MBA Mondays Fred Wilson

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2 MBA Mondays Fred Wilson This is a Leanpub book which is for sale at Leanpub helps you connect with readers and sell your ebook, while you re writing it and after it s done.

3 TABLE OF CONTENTS Preface 1 ROI and Net Present Value How to Calculate a Return on Investment The Present Value of Future Cash Flows The Time Value of Money 7 Compounding Interest Corporate Entities Corporate Entities 15 Piercing the Corporate Veil Accounting 21 Accounting 21 The Profit and Loss Statement The Balance Sheet 28 Cash Flow 34 Analyzing Financial Statements Business, Metrics and Pricing Key Business Metrics 43 Price: Why Lower Isn't Always Better Projections, Budgeting and Forecasting Projections, Budgeting and Forecasting 47 Scenarios 49 47

4 Budgeting in a Small Early Stage Company Budgeting in a Growing Company 55 Budgeting in a Large Company 58 Forecasting Risk and Return Risk and Return 63 Diversification 65 Hedging 68 Currency Risk in a Business Purchasing Power Parity Business Costs Opportunity Costs 77 Sunk Costs 78 Off Balance Sheet Liabilities Valuation 83 Enterprise Value and Market Value Bookings Vs. Revenues Vs. Collections Commission Plans Commission Plans 87 What a CEO Does What a CEO Does 91 What a CEO Does, Continued Outsourcing Outsourcing 95 95

5 Outsourcing Vs. Offshoring 97 Employee Equity 101 Employee Equity 101 Employee Equity: Dilution 103 Employee Equity: Appreciation 106 Employee Equity: Options 107 Employee Equity: The Liquidation Overhang Employee Equity: The Option Strike Price Employee Equity: Restricted Stock and RSUs Employee Equity: Vesting 119 Employee Equity: How Much? 122 Mergers and Acquisitions Acquisition Finance 127 M&A Fundamentals 128 Buying and Selling Assets

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7 Preface MBA Mondays is written by Fred Wilson 1, and licensed under the Creative Commons Attribution 3.0 license. For details, see this post

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9 ROI and Net Present Value How to Calculate a Return on Investment The Gotham Gal 1 and I make a fair number of non-tech angel investments. Things like media, food products, restaurants, music, local real estate, local businesses. In these investments we are usually backing an entrepreneur we've gotten to know who delivers products to the market that we use and love. The Gotham Gal runs this part of our investment portfolio with some involvement by me. As I look over the business plans and projections that these entrepreneurs share with us, one thing I constantly see is a lack of sophistication in calculating the investor's return. Here's the typical presentation I see: 2 The entrepreneur needs $400k to start the business, believes he/she can return to the investors $100k per year, and therefore will generate a 25% return on investment. That is correct if the business lasts forever and produces $100k for the investors year after year after year

10 ROI and Net Present Value 4 But many businesses, probably most businesses, have a finite life. A restaurant may have a few good years but then lose its clientele and go out of business. A media product might do well for a decade but then lose its way and fold. And most businesses are unlikely to produce exactly $100k every year to the investors. Some businesses will grow the profits year after year. Others might see the profits decline as the business matures and heads out of business. So the proper way to calculate a return is using the "cash flow method". Here's how you do it. 1) Get a spreadsheet, excel will do, although increasingly I recommend google docs spreadsheet 3 because it's simpler to share with others. 2) Lay out along a single row a number of years. I would suggest ten years to start. 3) In the first year show the total investment required as a negative number (because the investors are sending their money to you). 4) In the first through tenth years, show the returns to the investors (after your share). This should be a positive number. 5) Then add those two rows together to get a "net cash flow" number. 6) Sum up the totals of all ten years to get total money in, total money back, and net profit. 7) Then calculate two numbers. The "multiple" is the total money back divided by the total money in. And then using the "IRR" function, calculate an annual return number. Here's what it should look like: 3

11 5 ROI and Net Present Value Here's a link to google docs where I've posted this example 5. It is public so everyone can play around with it and see how the formulas work. It's worth looking for a minute at the theoretical example. The investors put in $400k, get $100k back for four years in a row (which gets them their money back), but then the business declines and eventually goes out of business in its seventh year. The annual rate of return on the $400k turns out to be 14% and the total multiple is 1.3x. That's not a bad outcome for a personal investment in a local business you want to support. It sure beats the returns you'll get on a money market fund. But it is not a 25% return and should not be marketed as such. I hope this helps. You don't need to get a finance MBA to be able to do this kind of thing. It's actually not that hard once you do it a few times. The Present Value of Future Cash Flows My friend Pravin 1 sent me an last week after my "How To Calculate A Return On Investment" 2 post. He said:

