When Investing, Chasing Growth May Cost You Millions

I was recently speaking with an entrepreneur who'd passed on an investment because it would not need yield the company at least a 10x growth opportunity. I told him those returns might be reasonable when investing in small businesses (under $5 million) but that he should consider lowering his ROI threshold when investing in larger ones. My logic was twofold: first, bigger companies are harder to grow as quickly as small ones, so the growth percentages will be lower; and second, there's the potential to make substantially more money on a bigger company investment, even if the ROI was only 3x to 5x. Here's how to know when it's better to focus on percentage returns vs. dollar returns when assessing your investment opportunities.

Read the rest of this post in Entrepreneur which I guest authored this week.

For future posts, please follow me on Twitter at: @georgedeeb.

Lesson #353: Staffing Your Finance Department as You Scale

I was recently introduced to Tim DeBone a finance and accounting expert with The Bagchi Group, a business consultancy group in Morrisville, NC.  He had some interesting suggestions about how best to staff your finance and accounting function within your company, and how that changes over time as the the company scales.  He was kind enough to assist me in writing this how-to lesson and sharing it with our Red Rocket Blog readers. 

Introduction

As tech companies grow and evolve, the company's finance/accounting requirements and challenges change along with the skills needed to successfully complete them.  Because of that, your first finance hire may not always have the right skillset for when the company is 10 times the size, as an example. And, you may need to augment that team with fractional strategic level help.  To address the variability in the work and the time required to complete, many high-growth companies use outsourced bookkeepers and fractional CFOs during their early years, until they can better afford full-time talent of their own.  In this article we discuss the appropriate resources a CEO can engage to ensure the finance suite is properly managed, along each stage of the company's growth, and whether that talent should be outsourced or internally staffed.

Role Descriptions

Before we dig in, here is a brief description of the roles discussed in this article below, so you can better understand what we are going to be talking about here:

• CFO – Senior Finance Person with normally 15+ years of finance/accounting experience
• Can come from a finance background with roles that are analysis heavy
• Their accounting background is normally deep in their industry of focus, but weaker outside that industry
• Can also come from an accounting background with roles that were focused on preparing financial statements
• Their analysis background is not as strong, but they may have taken roles in the past to improve this skillset
• Bookkeeper – transactionally focused employee that runs payroll, collects invoices, and pays bills
• Does not require any formal finance or tax background
• Accountant – a certified professional with an educational background in accounting, able to perform all the duties of the bookkeeper
• The accountant is senior to the bookkeeper with a better understanding of GAAP principles and why accounting entries need to happen
• Will partner with CPA firm on financial reviews and audits

• CPA Firm – Outside accounting experts that partner with businesses on tax issues and review of financial statements, including financial audits, if needed.
• They can also help identify small business and R&D tax credits to reduce tax liabilities

At Formation (Pre Revenue)

At the start, the CEO can manage the core finance functions. Software systems are now sophisticated enough that non-finance professionals can manage early-stage payroll, collections, and payments. Depending on the growth path or complexity of the business model, the CEO may want to engage a fractional CFO to help create the forecast and cash planning. But until the company has significant revenue or outside investors, the CEO can complete most activities. We would recommend that the company engage an outside accounting firm at formation to help with annual tax preparation. Even without the need for a financial review or audit, this resource prepares annual tax filings and significantly reduces tax risk for the company. 

Pre-Seed Stage (Generating Some Minimal Revenue) 

Once the company has revenue and non-founder employees, they should engage an outsourced bookkeeper to take over the back-end transactional work. This involves running payroll, collecting from customers, and paying vendors. While these are straightforward tasks, the CEO hesitates to outsource them and their time is better spent guiding development or aiding sales. At this stage, a fractional CFO can help on a project-to-project basis, but the company will not have enough work for the CFO to require a preset amount of help each week. The CFO can improve metric tracking, evaluate back-office processes to prepare for growth, and help prepare the business for a seed raise. The CFO helps the fundraise by preparing employee and customer documents for investor diligence, ensuring the management team understands their growth metrics and benchmarks, and creating forecasts showing how investor funds will grow the business.

