The less-known entrepreneur

Some musings about how to setup the financial structure between the “business” and the family finances, from somebody in the fray:

It’s helpful to set up a “business only” checking account (it’s free at my bank) to which I receive payments and pay business expenses.  I also pay myself monthly (to my other, personal account), but could use whatever frequency works best. That way I have some analytical source-documents to see how well the business is doing (and show the accountant/taxman as appropriate)…

I also only pay for business expense with the “business only” debit card – the one that’s funded by the “business only” checking account – it helps keeping a paper trail of expenses that my accounting solution can import easily (read: electronically), reducing data entry time, error risk, and source-document management effort.

Sometimes, due to cash flow and additional services considerations*, I pay for certain business expenses with my credit card (I only have one) – I pay the business expense on the card right away, even when I carry a balance on the “personal side” (which I try to avoid).

* Most credit cards have automatic insurance coverage on travel, rentals, and big ticket expenses, as well as other benefits. My MasterCard already saved me a bunch on a vehicular accident in which I was involved while driving a rental vehicle – the coverage didn’t cost a thing, and it allowed me to waive all the Hertz policies (and resulting expenses).

I run my business on QuickBooks (but I’m want to take a closer look at Xero) and my personal stuff on Wesabe (its analytics are more appropriate for a family economy).

I’m a big fan of Paul Graham’s essays; he’s got a great eye for the details that matter and the experience to put it to good use.  His writing style and topic choice also appeal to me.

In any case, Paul passes on the secret to being a successful entrepreneur: “Be relentlessly resourceful“.

I just can’t add anything to that.

I’m back in the US after almost a decade of entrepreneurial fun in Latin America.  As luck would have it, despite my best efforts to the contrary, I’m thrust once again into my, as they say in Argentina, metier – surfing the waves of creative destruction.

After 3 months here, the big finding is: it’s not all that different.  Sure, there are less obstacles, some advantages even, but the stiff competition still makes running an SME in the developed world as much of a challenge as anywhere else. Probably the biggest difference is where we would start laughing at the hockey stick graph – here, it takes more zeros to make folk snicker.  As a matter of fact, if there aren’t enough zeros people will snicker.

I think that I like it here, current economic woes notwithstanding.  As I mentioned to friends of mine while we contemplated staying here, the best times in a developing market still require more effort than similar activities in the Great North in the middle of an economic shakeout.

In June 2005, Cordaid invited me to speak at its Year of Microcredit Congress in Soesterberg, Netherlands.  I was asked to speak about Business Development Services as they pertain to Micro Finance Institutions (MFIs) – that is, how to improve the performance of MFIs through changes in their management practices.

Much to the chagrin of most of the nice folk in attendance (and the not-so-secret satisfaction of my sponsor), I made a comparison of MFIs to SMEs, based on the fact that the needs exhibited by most MFIs are very similar to SME needs (see what is an SME?).  The reaction from the crowd was sufficiently violent that I briefly considered aborting the presentation, but the support from my sponsor was enough for me to press on.

After I left the hotspot, a couple of people came up to me to express their vehement rejection of the possibility that the laudable institutions of poverty relief (MFIs) could be mentioned in the same breath as the money-grubbing, capitalist swine (SMEs).

In the intervening years I have been able to observe this same sentiment throughout the Microfinance sector.

One of the first impacts of this attitude is the rejection of management best-practices, especially those that come from commercial banking.  Without a doubt, the success of microfinance is based on some very “un-bank” activities (some of which commercial banks would do well to adopt - another post), but that doesn’t necessarily mean that all banking practices don’t have a place in MFI operations. This limits even regulated MFIs to “medium-sized” at best, as they just can’t seem to resolve their governance and strategy issues. Worse yet, it provides a vulnerability that Commercial Banks that wish (need?) to grow their market share may exploit.

The total absence of discussion and research regarding “management” in the International Development world, as compared to the attention directed at the Commercial Banking sector, underscores the prevailing attitudes of MFIs and their investors towards the professionalization of their management teams.  For example, at the recent Microfinance Leaders Retreat, which produced the Pocantico Declaration, the participants felt it necessary to declare “We are concerned by low standards of transparency in the sector and an emphasis on hype” (like that statement doesn’t apply to banking as a whole), but no mention was made of broader management practices.