12 ROI and Net Present Value 6 I wish there was a class that I could take that would teach me how to properly research stocks/companies for investment purposes and how that could be made into a private tutoring business. It'd be for people like me, people who didn't go to school for business but still are interested in understanding all the jargon, methods of investing, etc and how to apply it to a buy and hold strategy. Pravin then went on to say that the post I wrote was exactly the kind of thing he was looking for and that he'd like to see me do more of it. So with that preface, I'd like to announce a new series here at AVC. I'm calling it "MBA Mondays". Every monday I'll write a post that is about a topic I learned in business school. I'll keep it dead simple (many people thought my ROI post last week was too simple). And I'll try to connect it to some real world experience. I'll start with the topic Pravin wanted some help with: how to value stocks, what they are worth today, and what they could be worth in the future. This topic will take weeks of MBA Mondays to work through but we'll start with a fundamental concept, the present value of future cash flows. I was taught, and I believe with all my head and heart, that companies are worth the "present value" of "future cash flows". What that means is if you could know with certainty the exact amount of cash earnings that the company will produce from now until eternity, you could lay those cash flows out and then using some interest rate that reflects the time value of money, you could calculate what you'd pay today for those future cash flows. Let's make it really simple. You want to buy the apartment next to you for investment purposes. It rents for $1000/month. It costs $200/month to maintain. So it produces $800/month of "cash flow". Let's leave aside inflation, rent increases, cost increases, etc and assume for this post that it will always produce $800/month of cash flow.

13 7 ROI and Net Present Value And let's say that you will accept a 10% annual return on your investment. There are a multitude of reasons why you'll accept different interest rates for different investments, but we'll just use 10% for this one. Once you know the cash flow ($800/month) and the interest rate (also called the "discount rate"), you can calculate present value. And this example is as easy as it gets because the cash flow doesn't change and the interest rate is 10%. The annual cash flow is $9,600 (12 x $800) and if you want to earn 10% on your money every year, you can pay $96,000 for the apartment. In order to check the math, let's calculate 10% of $96,000. That's $9,600 per year. In practice, it is never this simple. Cash flows will vary year after year. You'll have to lay them out in a spreadsheet and do a present value analysis. We'll do that next week. But it is the principle here that is important. Companies (and other investments) are worth the "present value" of all the cash you'll earn from them in the future. You can't just add up all that cash because a dollar tomorrow (or ten years from now) is worth less than a dollar you have in your pocket. So you need to "discount" the future cash flows by an acceptable rate of interest. That basic concept is the bedrock of all valuation concepts in finance. It can get incredibly complex, way beyond my ability to calculate or even explain. But you have to understand this concept before you can go further. I hope you do. Next week we'll look at using spreadsheets to calculate present values. The Time Value of Money It's Monday, time for MBA Mondays.

14 ROI and Net Present Value 8 Last week, I posted about The Present Value Of Future Cash Flows 1 and in the comments Pascal-Emmanuel Gobry 2 wrote 3 : That being said, before even covering NPV, I would have first talked about the time value of money. To me, time value of money is one of the top 3 concepts that blew my mind in business school and that should be common knowledge. When you think about it, all of finance, but also much of business, is underpinned by that. Once you understand time value of money, you understand opportunity costs, you understand sunk costs, you just view the world in a whole different light. PEG is right. We have to talk about the Time Value Of Money and it was a mistake to dive into concepts like Present Value and Discount Rates before doing that. So we'll hit the rewind button and go back to the start. Here it goes. Money today is generally worth more than money tomorrow. As another commenter to last week's post put it "you can't buy beer tonight with next year's earnings". Money in your pocket, cash in hand, is worth more than cash that you don't actually have in hand. If you think about it that simply, everyone can agree that they'd rather have the cash in hand than the promise of the same amount at some later day. And interest rates are used to calculate exactly how much more the money is worth today than tomorrow. Let's say that you'd take $900 today instead of $1000 exactly a year from now. That means you'd accept a 11.1% "discount rate" on that transaction. I calculated that as follows: 1) I calculated how much of a "discount" you would take in order to get the money today versus next year. That is $1000 less $900, or $