Seed Stage ($250K-$1MM in Revenue)

After raising a seed round, the investors may strongly suggest that the company employ a fractional or full-time CFO to manage the finances and strategic planning. The CFO will introduce budget vs actual analysis, scenario planning, and project out the cap table. Dilution calculations become more complex as the company hires more employees and brings in outside resources, especially when those new funds are SAFEs or Convertible Notes. The company may also switch from cash accounting to accrual (or GAAP compliant) accounting at this stage. Accrual accounting may be outside the skillset of the original bookkeeper so upgrading that role to a part time accountant may be required. Depending on how fast the company scales, that part time accountant may become a full time hire before the Series A fundraise is completed. That accountant, along with the CFO, will partner with the CPA firm to prepare annual tax returns and any financial reviews or audits.

Series A Stage ($1MM-$5MM in Revenue)

Once the company has raised a Series A, the CFO will be spending 8-10 hours weekly on the business. In addition to the previous work around strategic planning, the CFO will be building and training the back-office team, introducing additional risk mitigation processes, partnering with the CEO on tracking company performance, and partnering with the CPA firm on tax issues. The company will be growing quickly with increasing complexity across all back-office functions, referred to as General and Administrative (G&A) on most financial statements. The CFO will be managing and training the HR, Recruiting, Finance, Accounting, and Facility planning teams to enable the company to support the company’s growth. At this stage, a full-time junior level hire is required, either heavier on accounting or finance depending on the business model and the CFO’s background. With the expansion of the employee base and revenue base from additional growth, the CFO will need to identify and mitigate potential risks before they happen. Those risks can involve employees, security, legal, tax, or financial issues. Key Performance Indicators (KPIs) become essential as current investors, and future investors, will need to understand how the company performs versus targets and industry benchmarks. The CFO should also be measuring forward-looking metrics to anticipate whether the plan is succeeding or failing compared to pre-set plans and budgets which have been prepared by the CFO. 

Late Series A or Series B Stage ($5MM-$10MM in Revenue)

If a company continues to grow and hit their metrics after the Series A fundraise, the workload will require a full-time CFO to join the team. The amount of effort required to help the next fundraise process, run the G&A team, and support the CEO will be too much for a fractional resource. Hiring this role before starting the Series B fundraising process allows time for the new CFO to learn the business and can assist with the fund raise. The fractional CFO should have the processes in place to enable a smooth transition, along with highlighting which areas need improvement to scale the business. Two full-time finance/accounting employees should be able to manage the business at the Series B start, but the company may want to expand the HR/Recruiting function at this time to include a full-time employee. 

Hopefully, you now have a better understanding of how best to staff your finance and accounting needs as your business scales.  Thanks again, Tim DeBone, for your help with this post.  If any of you need additional help around your finance team strategies, Tim is happy to help you answer any of your questions.  Feel free to reach out to Tim at (704) 907-5866 or tim@bagchigroup.com.

For future posts, please follow me on Twitter at: @georgedeeb.

Lesson #343: How to Analyze and Report Your Financial Results

 

You would be surprised how many entrepreneurs don't truly understand the financials of their business.  Yes they are creating them out of Fresh Books or Xero, and they most likely focus on high level numbers like total revenues and total profits.  But, they don't dissect everything in between.  And, more often than not, when it comes to managing the finances of your business, the devil is in the details.  This post will help you learn the basics of formatting, interpreting and reporting your financials, so you will look like a pro with your investors or whoever else may be asking for them.

The Key Financial Statements

There are typically three financials statements that are prepared: (i) the income statement (or often called the P&L statement); (ii) the balance sheet; and (iii) the cash flow statement.  The income statement measures all inbound revenues and outbound expenses of the company, for whatever date range you are interested in studying.  This is the most studied of the financial statements, as all companies are striving to grow their revenues and profits over time.  The balance sheet lists all the assets, liabilities and equity in the company at any single point in time.  As the name suggests, the asset values, must balance with the liability and equity values. The cash flow statement gives you a true sense to how your cash balance on the balance sheet are moving up and down with any operating, financing or investing activities that may not be entirely clear from the profit levels shown on the income statement.  For example, the cash flow statement will adjust for non-cash items like depreciation and show how cash was used other than for paying expenses on the income statement.

