost all industries to catch up with changes brought by the rapidly developing digitalization:

“The need for growth and competitiveness will force companies to build strong digital capabilities. Viewing them as assets rather than additional areas of spending requires a new set of management and financial lenses. Embracing them is a major shift—but one worth making for companies striving to master a still-evolving landscape.”

They continue to highlight that companies really need to focus on collecting and analyzing data from their activities. The digital development combined with big-data analysis capabilities offers new business opportunities but also threatens established players that are to slow to react.

“Since identifying intangible assets is difficult, companies may be missing growth opportunities. Many have realized only recently that they can use social-media interactions with their best customers to leverage innovation efforts or that they may have unused data they could restructure into valuable big-data assets to sharpen business strategy. Similarly, companies should take stock of how digital capital they don’t own may be relevant to the business. A retailer that doesn’t have access to digital behavioral data on consumers, for example, may be at a disadvantage. So could a bank whose customers access products through a third-party platform that limits the bank’s ability to capture information.”

So what now? We need better accounting methods that reflect the real value of digital capital allocation but this is not going to happen quickly. eCFOs will need to do a much better job explaining to markets, shareholders and capital providers how they are planning to make money due to their digital capital investment. Financial statements will again become more irrelevant for company valuations and future earnings expectations.

Due diligence – what is important for digital acquisitions?

Over the last month we have supported a wide range of acquisitions in Germany with eTribes. On the one hand we have worked with our clients to identify targets on the other hand we are constantly asked to evaluate business ideas by VC/angle investors or by entrepreneurs who are looking for feedback. In addition, we also have to work with the CEOs of our equity participations to create new business models and to react to a digital environment that has really picked up speed. Through these various mandates and evaluations a range of points have come up again and again – so I am now publishing a quick summary. I am hoping that some of it will save me from hearing the same catch phrases over and over again e.g. if I had a dime  for every time a marketing plan consist of “it will go viral”  I could probably buy Apple.

Team

Probably one of the most overused catch phrases is “team is everything” but again it is absolutely true. Give me an A team with a B idea anytime over a B team with an A idea. Therefore, we pay  lot of attention to the skill set of the founds and team – are they complementary? Can they cover the entire needed range from business skills to online marketing expertise? Will they be good at sales? How do they deal with stress? How well do they talk to investors? Here, we do not only look for solid CV credentials but also talk to people they have worked with in the past to get a good understanding of the work they have done historically.

Additionally, I would argue that not only having a certain skill set is key but that implementation trumps credentials every time. What do I mean by that – some people will have worked in corporates and gained substantial experience in a field (on paper) without ever actually doing the work. Supervising an add agency that prepares an online campaign is not the same as running your own web project with a marketing campaign you have to set-up and optimize. Often people will be surprised by the difficulty that is in between theoretically understanding a concept and implementing it.

Customer Acquisition Cost

This key variable is often connected to the marketing section shown below. 9 out of 10 entrepreneurs we talk with have not thought scalability and customer acquisition cost through. Every time we are surprised by this – online business models collect an amazing amount of data and so determining a rough estimate of customer acquisition cost very early one is not very hard. How much does it take to get a customer to buy your product? How often do you need to be in contact before a purchase is made and what does each contact cost? How often will your customer come back e.g. what is your customer lifetime value? I do not expect to get a formula that is absolutely correct but I do expect the entrepreneur to have thought about this!

Marketing (Viral does not work!)

Marketing is expensive. Even in times where zalando clearly spends millions and millions on advertising most business models still think that if there product is strong enough customers will just be running through the (non existent) doors of their website. Here we most often see horribly wrong assumptions about marketing costs. These days it is incredibly hard (and expensive!!!) to differentiate yourself online and to get a customers attention long enough to place your product. There are very few viral models that have worked historically and generally these work only in the United States and not in Europe.