I believe that as the competitiveness of the microfinance sector starts to rise (can that happen in a virtual oligopoly? - another post) MFIs will be forced to pay attention to how they manage their business (regardless of the profit focus that each institution pursues) – those teams that are open to including tried methods will generate faster positive results.

That is, if Commercial Banks don’t discover microfinance’s secrets and expand their presence to the low-income segments first…

I’m currently participating as a judge in a business plan competition. I do this kind of work frequently and always end up with feedback that sounds the same for most plans.

The principal fault I find in most proposals is a weak link to the market.

Most ideas are couched in terms of “I know how to do this really well, now I want them to pay me lots of money to do it”. Sometimes (read: very rarely) an entrepreneur’s personal interest connects with a market need, and when it does, most entrepreneurs are unprepared for the result – like taking a sip of water from a fire hydrant. Most of the time, only a small part of the entrepreneur’s interest overlaps accidentally with a market need, and the resulting enterprise spends a whole lot of time ramming their offering down their customers throats – this takes a whole lot more money than what was planned.

And “who” is “them” exactly? Most plans I read do a really poor job at identifying their target market – once we start talking about “who”, it’s amazing how quickly we discover that our “what” has little or no demand and that it requires extensive rework.

That’s related to the second most-common fallacy, my “what” sells itself. I still smile at business plans that include a commercial (sales, marketing, communications, etc.) budget with only 2 or 3 zeros. NOTHING gets to its intended market without consuming some resources – I scoff at people who claim that intermediaries aren’t worth their commissions.

This also leads to understating working capital needs. It takes a while for the company to reach break even, until then, company finances must cover the burn rate. Furthermore, in order to break into a market, especially an established one, sales must grow on some sort of credit terms. This, on top of the fact that inventories eat a whole bunch of cash. I love the face of most entrepreneurs when we go through a fully articulated financial model and see how the company can go broke by selling too much.

Thus, I see a lot of plans that are rife with structural obstacles: overestimating market acceptance compounds the underestimation of resources required to get to market, which undermines even the most carefully crafted budgets and distracts the management team with non-value added activities (like explaining to creditors why the company is in default).

Small and Medium Enterprises (SMEs) have become nearly synonymous with entrepreneurial activity and business innovation. Vaunted as the real source of sustainable (at least financially speaking) economic growth, much attention has been lavished by development specialists on these strange creatures, particularly in developing economies. Need I mention the popularity of the term in developed markets, where companies like SAP and Microsoft have “SME divisions”?

But, what is an SME?

According to Wikipedia, an SME is classified by the number of people it employs. What the article doesn’t state is that some institutions use yearly revenues, others go by net profit or by shareholders’ equity. Not only do the metrics change from country to country and among individual programs, but the specific values at which a micro enterprise is considered “small” or “medium” (and thus subject to the special treatment provided by the program in question) or “too big” are also a hot topic of discussion.

I believe that this “convention” (if its wide variability doesn’t belie the use of the term) is a crutch that helps bureaucratic managers justify themselves and their work, but only sometimes helps accomplish objectives – in fact, oftentimes the “definition” of SME hinders the success of most programs by creating a ton of Type I and Type II errors.

Here’s a quick example: consider Craigslist, Inc., a company that employs, as far as I can tell, less than 100 people (according to the Wikipedia entry, 24 souls earn a paycheck there). Clearly an SME, right? Some programs and institutions would say yes, while others, citing its estimated revenue or its ownership structure (eBay owns 25% – don’t get me started on that controversy), would adamantly say no. Who’s right?

It doesn’t matter.

The number of employees only tells you about the challenges that the company faces in the field of human resources, while revenue figures hint at the sales effort and accounting figures may indicate where to find some financial management opportunities. None of these figures give you any real idea of what the company really sees on the ground (but it sure makes it easy for program managers to justify their budgets).

Unlike Craigslist, SMEs in developing markets are beset by a myriad of issues all their own; issues that institutions and specialists try to mitigate or help fledgling companies to overcome. Wouldn’t it make sense, then, to classify SMEs by the issues they face? Wouldn’t “development” efforts become more effective if they could hit their mark with more precision?