Optimizing The Income Statement

To me, these are the key numbers to study on the income statement: (i) revenues; (ii) gross profit margin (revenues less cost of goods sold); (iii) EBITDA (gross profit less all expenses, resulting in earnings before interest taxes depreciation and amortization); (iv) return on ad spend or ROAS (revenues divided by sales and marketing costs); and (v) return on staff spend or ROSS (revenues divided by total payroll investment including salaries, bonuses, commissions and benefits).  There may be others depending on your industry or business model, but these are a few of the bigger ones that apply to most all companies.

Optimizing for revenues is pretty simple to understand--more is better than less!!  The bigger revenues grow, the better.  So, you are always trying to improve your revenues from the preceding period, either the prior week or the same week of the prior year if there is any seasonality in your business.

Optimizing for gross profit means that you want your gross profit margin (gross profit divided by revenues) to be improving, or at least staying flat in every future period.   Said another way, you want your cost of goods sold as a percentage of revenues to be staying flat or improving. Rising costs will obviously hurt your bottom line profits.  And, looking for opportunities to lower your costs, either with new vendors or more efficient processes will help you here.  Gross margins can vary wildly based on your business model, but often end up in the 20%-80% range, with most in the 30-40% range.

EBITDA is obviously benefitted by improvements in revenues and gross profits, but it is also benefitted by keeping all of your other expenses as a percentage of revenues flat or improving over time.  In terms of which expenses you need to focus on optimizing--focus on the big ones.  For most companies that is typically sales and marketing expenses and payroll expenses.  Those should clearly be broken out as separate line items.  The minor expenses can be bundled into "other expenses", but they too should be optimized where they can.  You are doing well if EBITDA is growing in dollars, and the EBITDA margin (EBITDA divided by revenues) is improving over time.  Worth noting, some expenses are fixed one-time expenses (e.g., your CEO's salary), so they will become less as a percentage of growing sales.  And, other expenses are variable recurring expenses that scale as you grow (e.g., shipping costs), that will most likely stay flat as a percentage of sales. So, know the differences here.  EBITDA margins typically end up in the 10-30% range, depending on your business model.

ROAS is probably the most important metric you are managing for.  You can't grow revenues without growing your sales and marketing investment.  And, you want to make sure you are acquiring new customers as cost effectively as possible.  ROAS typically ends up in the 3x to 10x range, and the higher the number, the more effective your advertising investment is.  Worth noting, it is okay if your ROAS slightly declines over time as you scale, as your initial marketing spend is typically more effectively invested than your tactics used at scale.  But, it always has to end up in a profitable return on marketing investment.

ROSS is another important metric to measure.  It helps to measure that your investment in human resources is maintaining or improving its efficiency over time.  ROSS typically ends up in the 5x-10x range depending on your business model.

Optimizing The Balance Sheet

To me, the key numbers to study on the balance sheet are: (i) cash; (ii) debt ratio (total debt divided by total debt plus invested equity); (iii) current ratio (current assets divided by current liabilities); (iv) inventory turnover ratio (cost of goods sold, divided by average inventory); and (v) return on capital or ROC (net profits divided by total invested capital).

Optimizing for cash is pretty straight forward, more cash is better than less!  You always want to have enough cash on hand to ensure you can at least manage your business needs for the coming 12 months or more.  If not, it may be time to consider a financing or lower your expenses and cash burn rate to extend your "life line".

Debt is typically a bad thing for early stage businesses, given all the risks and uncertainties of a startup environment.  And, most debt for small businesses comes with personal guarantees from the owners, which means if the business can't pay its debts, the individual owners are backstopping the liability, and you can personally bankrupt yourself with any business failings.  But, if you are going to take on debt, never let your debt ratio exceed 50% of invested capital.  And, seek-asset based funding sources that can secure your assets or inventories, without requiring any personal guarantees, where possible.

Your current ratio is basically measuring if your current assets exceed your current liabilities or not, and that there isn't any immediate cash squeeze needed to fund working capital needs.  So never let this ratio go below a 1:1 ratio, or there may be some short term capital needed to fund immediate liabilities.

