The less-known entrepreneur

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.

Sigo evaluando planes de negocio…

En esta ocasión quiero hacer algunas recomendaciones sobre “el financiamiento”.

A pesar de que he trabajado mucho con empresarios y emprendedores, todavía me sorprende el grado de desconocimiento que hay en el mercado sobre las fuentes de financiamiento.  En particular dado que no hay una falta de oficiales de crédito en las zonas urbanas (de donde provienen la mayoría de los planes que he evaluado en el transcurso de los años).

El error más común va algo así: “…nuestro plan requiere $X, de los cuales 20% serán aporte de los socios y el saldo crédito bancario…”; mejor aún “…estamos dispuestos a aceptar nuevos socios, pero preferimos un crédito bancario…”.

Creo que, a fondo, existe una pobre concepción del negocio de la banca – que existe para otorgar créditos. En el mejor de los casos, eso es solo la mitad del negocio.

La verdad es que el primer proceso que cuida una institución financiera es la seguridad del capital de sus depositantes – los acuerdos de Basilea II enfatizan aún más el tema, por lo que podemos esperar que los órganos normativos presten aún más atención al tema. Como ahorrista, la única razón por la que yo le confío al banco los estudios de mis hijos, su salud, nuestra estabilidad financiera familiar, etc., es porque sé que hay gente muy atenta a esta confianza. Cada vez que se propone “aflojar” el crédito bancario, se está proponiendo “aflojar” la seguridad de mis depósitos…

Bueno, entonces no nos debería sorprender que los bancos no prestan a empresas recién constituidas, ni a empresas que operan a pérdida o que no tienen claramente definida su fuente de repago de un crédito. Tampoco es extraño que pidan garantías reales, ¿no es cierto? Una visita de 15 minutos a la sucursal más cercana de cualquier institución serviría para confirmar estos hechos y dotar a nuestros planes de negocio un mejor vínculo con la realidad y, por ende, una mayor posibilidad para alcanzar el éxito.

Para dejar algunos temas más claros:

• El banco nunca va a prestar más del 50% de la necesidad financiera (si tan solo por el tema de la cobertura hipotecaria) .
• El banco no presta a empresas recién constituidas. Puede otorgar un préstamo personal si la persona que lo solicita tiene las garantía y fuentes de repago suficientes, mejor si es un “buen” cliente (lleva varios años trabajando con el banco).

Por lo tanto, para ser emprendedor, recomiendo iniciar una relación con el banco lo antes posible y empezar a formular el historial crediticio idóneo, manteniendo una conversación abierta y de largo plazo con el oficial asignado – la comunicación es de doble vía.

Estoy actualmente participando como juez en un concurso de planes de negocio. Hago este tipo de trabajo con cierta frecuencia y mis comentarios siempre terminan pareciéndose para la mayoría de los trabajos que evalúo.

La principal falla que encuentro es una pobre vinculación al mercado.

La mayoría de las ideas están planteadas desde el punto de vista de “yo hago esto bien; ahora quiero que me lo compren.” A veces (en realidad, muy pocas veces), el interés de una emprendedora coincide con una necesidad latente en el mercado.  Peor, cuando sí sucede, está mal preparada para aprovecharlo – termina ahogándose en su éxito. La mayoría de las veces solo una pequeña parte del interés del emprendedor se solapa con una necesidad del mercado, por lo que el emprendimiento termina forzando su oferta en el mercado, lo que requiere de mucho más tiempo y dinero que lo presupuestado.

Además, ¿quiénes son los nunca-nombrados “ellos”? ¿Quién pretendemos que compre nuestro qué? Los planes que leo, en gran medida, carecen de una clara definición de su usuario o cliente meta. Es sorprendente como, una vez que empezamos a examinar el quién, el qué queda claramente “fuera de lugar”, requiriendo extensiva reingeniería.

Ésto está relacionado al segundo problema que encuentro con frecuencia: “se vende solo”. Todavía me causa mucha gracia encontrarme con un presupuesto comercial (ventas, mercadotecnia, comunicación, etc.) con solo dos o tres ceros. NADA llega a su mercado meta sin consumir algo de recursos (a veces muchos) – me burlo de la gente que propone que los intermediarios no se han ganado sus comisiones.

A su vez, este error también lleva a la subestimación del capital de trabajo. Una empresa recién conformada tarda algo de tiempo en alcanzar su punto de equilibrio, mientras tanto, el patrimonio financiero de la misma se va reduciendo. Es más, para penetrar en un mercado, normalmente se tiene que vender a crédito. Ésto se suma al hecho que los inventarios consumen sumas considerables de efectivo. Me fascina el asombro de un emprendedor cuando notamos en un modelo financiero articulado que su empresa puede quebrar por haber vendido demasiado.