An accumulation of hype phrases is not a business model

Oh my – have you seen my newest mobile optimized app that through geo location really adds value in the social media space through its gaming characteristics … 🙂 Going to a digital conference and adding all the seminar titles together does not create a business. Where is the differentiating value? How do you plan to make money? How do you acquire your customers? What problem do you solve? These are questions that are not answered through hype phrases but through well thought out business plans!

Money & Billing 

So often I see entrepreneurs who sit here and tell me that they have already several very happy customers – my next questions always is: great, what is your revenue? Unbelievably enough I often get the reply: well we are using a freemium model and are not actually charging anything. If you do not value your product enough to charge money for it, why would or even should your customer value it? How honest is feedback for something you get for free? Make money right from the start – get a billing system and send out invoices!

Hockey Stick (but only in sales)

Never missing is the famous hockey stick for sales projections – customers will love the product after 6 months and make you rich. Unfortunately, lots of business plans show this trend but neglect to create a sensible cost to revenue ration. I do not believe that you can either increase revenue by 10x without hiring additional people nor do I think that additional people will not need new / bigger office space etc. Often business plans will have a strong cost /revenue correlation for 6-12 months and in month 18 show entirely surreal ratios.

Team

Is key! So here it is a second time 🙂

Google Analytics Summit Hamburg

Last week the first German Google Analytics Summit took place in Hamburg (http://www.analytics-summit.de). Certainly, a must-attend event for the online marketing crowd but for eCFOs, controller and such this event should have been a must-attend as well.

I was astonished when Moritz Habermann, senior key account manager at Google, asked whether there were any controllers present. Out of 350 attendees none raised their hand – so nobody from the financial analysis side was present. This is a huge mistake. Google is at its hard a data collection and analysis company that has many uses for financial focused employees. No longer can data sources like Google be for “marketing & sales” only. I really liked what Moritz continued to say – he mentioned the difference between financial KPIs and KPIs collected by Google Analytics and similar tools. The difference is that financial KPIs show success/failure at the end of the month/year but that non-financial data allows for day-to-day monitoring and steering of the business.

He still portrayed financial and non-financial data points as separate things but in reality they are the two sides of the same coin. It is essential to combine these data points! Google Analytics or other tools such as the Track Board from Trakken (http://www.trakken.de/) are great tools for an eCFO.  A business analyst should focus on displaying non-financial and financial KPIs in such a fashion that a business can be monitored, steered and managed by just looking at a single dashboard.

I am excited to see the next conference and I hope that more finance guys will start focusing on Google analytics and other web tools.

Preemptive obedience … or focusing on the right thing at the right time…

I just had a very interesting discussion with one of our CEOs. In essence it involved a heated debate on what to do with substantial accumulated funds of one of our portfolio businesses. Invest, save or distribute to shareholders – for me it was clear that a start-up needs to heavily invest if it sees an opportunity. Screw security, savings or distribution of returns! This often means taking on a substantial amount of risk and not focusing on those things that would be dear to a prudent eCFO. The CEO was totally surprised to hear that from me and said “that goes against everything you told us before. You made us focus on liquidity, told us we needed 3 month working capital in the bank and were not allowed to spend any money on stuff you considered not absolutely essential.”

This clearly showed me the danger of over emphasizing certain points.

Just because I firmly believe that liquidity is the one and only important measure for a start-up does not mean that once the business is generating cash it should not be re-invested. It also does not mean that I would suggest that savings and reserves should always be the right way to go. Each measure ALWAYS needs to be adopted to the environment it is applied to! Risks need to be taken once it has been sufficiently analyzed and understood – start-ups depend on the risk taking ability of its management.

For me this is an important lesson that as an eCFO you have to continuously further the education and situational awareness of your team and the people you work with. Never assume that people will understand that each measure is only applied for a certain period of a business lifecycle. It also means that I need to improve my communication in regards to a healthy balance between risky and risk adverse behavior.

Controlling – a CFOs sole purpose in life!