Your inventory turnover ratio is measuring how fast you are moving product in and out of your warehouse.  It is calculuated based on your average inventory levels in the studied period, not necessarily the point in time balance on a specific date.  The faster you are turning inventory the better, to reduce your out-of-pocket cash investment in inventory.  I would say an average business is turning inventory 3-4x per year.  If you are turning less than that, you may need to write off inventory that is not selling or change your product and sourcing decisions to help the business become more efficient.

Your ROC is helping to illustrate that you are getting your investors a good return on their investment.  Depending on how large your business and how fast you are growing, I would say ROC needs to be in the 15% to 35% range, on average, in order to attract and retain your investors. 

Optimizing The Cash Flow Statement

The cash flow statement is simply another way of studying your cash inflows and outflows, where you obviously shouldn't be spending more than you have to spend.  But, this statement is helping your CFO know whether cash was spent or generated from operations (e.g., capital expenditures for replacement equipment); investing (e.g., took an equity stake in a supplier) or financing activities (e.g., closed a new equity investment into the company).

Reporting Timing

To me, every business needs to be studying its business on at least a monthly basis.  Bigger companies tend to study their businesses on up to a weekly, or even a daily basis.  But, no less frequently than monthly.  So, at a minimum, when you get to the 1st day of any month, it is time to study the financial results of the preceding month.

Reporting Analysis

In your financial statements, I would be reporting results for: (i) the current month; and (ii) the year to date period.  And, I would be comparing them to; (i) the original budget; and (ii) the same results for the prior year period (e.g., compared March 2022 to March 2021).  And, the reports need to include: (i) dollar amounts; (ii) percentages of sales; and (iii) percentage growth rates, for every line item.  These reports need to include each of the important datapoints and metrics discussed in this post, so you can track their progress over time, and study if the business is doing better or worse than budget, and better or worse than last year, and to what extent.  

Here are example column headers for your income statement for the month of March: (i) March Dollars; (ii) March % of Sales; (iii) March % Increase; (iv) January to March YTD Dollars: (v) January to March YTD % of Sales; and (vi) January to March % Increase.

Once the reports are created, now you or your CFO need to study the data and metrics, and produce a Management's Discussion and Analysis document, that discusses the key trends and why the numbers are moving in the direction they are, and why they are better or worse than last year or the plan.  That "WHY" is the most important thing here, make sure you have a firm grasp on the reasons behind any movements in your results or metrics, so you can manage them accordingly.  So, build the monthly discipline of actually studying this when allocating your time.

Closing Thoughts

I was a finance major in college, so financial statement analysis is a pretty basic skillset of mine.  But, if you never studied finance, it can be a daunting exercise.  So, hopefully, this post can help point you in the right direction to truly mastering the numbers of your business.

For future posts, please follow me on Twitter at: @georgedeeb.

Lesson #334: Use Google Trends to Track Your Market Share and Success

 

I am sure many of you have used Google Trends in the past.  But, for those of you that are not aware of this terrific tool, now is the time to learn how valuable it can be for your business.  

What is Google Trends?

Google Trends is a tool that can tell you how searches for a specific keyword on Google have been trending over time, for whatever date range you are most interested.  As an example, here is the search traffic trend for the term "restaurant furniture" for the last year:

As an investor in Restaurant Furniture Plus, this data is very important to me, as a tool to know whether the industry is moving up or down, and how the industry is behaving year over year, which I then can compare to our own revenue results.  It also tells me whether or not we are gaining or losing market share, compared to our competitors, which I will detail below.  The way to read this chart is the highest point in the period is scored a 100, and then every other period is indexed against that peak.  So, a week showing a score of 25, would have 75% less traffic than the peak week.

What do we see is in this chart--there was a slump starting in March 2020, which is no surprise with the beginning of the COVID pandemic in the U.S.  Then, there was an unexpected spike in June 2020, which caught us in surprise.  Why was there a spike in the middle of a pandemic when most restaurants were closed?  In response to COVID, restaurants were racing to buy outdoor furniture to open patios which were allowed to operate.  And, then, the rest of the year, pretty much followed normal seasonal trends--this industry normally peaks in March-June, and then November-December are typically the slowest months of the year.  If you looked at this same chart in 2019, you would not have seen a dip in March, you would have seen steady acceleration in demand leading up to new summer restaurant openings and their need for furniture.