15 9 ROI and Net Present Value 2) I then divided the discount by the amount you'd take today. That is $100/$900, which is 11.1%. This transaction could be modeled out the other way. Let's say you are willing to loan a friend $900 and you agree that he'll pay you an interest rate of 11.1%. You multiply $900 times 11.1%, you get $100 of total interest, and add that to the $900 and calculate that he'll pay you back $1000 a year from now. As you can tell from the way I talked about them, interest rates and discount rates are generally the same thing. There are technical differences, but both represent a rate of increase in the time value of money. So if the interest rate describes the time value of money, then the higher it is, the more valuable money is in your hands and the less valuable money is down the road. There are multiple reasons that money can be more valuable today than tomorrow. Let's talk about two of them. 1) Inflation - This is a complicated topic that we are not going to get into in detail here. But I need to at least mention it. When prices of things rise faster than they should, we call that inflation. It can be caused by a number of things, most often when the supply of money is rising faster than is sustainable. But the important thing to note is that if a house that costs $100,000 today is going to cost $120,000 next year, that represents 20% inflation and you'd want to earn 20% on your money every year to compensate you for that inflation. You'd want a 20% interest rate on your cash to be compensated for that inflation. 2) Risk - If your money is in a federally guaranteed bank deposit for a year, you might accept 2% interest on it. If it is invested in your friend's startup, you might want a double on your money in a year. Why the difference between a 2% interest rate and a 100% interest rate? Risk. You know you are getting the money in the bank back. You are pretty sure you aren't getting the money back that you invested in your friend's startup and want to get a lot back if it works out.

16 ROI and Net Present Value 10 So let's deconstruct interest rates a bit to parse these different reasons out of them. Let's say the current rate of interest on a one year treasury bill (a note sold by the US Gov't that is federally guaranteed) is paying a rate of interest of 3%. That is an important rate to pay attention to. Because it is a one year interest rate on a risk free instrument (assuming that the US Gov't is solvent and always will be). We will assume for now that is true. So the "risk free rate" is 3%. That is the rate that the "market" says we should be accepting for a one year instrument with no risk. Now let's take inflation into account. If the Consumer Price Index (the CPI) says that costs are rising 2.5% year over year, then we can say that the one year inflation rate is 2.5%. It can get a lot more complicated than this, but many real estate leases use the CPI so we can use it too. If you subtract the inflation rate from the risk free rate, you get something called the "real interest rate". In our example, that would be 0.5% (3% minus 2.5%). And we call the 3% rate, the "nominal rate". Now let's take risk into account. Let's say you can find a corporate bond in the bond market that is coming due next year and will pay $1000 and it is trading for $900 right now. We know from the example that we started with that it is "paying" a discount rate of 11.1% for the next year. If we subtract the 3% risk free rate of interest from the 11.1%, we can determine that market is demanding a "risk premium" of 8.1% over the risk free rate for this bond. That means that not everyone thinks that this company is going to be able to pay back the bond in full, but most people do. Ok, so hopefully you'll see that interest rates and discount rates have components to them. In its simplest form, and interest rate is composed of the risk free rate plus an inflation premium plus a risk premium. In our examples, the risk free "real" interest rate is 0.5%, the inflation premium is 2.5%, and the risk premium on the corporate bond is 8.1%. Add all of those together, and you get the 11.1% rate that is the discount rate the corporate bond trades at in the markets.

17 11 ROI and Net Present Value Which leads me to my final point. Markets set rates. Banks don't and governments don't. Banks and governments certainly impact rates and governments can do a lot to impact rates and they do all the time. But at the end of the day it is you and me and it is the traders, both speculators and hedgers, who determine how much of a discount we'll accept to get our money now and how much interest we'll want to wait another year. It is the sum total of all of these transactions that create the market and the market sets rates and they change every second and always will (at least in a capitalist system). That was tough to do in a blog post. It's a very simple concept but very powerful and as Pascal-Emmanuel said, it is fundamental to all of finance. I hope I explained it well. It's important to understand this one. Compounding Interest It's time for MBA Mondays again. For the third week in a row, the topic of the post has been suggested by a reader. Last week, Elia Freedman wrote: "A suggestion for your next post. The logical follow-on is to explain the second half of the TVM (time value of money), which is compounding interest." Before I address the issue of compounding interest, I'd like to recognize two things about the MBA Monday series. The first is that each post has a very rich comment thread attached to it. If you are seriously interested in learning this stuff, you would be well served to take the time to read the comments and the replies to them, including mine. The second is that the readers are building the curriculum for me. Each post has resulted in at least one suggestion for the next week's

18 ROI and Net Present Value 12 post. I dove into MBA Mondays without thinking through the logical progression of topics. At this point, I'm just going to run with whatever people suggest and try to assemble it on the fly. It's working well so far. So if you have a suggestion for next week's topic, or any topic, please leave a comment. Last week, I described interest as the rate of change in the time value of money. And we broke interest rates down into the real rate, the inflation factor, and the risk factor. And we calculated that if you invested $900 today at an 11.1% rate of interest, you'd end up with $1000 a year from now. But what happens if you wait a few years to get your money back and receive annual interest payments along the way? Let's say you invest the same $900, receive $100 each year for four years, and then in the last year, you receive $1000 (your $900 back plus the final year's $100 interest payment). There are two scenarios here and they depend on what you do with the annual interest payments. In the first scenario, you pocket the cash and do something else with it. In that scenario, you will realize the 11.1% rate of interest that you would have realized had you taken the $1000 one year later. It's basically the same deal, just with a longer time horizon. And your total proceeds on your $900 investment are $1400 (your $900 return of "principal" plus five $100 interest payments). In the second scenario, you reinvest the interest payments at 11.1% each year and take a final payment in year five. If you reinvest each interest payment at 11.1% interest, at the end of year five, you will receive $1524 as your final payment. Notice that the total proceeds in this scenario are $124 higher than in the other scenario. That is because you reinvested the interest payments instead of pocketing them.