Regrettably, as mentioned in a previous post, we don’t have the rich research data that would help us formulate an indisputable taxonomy; however, based on experience, here goes a first draft.

The following guidelines are based on enterprise “life cycle” stages that we have observed throughout Latin America and on the characteristics found in companies in each of the following areas:

• Incorporation
• Accounting procedures
• Documentation
• Management
• Strategy

You may have noticed that these areas are in ascending order from easiest to hardest to diagnose, which coincides, not accidentally, to the degree of importance in the survival and growth of the company.

Small enterprise

More often than not, the small enterprise is managed by the founding entrepreneur with the help of a small staff – this staff is usually mid to low level “worker ants” and very infrequently includes a senior ejecutive.

Incorporation: the company, if at all legally incorporated, is a sole proprietorship; less frequently, it is a limited liability company (in Spanish, Sociedad de Responsabilidad Limitada or SRL).

Accounting: limited to basic bookkeeping for tax purposes (often highly distorted to “optimize” the “fiscal footprint”), small companies usually carry little more than a balanced checkbook – cash flow, after all, requires at least that much.

Documentation: similar to the books, small companies keep only those documents that are required by government officials: powers of attorney, articles of incorporation, tax identity, etc. These are usually out of date. If the company doesn’t need it to do business, it doesn’t exist on the premises.

Management: of the four broad functional skill groups (purchasing, operations, sales, and administration – think Porter’s Value Chain, simplified), the management team’s (if there is more than one manager) experience and or knowledge is limited to one, sometimes two, of these areas, where the most common is operations. The other areas are carried out empirically – which doesn’t necessarily always mean poorly.

Strategy: long-term planning and business vision is usually vague and easily molded by current events. The company’s history is merely a long series of crises that has branded management as “survivors”. This approach doesn’t always lead to failure, and can sometimes contribute to resounding success if the principal entrepreneur is sufficiently astute.

Medium enterprise

Driven by the inherent limits of human management capacity, the founding entrepreneur has found it necessary to hire a couple of executives, sometime these are experienced professionals. Nonetheless, decision making is not normally delegated in any material way.

Incorporation: as many medium companies have several shareholders, the overwhelming majority have incorporated as limited liability companies (SRL, based on a common misconception about liability – another post), but in some cases as NGOs, Cooperatives and Corporations. A notable exception to this is Mexico, where the corporation dominates (aka Sociedad Anónima de Capital Variable or SA de CV).

Accounting: at this size, the company has developed some meaningful accounting data. Many still keep several sets of books and few really leverage the management information that their system contains.

Documentation: having moved up the formality scale, it’s usual to find a more significant archive of legal documents, to include contracts, board minutes, powers of attorney, etc. However, these are drafted from boilerplate and without the assistance of qualified legal counsel. Though this is seldom a big problem given the type of legal system (civil law, see post about put options), mainly because it is easily corrected, it does make for some fun during a due diligence process.

Management: having incorporated other people to the management team, it is usual to see some serious corporate governance issues. Clear symptoms of this are a lack of agreement between an executive’s title (CFO, for instance) and her function (head accountant, for instance), and finding the decision making powers still concentrated in the chief executive (even for the mundane task of signing checks). This is a rich enough area to deserve it’s own post (another post).

Strategy: there begins to be some mid-term planning, if only to get a handle on the company’s operations, however, execution is still near-sighted and reactive. The “business plan” is treated as a necessary gesture to gain access to funding, and infrequently used as a real management tool.

As you can see, using this classification, programs directed at SMEs would be more effective in identifying which companies to work with, and, more importantly, what to do do with them (another post) . Of course, it would require program managers to take a different approach to accomplishing their mission.

This post from Scott Adams (creator of the popular Dilbert comic) might as well be directed at entrepreneurs, as it goes to the heart of sources of competitive advantage:

Capitalism rewards things that are both rare and valuable. You make yourself rare by combining two or more “pretty goods” until no one else has your mix.

Read the entire post, though, as it is really great advice.

Kudos to Scott for sharing the wisdom

Most people, even micro finance experts, consider that the micro finance industry is dedicated to providing financial access to the bottom of the pyramid (BOP) through credit or lending technologies similar to bank loans.

In my mind, nothing could be further from the truth: I consider most of the work done by micro finance institutions to be more related to equity investing than anything else.