How to Use This Data For Your Business--A Couple Case Studies

As discussed, the above can show how the industry is trending, for you to compare your own revenue results.  But, if you dive a little bit deeper, it can tell you if you should be happy or sad with your own revenue results.  Let's talk through an example, using the above chart.  The month of April had an average score of 27 and the month of May had an average score of 48.  That was a 78% increase as the restaurant industry started to shake off the immediate paralysis coming out of COVID.

As I compare that to our Restaurant Furniture Plus data, our revenues in May were up 128% over April.  So, yes when I looked at our revenue data in isolation, without Google Trends data , I was obviously happy with the 128% growth.  But, when I layered in the fact the industry growth was only 78%, that means that Restaurant Furniture Plus was actually growing 29% faster than the industry was growing.  In other words, we were increasing our market share, taking volume away from our competitors, which obviously made us ecstatic.  It turned out that in a world post COVID, the internet dealers like us, where taking share away from the offline brick-and-mortar dealers, many of which were closed during this period.

This data is especially helpful in this following scenario.  I had a client that was really pleased with their 10% month-over-month revenue growth.  And, he thought everything was fine with his business, until we layered on the 20% industry growth from the Google Trends data!  It was a very sobering moment for my client, as his mood changed from "great, we are growing", to "oh crap, we are losing material market share" in the snap of a finger.

Some Additional Guidance

Remember, Google Trends is simply traffic data from Google.  Your website traffic growth, may or may not be in synch with Google trends.  Maybe you have a bottleneck there, with poor search engine optimization, and you are not getting your fair share of the overall internet searches (so, fix that!).  And, the above example assumes you have an immediate conversion of website traffic into sales in the same month.  That may be the case for low ticket consumer products.  But, that is most likely not the case for more expensive B2B products or services, that have a longer sales cycle, especially if they are converted offline.  So, instead of mapping Google Trends data to sales or transactions, map it to leads.  And, if you are going to map to sales, adjust the analysis for your sales cycle (e.g., April traffic growth with a three month sales cycle will drive July sales growth).

Closing Thoughts

Hopefully, you now have a new tool that can help you with instantaneous market research and trends on your industry.  Use this data to help you plan your month-by-month budgets, for any seasonality in your industry, and to compare how your business is trending versus the industry overall.  If you are losing market share, you may not realize it now, but you have a pretty big problem on your hands, that you will need to fix asap.  Good luck!

For future posts, please follow me on Twitter at: @georgedeeb.

Lesson #319: How to Pitch a Business Investment Case to Your CFO

Chief Financial Officers are often the “gatekeepers” to the company’s cash coffers.  And, as you can imagine, the have a lot of people tugging on their sleeves looking for investments into various projects within the company.  But, CFO’s need to prioritize their spend, based on what is in the best interests of the company.  This post will help you learn to think like a CFO and how best to pitch your business investment case with the highest odds of success.

First of all, there are many different scenarios in which the business may require capital.  Perhaps the CEO wants to make a big strategic acquisition.  Or, the CMO needs to scale up the company’s sales and marketing efforts.  Or, the head of product wants to launch a new business line.  Or, the CTO needs to develop new technologies for the business.  Or, the head of HR needs to make a few new hires.  The ways capital can be invested in the business are limitless, and the asks from the team are endless.  So, you better make sure your pitch resonates to break through the clutter.

Here are examples of the best ways to pitch for internal funds, for each of the scenarios above:

Pitching for Strategic Capital

Like in any investment, your CFO is going to be most focused on the potential return on investment (ROI).  It is no different than pitching a venture capitalist for outside funds; now you are pitching your inside team for internal funds with an “ROI First” mindset.  Let’s say the CEO wants to invest $5MM into an acquisition of a competitor.  The business case he would want to make is: (i) it adds $10MM of revenues and $1MM in annual cash flow to the business; (ii) it removes a big competitor, making it easy to price our products and grow our margins; (iii) it grows our market share in the space; (iv) it will help us accelerate revenue growth by cross-selling our respective products into non-overlapping industries; and (v) it will help us to achieve a 10x return on the invested capital within the next five years, based on these reasonable financial assumptions.