19 13 ROI and Net Present Value Both scenarios produce a "rate of return" of 11.1%. If you look at this google spreadsheet 1, you can see how these two scenarios map out. And you can see the calculation of total profit and "internal rate of return". The fact that you make a larger profit on one versus the other at the same "rate of interest" shows the power of compounding interest. It really helps if you reinvest your interest payments instead of pocketing them. While $124 over five years doesn't seem like much, let's look at the power of compounding interest over a longer horizon. Let's say you inherit $100,000 around the time you graduate from college. Instead of spending it on something, you decide to invest it for your retirement 45 years later. If you invest it at the 11.1% rate of interest that we've been using, the differences between pocketing the $11,100 you'd get each year and reinvesting it are HUGE. If you pocket the $11,000 of interest each year, you will receive $599,500 on your $100,000 investment over 45 years. But if you reinvest the $11,000 of interest each year at 11.1% interest, you will receive $11.4 million dollars when you retire. That's right. $11.4 million dollars versus $599,500. That is the power of compounding interest over a long period of time. You can see how this models out in this google spreadsheet (sheets two and three) 2. Now let's tie this issue to startups and venture capital. Venture capital investments are often held for a fairly long time. I am currently serving on several boards of companies that my prior firm, Flatiron Partners, invested in during 1999 and Our hold periods for these investments are into their second decade. Of course not every venture capital investment lasts a decade or more. But the average hold period for a venture capital investment tends to be about seven or eight years

20 ROI and Net Present Value 14 And during those seven to eight years, there are no annual interest payments. So when you calculate the rate of return on the investment, the spreadsheet looks like this. It's a compound interest situation. If you go back to the $100,000 over 45 years example, you'll see that a return of 114x your money over 45 years produces the same "return" as 6x your money with annual interest payments. The differences are not as great over seven or eight years but they are made greater by virtue of the fact that VCs seek to make 40-50% annual rates of return on their capital. If you read last week's post, you'll know that comes from the risk factor involved. The more risk an investment has, the higher rate of return an investor will require on their money in a successful outcome. If you want to generate a 50% rate of return compounded over eight years on $100,000, you will need to return $2.562 million, or 25.6x your investment. See this google spreadsheet (sheet 4) 3 for the details. The good news is that most venture capital investments are made over time, not all at once in the first year. So the "hold periods" on the later rounds are not as long and make this math a bit easier on everyone involved (maybe a topic for next week or some other time?). But as you can see, compounding interest over any length of time increases significantly the amount of money you need to return in order to pay the same rate of return as a security with annual interest payments. There are two big takeaways here. The first is if you are an investor, you should reinvest your interest payments instead of spending them. It makes a huge difference on the outcome of your investment. The second is if you are an entrepreneur, you should take as little money as you can at the start and always understand that your investors are seeking a return and that the time value of money compounds and makes your job as the producer of that return particularly hard. 3

21 Corporate Entities Corporate Entities I'm taking a turn on MBA Mondays today. We are moving past the concepts of interest and time value of money and moving into the world of corporations. Today, I'd like to talk about what kinds of entities you might encounter in the world of business. First off, you don't have to incorporate to be in business. There are many people who run a business and don't incorporate. A good example of this are many of the sellers on Etsy 1. They make things, sell them, receive the income, and pay the taxes as part of their personal returns. But there are three big reasons you'll want to consider incorporating; liability, taxes, and investment. And the kind of corporate entity you create depends on where you want to come out on all three of those factors. I'd like to say at this point that I am not a lawyer or a tax advisor and that if you are planning on incorporating, I would recommend consulting both before making any decisions. I hope that we'll get both lawyers and tax advisors commenting on this post and adding to the discussion of these issues. I'll also say that this post is entirely based on US law and that it does not attempt to discuss international law. With that said, here goes. When you start a business, it is important to recognize that it will eventually be something entirely different than you. You won't own all of it. You won't want to be liable for everything that the company does. And you won't want to pay taxes on its profits. 1