This is a topic that could be covered in a series of books based on a lot of real interesting research that hasn’t yet been carried out, but let me try to do it some justice.

Time frame: the GAAP periods in traditional businesses (month, quarter, semester, year) work well because a company’s cash ebbs and flows in tune with these time frames; thus, the calendar (which permeates our lives) is more or less synchronized with our expectations of the business cycle we’re examining. We expect that whatever management does, it’ll take a month or a quarter to show up as net income. It is reasonable for us to wait two or three years to see an investment develop meaningful returns. Banks usually lend in year terms.

This is not the case with BOP entrepreneurs, who can easily have four or five different businesses in a calendar year, some of which will survive from year to year, perhaps due to seasonality, while others will rise and fall as a business opportunity presents itself, is capitalized, and liquidated as a normal course of business, in scant weeks or months!

Repayment: many people who are not familiar with micro finance are surprised to find out that a micro finance portfolio has a natural tendency to perpetually grow, even if its MFI stops acquiring new clients (ceteris paribus). I still can see the face of an investor who exclaimed in surprise after he finally got it: “…but that’s an evergreen scheme!” Yes it is.

This is due to the fact that micro entrepreneurs never pay the principal back; sure, they make periodic payments (some call them capital amortization and interest, I call them dividends) weekly or monthly, but, at the end of each “loan” cycle (as little as weeks and as long as months), most of them are looking to get the principal back and then some.

This is one of the methods used to ensure that they pay the MFI its cut: they borrow say $50 for 16 weeks, pay it back with the promise that they will be able, if they prove their worthiness, to borrow say $60 immediately after (or the same $50 for longer). More like a new round of financing with a capital gains payout (indulge me).

The only exception to this arises from a liquidity event or a liquidation, both of which happen surprisingly frequently in the BOP.

Guarantees: most MFIs have figured out how to work with “social guarantees”. These aren’t real or tangible assets, or if they are, not very useful in recuperating much of the amount in default, but rather anchors in the entrepreneur’s psyche that formalize his or her commitment to abide by the terms of the disbursement. More of a “my word is my bond” kind of thing – very similar to the “informality” mostly seen in angel investing and definitely far from the boilerplate contracting that is the norm in credit operations.

Concluding, a BOP entrepreneur starts and finishes business opportunities in the matter of months, can cover “debt” service from the turnover of her entire business, and takes micro finance on little more than her word. Thus, MFIs behave more like traditional equity players than like loan givers because they cover the entire lifespan of the enterprise, get paid from real or virtual liquidation of the business, are involved in additional rounds of financing, do not base the bulk of their risk management on legal contracts, but rather on relationship management, and defaults are largely written off (after some due effort building and maintaining default disincentives).

Some corollaries (another post):

• Eradicating informality in the BOP would require extensive rewrites of most codes of commerce and the institutionalization of incredibly agile bureaucracies (an oxymoron?).
• Banks can’t do micro finance.
• Successful BOP entrepreneurs (serial micro entrepreneurs), by the very nature of their success, will have trouble growing beyond the BOP – they’re more like arbitrageurs than business managers.
• “Do you have any financial statements?” is a silly question.

According to the SBA, more than 500,000 firms “die” each year (approximately 10% of the total amount of firms¹) in the US, the bulk of which have less than 20 employees². This mortality corresponds to some pretty tough attrition rates for entrepreneurs: “44 percent [of new establishments] were still in existence 4 years [after their birth]“³ – which means that over half didn’t make it. Furthermore, most of the factors related to firm closure fall under the entrepreneur’s purview (as in, they are not due to external forces) – sometimes summarized as Money, Management, and Marketing. ⁴,⁵,⁶,⁷

This is supported by research indicating that entrepreneurs are more cavalier about their capacity than they are about the business risks they face:

The research shows that entrepreneurs, while risk averse in their role as risk-bearers, are willing to bear economic risk when overconfidence compensates for their aversion.⁸

But is it the same in alternative markets?