Pitching for Marketing Growth Capital

Your CMO may be looking for capital to spend on $1MM on additional marketing activities or to expand the sales team.  So, she is going to have to communicate things like: (i) I am expecting a 5x return on my advertising spend, adding $5MM in revenues; (ii) the investment should realize a return of funds invested within 6 months of the spend; (iii) my expected cost of customer acquisition is $250, well below our expected gross profit of $1,000 per transaction; or (iv) we will be able to sell into twice as many regions or sectors than we are today, increasing our potential reach and ability to scale the business.

Pitching for Product R&D Capital

Your head of product research and development may want to invest $1MM into launching a new product line.  So, she is going to have emphasize points like: (i) by doubling our product line, we should be able to double our sales, by increasing our average order size; (ii) the new product line will be a “first mover” in the space, with limited competition; (iii) it will make us less dependent on our original product suppliers, better diversifying our vendor concentration risk; (iv) we have researched our customers, and 75% of them said they would buy this new product if it was available for sale; and (v) I expect the investment to allow to build $10MM in additional revenues, a 10x ROI, within the first three years.

Pitching for Technology Capital

The process is exactly the same for your CTO, when asking for $1MM to develop and upgrade the companies systems in the next year.  He is going to have to impress your CFO with information like: (i) our old technology can crash at any time and is putting our current $10MM in revenues at risk if the site goes down (saving a -10x loss); (ii) by improving our user experience on the website, I expect to reduce our abandoned cart percentage by 25%, theoretically adding $2.5MM in new revenues  (a 2.5x ROI); and (iii) if we don’t make this investment, hackers will be able to get into our systems and get access to all of our customer data, which we don’t want to happen to our customers or ourselves for competitive reasons.

Pitching for Human Capital

Adding $1MM of payroll happens throughout the organization, by department, but adding human resources to the organization requires the same ROI-driven financial disciplines: (i) we need that new salesperson because we are under capacity, with more leads than we can reasonably handle today, and we expect to close $1MM of new sales from that $250K investment in a new salesperson (4x ROI); (ii) our employees are on the “hamster wheel”, getting burned out working at 110% capacity; if we don’t add additional staff members, 25% of our current team is going to quit, taking those relationships and institutional knowledge with them; and (iii) to improve our recruiting, retention and morale, we are going to have to upgrade our employee benefits offering, which should improve our hiring time by 25% (helping us drive efficiencies and revenues faster) and reduce our employee turnover rate by 30% (which stops the revolving door we have with talent, and the inefficiencies and lost revenues that come with that—aggregating around a 5x ROI).

Rinse and Repeat This Process Within Departments

And, this logic needs to flow all the way down to the department level, as well.  Your CMO needs to have their heads of search engine marketing, social media marketing and display advertising each make their ROI case to her, so she can prioritize her overall marketing spend. And, your CTO needs to prioritize the 100 technology improvement requests from the technology team, based on the expected ROI of each one, so he knows which projects to tackle first.  You get the point.

Concluding Thoughts

So, as you can see, if you know how to ask for capital from your CFO, in the language that he is used thinking about it (with an ROI mindset), you should materially improve your odds of securing it.  Your company should develop a template business investment case form that everyone asking for capital should fill in.  First, that will require everyone to “think” before they ask; and second, that will help your CFO to better prioritize the investments based on the expected ROIs from each one. 

But, just because you ask, and have a well-thought plan, does not necessarily mean you will get the capital.  You never know what other competing forces are out there, tugging on the company’s purse strings.  Your CFO’s job is to keep the company liquid and out of trouble, and their job is to make sure all investments are made within the overall budget of the company.  You can count on the CFO to prioritize his spend based on the amount of the ask, the expected timeframe to return the funds and the expected ROI from that investment.

So, based on the above examples: (i) the CEO asked for $5MM to return 10x in five years; (ii) the CMO asked for $1MM to return 5x in six months; (iii) the head of product asked for $1MM to return 10x in three years; (iv) the CTO asked for $1MM to protect 10x and add 2.5x in one year; and (v) the head of HR asked for $1MM to add 4x ROI on the new hire and 5x ROI by making the current hires happier and more efficient.  So, you decide; put on your CFO hat and tell me how you would prioritize the spend?  I have a hint for you:  the CEO’s acquisition would not be my first choice.  (Gulp!)  I’ll let you tell him that!