Controlling is a key aspect for each new venture. It starts out initially with a solid understanding of cash flows and moves across various phases as a business growths. In my experience the key aspects for each venture development stage can be summarized with the following headlines:

1. Liquidity awareness
2. Profitability measures
3. Balance sheet optimization

Each of these three steps requires different controlling techniques and management focus on various aspects of the business. As a venture develops it is not only these above mentioned points but also controlling techniques for each key business resource that will keep management busy.

Also be aware that, “measures” and “optimization” have been picked on purpose – your role as a CFO will change with each of the steps listed above. You will move from making decisions that might be bad for profitability but good for liquidity to pure financial engineering actions that will optimize your balance sheet. This also requires a move in your strategic thinking from survival (liquidity), to operations (profitability) to strategic, long-term goals (balance sheet and capital structure optimization).

eCFO Tip: Controlling is all about data ANALYSIS and FOLLOW-UP ACTION. If you cannot effectively collect, store, organize and eventually analyze data you will not be able to install effective controlling measures. Nevertheless, be mindful that all too often management will focus on the process of collecting, storing and organizing data and will forget that the key aspect is the analysis and the changes/learnings/actions you derive from it! Action trumps collection!

Liquidity awareness

As mentioned in previous posts this is a key aspect for each new venture but how do you actually make sure that you are aware of liquidity issues? Based on my experience you can do the following:

Compile a weekly Excel spreadsheet that lists all liquidity in- and outflows for the next 8 weeks. Here it does not matter if it is tax, P&L relevant or a rent deposit – any payment that comes in or goes out is traced. This will provide you with a solid understanding of when you will be running low on cash for the next two months.

This will require that either yourself or an extremely reliable employee is fully aware of all payment cycles (salaries, subscriptions, taxes, customer payment discipline etc.) in your business. It also goes beyond a simple accounting measurement since the person compiling these numbers will have to be aware of all operational aspects of your business. As your business continues to grow, it will be increasingly difficult to get every department head to provide the necessary information – make sure that you install well-thought out reporting structures early on. If people are used to providing information from the get-go, it will save you a lot of trouble later on.

eCFO Tip: Be aware of cash accounts outside of your normal banking activity. Paypal, AdWords/Sense, Affiliate accounts, Amiando, e-commerce shop accounts etc. can be a significant source or drain of cash. Make sure that each employee notifies either you or your team when a new account is created. Every account that uses cash should be treated as you would treat a regular bank account. I am sure as CFO you wouldn’t allow everyone to open a bank account by themselves – why should it be different for these accounts?

In addition, I would recommend that every serious CFO does the following to make sure that liquidity is well understood within the business:

1. Check bank balance and transactions for each account EVERY day
2. Control any payment that is made as long as the business is below a revenue of EUR500.000 p.a. / once it is above that revenue figure install a limit for each employee e.g. EUR100 per transaction which can be processed without your explicit consentJ
3. Be fully aware of every invoice that is issued and when a customer is expected to pay

eCFO Tip: I have found a range of great SAAS products that support this process. Remember it is not your job to collect, store and prepare data for an analysis – as CFO you have to act on this data! Personally, I like the functionality of:

a)    easybill.de for organizing my invoices

b)   mite.com for time tracking and budget planning

c)    highrise.com as CRM tool

Using a SAAS tool makes it fairly easy and inexpensive to keep track of your key data. Confidentiality here is also very important but in general these tools have solid user controls and are well protected from possible hacker attacks – even though there is of course the risk that your data is stored on a server that is not under your control.