22 Corporate Entities 16 Creating a company is implicitly recognizing those things. It is putting a buffer between you and the business in some important ways. Let's talk first about liability. When you create a company, you can limit your liability for actions of the corporation. Those actions can be for things like bills (called accounts payable in accounting parlance), promises made (like services to be rendered), and lawsuits. This is an incredibly important concept and the reason that most lawyers advise their clients to incorporate as soon as possible. You don't want to put yourself and your family at personal risk for the activities you undertake in your business. It's not prudent or expected in our society. Taxes are the next thing most people think about when incorporating. There are two basic kinds of corporate entities for taxes; "flow through entities" and "tax paying entities." Here is the difference. Flow through corporate entities don't pay taxes, they pass the income (and tax paying obligation) through to the owners of the business. Tax paying entities pay the taxes at the corporate level and the owners have no obligation for the taxes owed. Your neighborhood restaurant is probably a "flow through entity." Google is a tax paying entity. When you buy 100 shares of Google, you are not going to get a tax bill for your share of their earnings at the end of the year. And then there is investment/ownership. Even before we talk about investment, there is the issue of business partners. Let's say you want to split the ownership of your business 50/50 with someone else. You have to incorporate to create the entity that you can co-own. And when you want to take investment, you'll need to have a corporate entity that can issue shares or membership interests in return for the capital that others invest in your business. So now that we've talked about the three major considerations, let's talk about the different kinds of entities you will come across. For many new startups, the form of corporate entity they choose is called the LLC. It stands for Limited Liability Company 2. This form of business has been around for a long time in some countries but be- 2

23 17 Corporate Entities came recognized and popular in the US sometime in the past 25 years. The key distinguishing characteristics of a LLC is that you get the limitation of liability of a corporation, you can take investment capital (with restrictions that we'll talk about next), but the taxes are "flow through". Most companies, including tech startups, start out as LLCs these days. Owners in LLC are most commonly called "members" and investments or ownership splits are structured in "membership interests." As the business grows and takes on more sophisticated investors (like venture funds), it will most often convert into something called a C Corporation 3. Most of the companies you would buy stock in on the public markets (Google, Apple, GE, etc) are C Corporations. Most venture backed companies are C Corporations. C Corporations provide the limitation of liability, provide even more sophisticated ways to split ownership and raise capital, and most importantly are "tax paying entities." Once you convert from a LLC to a C corporation, you as the founder or owner no longer are responsible for paying the taxes on your share of the income. The company pays those taxes at the corporate level. There are many reasons why a venture fund or other "sophisticated investors" prefer to invest in a C corporation over a LLC. Most venture funds require conversion when they invest. The flow through of taxes in the LLC can cause venture funds and their investors all sorts of tax issues. This is particularly true of venture funds with foreign investors. And the governance and ownership structures of an LLC are not nearly as developed as a C corporation. This stuff can get really complicated quickly, but the important thing to know is that when your business is small and "closely held" a LLC works well. When it gets bigger and the ownership gets more complicated, you'll want to move to a C corporation. A nice hybrid between the C corporation and the LLC is the S corporation 4. It requires a simpler ownership structure, basically one class of stock and less than 100 shareholders. It is a "flow through entity"

24 Corporate Entities 18 and is simple to set up. You cannot do as much with the ownership structure with an S corporation as you can with a LLC so if you plan to stay a flow through entity for a long period of time and raise significant capital, an LLC is probably better. Another entity you might come across is the Limited Partnership 5. The funds our firm manages are Limited Partnerships. And some big companies, like Bloomberg LP, are limited partnerships. The key differences between a Limited Partnership and LLCs and C corporations are around liabilities. In the limited partnership, the investors have limited liability (like a LLC or C corporation) but the managers (called General Partners) do not. Limited Partnerships are set up to take in outside investment and split ownership. And they are flow through entities. There are many other forms of corporate ownership but these three are among the most common and show how the three big issues of liability, ownership, and taxes are handled differently in each. The important thing to remember about all of this is that if you are starting a business, you should create a corporate entity to manage the risk and protect you and your family from it. You should start with something simple and evolve it as the business needs grow and develop. As an investor, you should make sure you know what kind of corporation you are investing in, you should know what kind of liability you are exposing yourself to, and what the tax obligations will be as a result. And most of all, get a good lawyer and tax advisor. Though they are expensive, over time the best ones are worth their weight in gold. 5

25 19 Corporate Entities Piercing the Corporate Veil Yet another MBA Monday topic comes from the comments of last week's post 1. This series is turning into a conversation which makes me very pleased. Mr Shawn Yeager said 2 : As a recovering lawyer, and a serial entrepreneur, I constantly have associates, friends, and family coming to me for advice on formation issues (amongst other things). I think your high level overview leaves out something that always comes as a surprise to these people: the concept of "Piercing the Corporate Veil" of liability protection. I said last week that forming a company is the best way to "putting a buffer between you and the business." But as Shawn and others point out in last week's comment thread, you can't just pretend to be a business, you have to be a business. "Being a business" means separating your personal and business records, separating your personal and business bank accounts, treating the business as a real entity, having board meetings, taking board minutes, doing major activities via board resolutions, following "due process." If you don't behave as a real business, you could find yourself in a situation where someone, most commonly someone who is suing your business, can come after you (and your business partners) personally. And then you are going to say "but what about the liability limitation the business provides?" It may not be there for you

26 Corporate Entities 20 That's called "piercing the corporate veil". And you should take that threat seriously. So once you create a company, treat it seriously, follow the rules, and do it right. Once again, if you have a good lawyer, he or she will lay this all out for you and even give you many of the tools to do this stuff right.