For future posts, please follow me on Twitter at: @georgedeeb.

Lesson #273: Benchmarking SaaS Financial Metrics

My colleagues at River Cities Capital Funds, a Cincinnati and Raleigh based growth-stage venture capital fund with deep expertise in the SaaS technology industry, has recently published a terrific new report with a treasure trove of operating and valuation benchmarking data in the SaaS space.  The report was based on studying the financial reports of 92 publicly-traded SaaS companies, to see how those companies grew over time.  For purposes of this blog post, I focused on the operating metrics only, to help give earlier stage entrepreneurs a blueprint on how to grow their businesses.

THE KEY DATA

To simplify reading the full 30 page report, I curated the most-relevant median financial metrics for the 92 companies studied into the below chart.

Now, you have a better understanding of what it takes to plan and budget for your own SaaS business, along every step of the revenue curve.  Especially, if you are venture capital backed, or plan to go head-to-head against other venture capital backed companies (and the deep pockets they will have in shooting bullets in your direction).

LEARNINGS FROM THE DATA

Growth:  Buckle your seat belts, and get ready for a wild ride.  These companies were averaging some pretty fast 40-50% growth rates, over time.  It only took these 92 companies an average of 6 years to grow from under $5MM in revenues to over $100MM in revenues. And, while growth is exciting, it sure brings a lot of headaches when trying to scale your business and processes along the way.  So, plan ahead.

Gross Margin:  I was surprised the 60-70% gross margins were as low as they were here.  You hear about how much venture capitalists like the SaaS space because of their high margins, but that is much harder to see in the above chart.  So, if you were planning to strike it rich with 80-90% margins, think again, as it looks like prices are coming down.

Sales & Marketing Investment:  In order to get to their first $1MM in revenues, they needed to invest $1.5MM in sales and marketing, on average.  To get to their first $1MM in gross profit, they needed to invest $2.4MM in sales and marketing, on average.  Hopefully, you have raised enough capital to put enough sales and marketing muscle behind your business, and fund these startup losses.  The investment here is material in the 40-50% range, and maintains itself at very high levels over time, resulting in almost a two year payback period!!  Don't forget to read this post on metrics specifically related to SaaS sales team metrics, for deeper-level benchmarks.

R&D and Capex:  Don't think you build a product and you are done with it.  These companies are plowing in tons of monies into improving their products over time.  Think 25% of revenues long term, and that takes a lot of capital backing in the absence of material profits.

EBITDA:  I understand that investing in long term growth requires a material investment, often resulting in near term losses.  But, I was surprised how long the losses continue, over many years.  These companies didn't really break even until they got to $75MM in revenues, on average.  And, even then, the bottom line profits were not all that exciting, at 4% of sales.  Yes, I know, the numbers will look a lot better at $200MM in revenues, than they do at $100MM in revenues, but that is a really a long time to have investors wait for a meaningful return on their investment.

Valuation:  Think about this--a $100MM revenue SaaS business is worth $380MM at the 3.8x average multiplier cited in the report, which means it is trading at a whopping 95x cash flow.  I'm sorry, I just don't see the logic in that.  There are tons of other cash-generating businesses you can buy for a lot less money, and actually have a lot more to show for it. So, buyer beware!

Thanks again to the River Cities team to putting all that hard work into their research report.  Now we all can benefit from it, in terms of modeling our own SaaS businesses.


For future posts, please follow me on Twitter at: @georgedeeb.

Lesson #266: Managing for Net Cash Flow vs Net Profit

As many of you know, Red Rocket has been looking for a businesses to buy.  We have previously written about all the challenges that come with buy-side mergers and acquisitions work.   But, there is a new wrinkle we have been running into, that is worth talking about.  Most businesses we have looked at were managed to maximize net profit, which is typically a good thing.  But, when trying to attract an acquirer, they really should have been managed to maximize net cash flow.  As at the end of the day, that is really want matters most to investors--getting visibility into a near term return of their invested capital, that hopefully can pay back in 12-18 months, not 4-5 years.  Let me explain further.