Let’s recall that there are many less entrepreneurs per capita off the beaten path, and that their mortality is much lower than in developed markets. If we eliminate what the Global Entrepreneurship Monitor (GEM) calls necessity entrepreneurs (most of which work in the micro enterprise sector – see Poor entrepreneur post) and concentrate on the “opportunity entrepreneurs”, aside from a dire dearth of data, we’ll notice very similar anecdotal evidence – most of the trouble that entrepreneurs face, is self inflicted and therefore, perfectly avoidable.

I know many investors in alternative markets who insist on including a put option in their investment agreement. Though I understand the motivation, I always caution the negotiating parties about options because of their unintended consequences.

During the negotiations, the entrepreneur is so caught up in the soon-to-arrive disbursement (another post) that the point-blank question “Do you understand what a put option is?” fails to elicit an honest answer and simply causes the person answering the question to respond in a way the will keep the momentum going towards disbursement.

After the proceeds have been spent in accordance with the investment memorandum and subsequent contracts (sure they have! another post), then controversies arise and the stakeholders begin to examine the legal documents more meticulously. That’s when the real questions about terms begin.

“What’s a put option?” asks the entrepreneur fully 18 months after disbursement – the investment officer usually answers “Remember, we talked about this before we signed; it means that we have the right, but not the obligation, to sell you our shares a this valuation once the option has vested – I explained it several times.” The look of utter astonishment on the face of the entrepreneur as she realizes that she has signed a post-dated check to the tune of several million dollars quickly changes to denial, then anger – acceptance may never come. Trust has been undermined.

Once in a while you’ll find an entrepreneur who understands options. In order to accept the put, she insists on a call option – it’s only fair, if you’re mitigating your exit risk by obligating her to buy your shares in the future at some valuation set now, potentially forcing her to buy shares at a “premium”, she’s going to keep the upside by obligating you to sell your shares at a maximum price set now, potentially at a “discount”. Thus, if the company survives but doesn’t become a star, the investor gets his money back and something for his trouble, potentially at a price-per-share above its market price. On the other hand, if the company does skyrocket, the entrepreneur can buy her company back at a price-per-share that may be lower than fair market value (the investor still makes money, mind you, but not as much as he would have without the call). That’s the way it’s supposed to work, in theory anyway.

The problem with options arises when the investor tries to exercise his right to sell – it has been several years since they negotiated and signed the agreement, and the very fact that the put is being exercised means that the company has not done as well as planned. This usually means that there have been disagreements among the shareholders (on who has made poor management decisions, on why the company has missed its targets – you get the idea), which means that there is some degree of enmity between the writer of the put (the entrepreneur) and its holder (the investor). Furthermore, as the entrepreneur is most likely illiquid (investor normally insist that their portfolio entrepreneurs have some “skin in the game”, which normally means, most of her worldly possessions), the put becomes contentious. At best we face a situation where the entrepreneur wants to buy our shares, but can’t, and at worst we face an entrepreneur that not only can’t, but won’t comply with the option. So how do you enforce a put in this condition?

Keep in mind that most of the “alternative” markets work under civil law, wherein the letter of the law is enforced and contracts are limited to repeating what has been legislated – not at all like what our “northern” brethren experience, common law, where the system supports the stipulations of the contract – read more about legal systems. Imagine, then, what happens to a put option clause when “options” have not been included in the local Code of Commerce. Surely, in the face of this void, the legal system will recognize the spirit and intent of the contract and do the reasonable thing?

I know that in more advanced jurisdictions, jurists undergo many years of academic and practical training, and that public service is a laudable professional pursuit. Unfortunately, that is not always true in markets off the beaten path. Because the public sector normally pays so poorly, those lawyers who can, go into private practice, leaving “the rest” to pursue their careers as judges and prosecutors. For sure, there are some great people in the public sector, but more often than not, their knowledge of the law and jurisprudence is tenuous, the motivation is questionable, and their intellect challenged. A ruling, in many cases, boils down to “arguments” not necessarily related to law…

On the other hand, if the investment goes very well and the entrepreneur exercises her call, it is in the best interest of the investor to comply.

Thus, put options don’t really protect investors from the downside, could limit their upside, may undermine the investor-entrepreneur relationship, and will introduce unwanted legal risk into the investment contract.

Please see the rules.

[13 Nov 2008: I get a lot of traffic to this post on the "do put options work?" search string.  I'm curious: are you getting what you're looking for?  Leave me a comment, maybe I can improve it.]