27 Accounting Accounting I'm making up the curriculum for MBA Mondays on the fly. The end game is to lay out how to look a businesses, value it, and invest in it. We started with the time value of money and interest rates, we then talked about the corporate entity. Now I want to talk about how to keep track of the money in a company. That is called accounting. This will be a multi-post effort and will include posts on cash flow, profit and loss, balance sheets, GAAP accounting, audits, and financial statement analysis. But before we can get to those issues, we need to start with the basics of accounting. Accounting is keeping track of the money in a company. It's critical to keep good books and records for a business, no matter how small it is. I'm not going to lay out exactly how to do that, but I am going to discuss a few important principals. The first important principal is every financial transaction of a company needs to be recorded. This process has been made much easier with the advent of accounting software. For most startups, Quickbooks 1 will do in the beginning. As the company grows, the choice of accounting software will become more complicated, but by then you will have hired a financial team that can make those choices. The recording of financial transactions is not an art. It is a science and a well understood science. It revolves around the twin concepts of a "chart of accounts" and "double entry accounting." Let's start with the chart of accounts. The accounting books of a company start with a chart of accounts. There are two kinds of accounts; income/expense accounts and as- 1

28 Accounting 22 set/liability accounts. The chart of accounts includes all of them. Income and expense accounts represent money coming into and out of a business. Asset and liability accounts represent money that is contained in the business or owed by the business. Advertising revenue that you receive from Google Adsense would be an income account. The salary expense of a developer you hire would be an expense account. Your cash in your bank account would be an asset account. The money you owe on your company credit card would be called "accounts payable" and would be a liability. When you initially set up your chart of accounts, the balance in each and every account is zero. As you start entering financial transactions in your accounting software, the balances of the accounts goes up or possibly down. The concept of double entry accounting is important to understand. Each financial transaction has two sides to it and you need both of them to record the transaction. Let's go back to that Adsense revenue example. You receive a check in the mail from Google. You deposit the check at the bank. The accounting double entry is you record an increase in the cash asset account on the balance sheet and a corresponding equal increase in the advertising revenue account. When you pay the credit card bill, you would record a decrease in the cash asset account on the balance sheet and a decrease in the "accounts payable" account on the balance sheet. These accounting entries can get very complicated with many accounts involved in a single recorded transaction, but no matter how complicated the entries get the two sides of the financial transaction always have to add up to the same amount. The entry must balance out. That is the science of accounting. Since the objective of MBA Mondays is not to turn you all into accountants, I'll stop there, but I hope everyone understands what a chart of accounts and an accounting entry is now. Once you have a chart of accounts and have recorded financial transactions in it, you can produce reports. These reports are simply

29 23 Accounting the balances in various accounts or alternatively the changes in the balances over a period of time. The next three posts are going to be about the three most common reports; the profit and loss statement which is a report of the changes in the income and expense accounts over a certain period of time (month and year being the most common) the balance sheet which is a report of the balances all all asset and liability accounts at a certain point in time the cash flow statement which is report of the changes in all of the accounts (income/expense and asset/liability) in order to determine how much cash the business is producing or consuming over a certain period of time (month and year being the most common) If you have a company, you must have financial records for it. And they must be accurate and up to date. I do not recommend doing this yourself. I recommend hiring a part-time bookkeeper to maintain your financial records at the start. A good one will save you all sorts of headaches. As your company grows, eventually you will need a full time accounting person, then several, and at some point your finance organization could be quite large. There is always a temptation to skimp on this part of the business. It's not a core part of most businesses and is often not valued by tech entrepreneurs. But please don't skimp on this. Do it right and well. And hire good people to do the accounting work for your company. It will pay huge dividends in the long run.