Es así que veo muchos planes repletos de obstáculos estructurales: la sobre estimación de la aceptación de su producto o servicio exacerba la subestimación de los recursos requeridos para llevarlo a su mercado meta, lo que socava hasta el más minuciosamente preparado presupuesto y distrae al equipo gerencial de actividades de valor agregado (explicándole a un acreedor por qué está en mora, por ejemplo).

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

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.]

My last post probably gave you the idea that my writing was going to focus on the financial aspects of entrepreneurial activity. Not so. There are way more entrepreneurs off the beaten path than there are investors, and the investors, given their raison d’être, don’t much care to look (much less invest) outside their controlled environments (before you take umbrage to that snide remark, please be aware that I understand why that is and don’t blame you for your reticence; also, see rule #2).

Will the entrepreneurs who stumble upon this blog find useful information in their struggle for survival? Absolutely. Will reading this blog ward off all evil and keep you alive? Sure! (and I’ve got beach front property in Cabo San Lucas real cheap). You’ll come to understand that what “Sure!” really means and why I didn’t include it in the rules…

What follows is the summary of the results of some very pointy research on the subject of entrepreneurship – I’ll sweep back one day and do all the required source cites and bibliography (hold your breath).

From what I’ve read, the mortality of entrepreneurial activity is very high in the most sophisticated markets. The good news is that once you leave those highly competitive environments, the mortality actually goes down! This is one “fact” that you’re going to have to take on faith and the following argument. On faith because, given that there aren’t any “big guns” pointed off the beaten path, researchers and consultants can’t make a whole lot of money -this is a fact I can personally corroborate- digging up facts and analyzing the fauna of the uncharted areas, so there is very little statistically stable information regarding entrepreneurial activity.

So how can I say that entrepreneurial activity has a higher survival rate in the long tail? It’s easy, the downside of risk is, at best, social death (you’d be surprised how unglamorous it is to be ostracized) and, at worst, death from starvation (literally!). So entrepreneurs, by the very definition of their existence, are survivors. This is clearly supported by the existence and growth of the micro-entrepreneurial class and the proven success of the micro finance industry worldwide as compared to highly developed countries. Thus, though there are many less entrepreneurs per capita, the ones that do make it are real scrappers.

Here’s how that comes to be:

1. Lack of restructuring process: very few jurisdictions have bankruptcy laws on the books, and the ones that do, have onerous terms for any real restructuring effort. This is true if only because there are only a handful of specialists who can help you really cut your losses legally – scarcity makes for price-takers and substitutes (cutting your losses by “alternative” -less legal or legally gray- means).

2. Highly developed social networks: this helps entrepreneurs who are “in” survive, but also shuts out both “outsiders” and “failures”. For example, in most countries (to a lesser degree in the economic hubs), if my brother fled the country because he couldn’t pay his bank loan (because there is no restructuring protection under the law), all bankers would quickly find out about it and classify me as high risk, regardless of my credit history. After an appropriately prudent “cautionary period”, say, 5 to 10 years, then I would have proven my mettle and allowed to grow my exposure in the formal banking sector again. Can you say “off-balance sheet” financing? That’s further complicated by the fact that, in some jurisdictions, my children will inherit my liabilities (especially those liabilities held by the post-Basil II bank system).

3. The high cost of doing business: all the Transparency International research aside (at it’s core, it’s all social “perception” veiled in statistical analysis), it really does cost a lot more to become an fully vested member of the formal economy in these markets – not only does the tax man know where to find you, his minions know how to extort you, and, given the fact that your competition isn’t playing by the rules, you’re at a cost disadvantage in very price-sensitive markets.

4. Human resources: due to many years of systematic brain-drain, coupled with very poor educational systems, and highly differentiated “expat” vs. “local” personnel systems (an argument onto itself: I need to bring in expats at high pay because the locals just don’t cut it), the talent pool is very, very shallow. Because the talent pool is shallow, business managers don’t like to pay high wages, forcing those who have the talent to migrate to where the salaries are commensurate with their expertise and experience, but they never come back because the expectations of hiring managers back home are so low – did I mention why I’m looking to relocate from South America? This applies to entrepreneurs, too – that’s why you find so many nationalities in the economic hubs throughout the continent, and why the brass ring is Silicon Valley (for example).

Now if you didn’t stop to ponder where I said “…there are many less entrepreneurs per capita…”, let me make my point: poor entrepreneur – though entrepreneurial mortality is low, it’s because many less people take the plunge in their markets of origin, preferring instead either to get regular jobs at low pay or to migrate to more sophisticated markets.