Profitability measures

Once a venture has been able to either secure significant financing or cash generation has reached a point where closely monitored liquidity control is no longer a key aspect for survival, profitability moves more and more into focus. Here, it is important that the CFO fully understands all profitability enhancement techniques and makes sure that a good understanding for percentages is established. What I mean by that, is that certain key measures such as staff cost as a percentage of sales, EBIT margin, travel expenses as % of sales, etc. should always move within a certain range – once they move outside of this range you need to take corrective measures. Here a step-by-step recommendation:

1. Reduce focus on liquidity by implementing liquidity checks every other week or even every three weeks – never completely stop since your liquidity situation might change
2. Budget planning – there will be a whole additional post on this topic so I will stay brief here – you need to get a good understanding of the 12 months forecast. It does not matter if you actually hit these numbers. What does matter is that you can compare your actual vs. planned numbers and understand why they might be different. You can either go bottom-up or top-down on this forecast. Again the method is not that important – it is more important that these numbers are agreed upon by everybody who can actively influence them (top, middle management at least) and that they are regularly reviewed.
3. Check out comparable companies and talk to CFOs of larger businesses from your industry. They will have a good understanding of what these percentages should be, once the business has matured. As an example: we work a lot with service agencies and therefore our HR costs should be approximately 80-90% of all operating expenses – if we are significantly below or above we are either underpaying (never!), waste too much money (very likely!) on other expenses or something else is going wrong – now it would be the CFO’s task to find out what exactly is causing the discrepancy.
4. Make sure that you get a carefully prepared monthly P&L overview from your accountant so that you have a fairly reliable set of numbers. Make sure that you are familiar with every line item!
5. Check, check and check again – calculate some key ratios every month. Check through each statement your accountants send to you.
6. In the end profitability is simple – you need to make more money than you spend.

There are two major things you can do:

1. Earn more money (increase sales, increase prices for existing products/services and so on)
2. Spend less (do you really need: company cars, a desk, new offices, coffee maker that can make latte, Apple computers, , lawyers etc.)

ANY measure you take will either influence A or B – what you specifically do or how creative you get is up to you.

Comes back to an old CFO joke: a young CFO gets hired and the old, experienced CFO gets fired. The young gun asks the old guy: any tips? The old guy gives him three letters and tells him to open each letter if the business is performing really badly and he is suffering. So time goes on and things don’t go well. The young guy opens the first letter: It says “increase sales” and the young guy goes out and does everything in his power to pump up sales – nothing works. He opens the second letter – it says “cut costs” so he cut costs like Warren Buffet himself and cuts and cuts and cuts – no success. So he decides to open the last letter. It says: write three letters!

eCFO Tip: Don’t have blind trust in your accountants – meet them at least every two months and explain your business model, each large project and what you do – only if you do that  will they be able to prepare correct statements. They are not part of your business – especially if you work on innovative projects or in new technologies such as Facebook, Google etc. Therefore, they will not have a strong operational understanding.

I had a long chat with our accountant about Facebook fans we acquired in our internal, generic Facebook groups for later advertising purposes. The question was, whether this wasa pure operating expense or were we actually generating lasting value that should be depreciated over time – there is no rule, no case study and no exact guideline for this. Nevertheless, if your accountant understands the concept she can apply “old” rules to “new” technologies and that might be very positive for your business.

Also make sure that you do not only talk with the head of the company or some senior members –training and discussion should be aimed towards the employees/accountants who actually work with your numbers every day. They are the ones who make the decision how something should be booked in the first place – so they need to be informed first.

Balance sheet optimization

By now you should be feeling pretty good about yourself. You have conquered liquidity problems and you are running a highly profitable business. Now it’s time for the real CFO stuff – balance sheet optimization and financial engineering. Before you call Goldman Sachs and invest into derivative products I would recommend that you fully understand what you are trying to achieve – you have probably gone for the low hanging fruits of liquidity and profitability with nothing more in mind than survival and solid operational goals.

Balance sheet optimization is far more strategic. There is no right or wrong answer to: “What should my optimal capital structure be?” “Which assets should I show on my balance sheet?” “Equity vs. assets vs. liability ratio analysis.” “Should I lease all my equipment or buy?” “Rent or build office space?” In order to be good at this you need at least a strong three-year strategy that guides your action – do you want to increase your debt level, sell the business, acquire other businesses etc. These are all questions that will determine how your balance sheet should be build. Remember that all the financial engineering is not worth anything, if it does not lead towards a specific goal.