30 Accounting 24 The Profit and Loss Statement Today on MBA Mondays we are going to talk about one of the most important things in business, the profit and loss statement (also known as the P&L). Picking up from the accounting post 1 last week, there are two kinds of accounting entries; those that describe money coming into and out of your business, and money that is contained in your business. The P&L deals with the first category. A profit and loss statement is a report of the changes in the income and expense accounts over a set period of time. The most common periods of time are months, quarters, and years, although you can produce a P&L report for any period. Here is a profit and loss statement for the past four years for Google 2. I got it from their annual report (10k). 3 I know it is too small on this page to read, but if you click on the image, it will load much larger in a new tab

31 25 Accounting The top line of profit and loss statements is revenue (that's why you'll often hear revenue referred to as "the top line"). Revenue is the total amount of money you've earned coming into your business over a set period of time. It is NOT the total amount of cash coming into your business. Cash can come into your business for a variety of reasons, like financings, advance payments for services to be rendered in the future, payments of invoices sent months ago. There is a very important, but highly technical, concept called revenue recognition. Revenue recognition determines how much revenue you will put on your accounting statements in a specific time period. For a startup company, revenue recognition is not normally difficult. If you sell something, your revenue is the price at which you sold the item and it is recognized in the period in which the item was sold. If you sell advertising, revenue is the price at which you sold the advertising and it is recognized in the period in which the advertising actually ran on your media property. If you provide a subscription service, your revenue in any period will be the amount of the subscription that was provided in that period. This leads to another important concept called "accrual accounting." When many people start keeping books, they simply record cash received for services rendered as revenue. And they record the bills they pay as expenses. This is called "cash accounting" and is the way most of us keep our personal books and records. But a business is not supposed to keep books this way. It is supposed to use the concept of accrual accounting. Let's say you hire a contract developer to build your iphone app. And your deal with him is you'll pay him $30,000 to deliver it to you. And let's say it takes him three months to build it. At the end of the three months you pay him the $30,000. In cash accounting, in month three you would record an expense of $30,000. But in accrual accounting, each month you'd record an expense of $10,000 and because you aren't actually paying the developer the cash yet, you charge the $10,000 each month to a balance sheet account called Accrued Expenses. Then when you pay the bill, you don't touch the P&L, its simply a balance

32 Accounting 26 sheet entry that reduces Cash and reduces Accrued Expenses by $30,000. The point of accrual accounting is to perfectly match the revenues and expenses to the time period in which they actually happen, not when the payments are made or received. With that in mind, let's look at the second part of the P&L, the expense section. In the Google P&L above, expenses are broken out into several categories; cost of revenues, R&D, sales and marketing, and general and administration. You'll note that in 2005, there was also a contribution to the Google Foundation, but that only happened once, in The presentation Google uses is quite common. One difference you will often see is the cost of revenues applied directly against the revenues and a calculation of a net amount of revenues minus cost of revenues, which is called gross margin. I prefer that gross margin be broken out as it is a really important number. Some businesses have very high costs of revenue and very low gross margins. And example would be a retailer, particularly a low price retailer. The gross margins of a discount retailer could be as low as 25%. Google's gross margin in 2009 was roughly $14.9bn (revenue of $23.7bn minus cost of revenues of $8.8bn). The way gross margin is most often shown is as a percent of revenues so in 2009 Google's gross margin was 63% (14.9bn divided by 23.7). I prefer to invest in high gross margin businesses because they have a lot of money left after making a sale to pay for the other costs of the business, thereby providing resources to grow the business without needing more financing. It is also much easier to get a high gross margin business profitable. The other reason to break out "cost of revenues" is that it will most likely increase with revenues whereas the other expenses may not. The non cost of revenues expenses are sometimes referred to as "overhead". They are the costs of operating the business even if you have no revenue. They are also sometimes referred to as the "fixed costs" of the business. But in a startup, they are hardly fixed. These expenses, in Google's categorization scheme, are R&D, sales and

33 27 Accounting marketing, and general/admin. In layman's terms, they are the costs of making the product, the costs of selling the product, and the cost of running the business. The most interesting line in the P&L to me is the next one, "Income From Operations" also known as "Operating Income." Income From Operations is equal to revenue minus expenses. If "Income From Operations" is a positive number, then your base business is profitable. If it is a negative number, you are losing money. This is a critical number because if you are making money, you can grow your business without needing help from anyone else. Your business is sustainable. If you are not making money, you will need to finance your business in some way to keep it going. Your business is unsustainable on its own. The line items after "Income From Operations" are the additional expenses that aren't directly related to your core business. They include interest income (from your cash balances), interest expense (from any debt the business has), and taxes owed (federal, state, local, and possibly international). These expenses are important because they are real costs of the business. But I don't pay as much attention to them because interest income and expense can be changed by making changes to the balance sheet and taxes are generally only paid when a business is profitable. When you deduct the interest and taxes from Income From Operations, you get to the final number on the P&L, called Net Income. I started this post off by saying that the P&L is "one of the most important things in business." I am serious about that. Every business needs to look at its P&L regularly and I am a big fan of sharing the P&L with the entire company. It is a simple snapshot of the health of a business. I like to look at a "trended P&L" most of all. The Google P&L that I showed above is a "trended P&L" in that it shows the trends in revenues, expenses, and profits over five years. For startup companies, I prefer to look at a trended P&L of monthly statements, usually over a twelve month period. That presentation shows how revenues are

34 Accounting 28 increasing (hopefully) and how expenses are increasing (hopefully less than revenues). The trended monthly P&L is a great way to look at a business and see what is going on financially. I'll end this post with a nod to everyone who commented last week that numbers don't tell you everything about a business. That is very true. A P&L can only tell you so much about a business. It won't tell you if the product is good and getting better. It won't tell you how the morale of the company is. It won't tell you if the management team is executing well. And it won't tell you if the company has the right long term strategy. Actually it will tell you all of that but after it is too late to do anything about it. So as important as the P&L is, it is only one data point you can use in analyzing a business. It's a good place to start. But you have to get beyond the numbers if you really want to know what is going on. The Balance Sheet Today on MBA Mondays we are going to talk about the Balance Sheet. The Balance Sheet shows how much capital you have built up in your business. If you go back to my post on Accounting 1, you will recall that there are two kinds of accounts in a company's chart of accounts; revenue and expense accounts and asset and liability accounts. Last week we talked about the Profit and Loss statement 2 which is a report of the revenue and expense accounts. The Balance Sheet is a report of the asset and liability accounts. Assets are things you own in your business, like cash, capital equipment, and money that is owed to you for products and services you have de

35 29 Accounting livered to customers. Liabilities are obligations of the business, like bills you have yet to pay, money you have borrowed from a bank or investors. Here is Google's balance sheet as of 12/31/2009:

36 Accounting 30 3 Let's start from the top and work our way down. 3

37 31 Accounting The top line, cash, is the single most important item on the balance sheet. Cash is the fuel of a business. If you run out of cash, you are in big trouble unless there is a "filling station" nearby that is willing to fund your business. Alan Shugart, founder of Seagate and a few other disk drive companies, famously said "cash is more important than your mother." That's how important cash is and you never want to get into a situation where you run out of it. The second line, short term investments, is basically additional cash. Most startups won't have this line item on their balance sheet. But when you are Google and are sitting on $24bn of cash and short term investments, it makes sense to invest some of your cash in "short term instruments". Hopefully for Google and its shareholders, these investments are safe, liquid, and are at very minimal risk of loss. The next line is "accounts receivable". Google calls it "net receivables' because they are netting out money some of their partners owe them. I don't really know why they are doing it that way. But for most companies, this line item is called Accounts Receivable and it is the total amount of money owed to the business for products and services that have been delivered but have not been collected. It's the money your customers owe your business. If this number gets really big relative to revenues (for example if it represents more than three months of revenues) then you know something is wrong with the business. We'll talk more about that in an upcoming post about financial statement analysis. I'm only going to cover the big line items in this balance sheet. So the next line item to look at is called Total Current Assets. That's the amount of assets that you can turn into cash fairly quickly. It is often considered a measure of the "liquidity of the business." The next set of assets are "long term assets" that cannot be turned into cash easily. I'll mention three of them. Long Term Investments are probably Google's minority investments in venture stage companies and other such things. The most important long term asset is "Property Plant and Equipment" which is the cost of your capital equipment. For the companies we typically invest in, this number is not large

38 Accounting 32 unless they rack their own servers. Google of course does just that and has spent $4.8bn to date (net of depreciation) on its "factory". Depreciation is the annual cost of writing down the value of your property plant and equipment. It appears as a line in the profit and loss statement. The final long term asset I'll mention is Goodwill. This is a hard one to explain. But I'll try. When you purchase a business, like YouTube, for more than it's "book value" you must record the difference as Goodwill. Google has paid up for a bunch of businesses, like YouTube and Doubleclick, and it's Goodwill is a large number, currently $4.9bn. If you think that the value of any of the businesses you have acquired has gone down, you can write off some or all of that Goodwill. That will create a large one time expense on your profit and loss statement. After cash, I believe the liability section of the balance sheet is the most important section. It shows the businesses' debts. And the other thing that can put you out of business aside from running out of cash is inability to pay your debts. That is called bankruptcy. Of course, running out of cash is one reason you may not be able to pay your debts. But many companies go bankrupt with huge amounts of cash on their books. So it is critical to understand a company's debts. The main current liabilities are accounts payable and accrued expenses. Since we don't see any accrued expenses on Google's balance sheet I assume they are lumping the two together under accounts payable. They are closely related. Both represent expenses of the business that have yet to be paid. The difference is that accounts payable are for bills the company receives from other businesses. And accrued expenses are accounting entries a company makes in anticipation of being billed. A good example of an accounts payable is a legal bill you have not paid. A good example of an accrued expense is employee benefits that you have not yet been billed for that you accrue for each month. If you compare Current Liabilities to Current Assets, you'll get a sense of how tight a company is operating. Google's current assets are $29bn and its current liabilities are $2.7bn. It's good to be Google, they are