DEFINING THE DIFFERENCE BETWEEN NET PROFIT AND NET CASH FLOW

Net profit is a pretty straight forward calculation; it takes all the revenues of the business collected from customers in a time period and subtracts all the expenses of the business in that same period.  Those expenses include things like the cost of goods sold and all the selling, general and administrative costs of the business (e.g., marketing, payroll, home office).  Net profit is an income statement output.

Net cashflow is a cash flow statement output.  It starts with the net profit calculated above and then adds back non-cash items like depreciation and amortization, and then subtracts other longer term investments made in the business, like build-up of inventory for future months' sales, research and development costs made for future product offerings and other capital expenditures (e.g., for new equipment or capitalized software investments).

WHY MANAGING TO CASH FLOW MATTERS

Let's say we had a business with $5MM in revenues generating $800K in profit before taxes and $1MM in EBITDA when you add back $200K of non-cash items, like depreciation.  Since most businesses are valued on a multiple of EBITDA, this business may be worth 4x cash flow, or $3.2MM to a potential acquiror, depending on how fast it is growing.

But, then the potential buyer of that business starts to peel back the layers of the onion on the cash flow statement, and uncovers the business is making $1MM of off-income statement investments to support their growth, into things like building up inventory for future months and R&D investments into future products.  That takes the net cash flow of the business down to zero.

So, with most acquirers looking for businesses with high net cash flow, with which to attract bank financing and to have funds from operations with which to pay down their loan and interest over time, this presents a major challenge for the buyer.  Instead of getting a business that they thought was generation a lot of profits (which is valuable to them), they are getting a business which is cash flow neutral (which is not that valuable to them, given the nature of their business).  What worked well for the entrepreneur in growing their revenues at the expense of short term distributions, does not work well for most private equity investors or acquirers of your business.

WHEN THIS IS NOT THE CASE

Obviously, if you are not trying to sell your business, making potential investors or acquirers happy doesn't matter.  You can do what you like in those cases.  And, the reason most businesses don't care about not driving huge positive cash flow, is because they are more focused on re-investing all cash flow into the company, to help propel the business to new heights in future years (not caring about the impact to profits or cash flow in the current year).  Amazon is a great example of a company that has had major success with a strategy like this, although it ruffled the feather of many of their early investors as a public company, since it was counter to the norm of maximizing near term profits.

CASE STUDY

We were studying the potential acquisition of an ecommerce seller of branded shoes.  They were showing very impressive revenue growth from $5MM to $10MM to $15MM over a three year period, and net profits were growing right along with it, from $1MM to $2MM to $3MM.  That would attract the excitement of most any investor or buyer.

Until, we looked at the cash flow statement in more detail.  And, we learned, they needed to invest the full $3MM of profit into their future inventory investment required to support the next year's expected revenues of $20MM.  With a 50% cost of sales ($10MM) and a 3x inventory turnover ratio ($3.3MM of inventory needed for next four months), they needed every penny of the prior year profits, and more, to fund their growth.

So, yes, if the plan was to shut off the growth at $15MM, and milk the $3MM of profits out of the business in perpetuity, that would appeal to certain buyers.  But, if the plan, was to grow a $15MM business into a $50MM business, all while distributing a portion of profits to the shareholders or the lenders along the way, this business wouldn't attract anyone.

WHAT THIS MEANS TO YOU

Yes, profits are important and should be maximized.  Especially since they are the root driver of EBITDA which is relied on heavily in valuing companies.  But, if at the same time, you are not being sensitive to maximizing cash flow during growth periods of your business, you are going to have a hard time attracting new investors, lenders or acquirers for your business.  At the end of the day, there has to be enough cash left to distribute out to the investment partners in a business (e.g., banks, private equity firms), along the way, in order to get their upfront attention.  So, plan accordingly.


For future posts, please follow me on Twitter at: @georgedeeb.

Lesson #219: Stock Option & Incentive Plans for Startups

I previously wrote about the importance of spreading equity to your employees or key partners. Stock options or other similar incentive plans are a great way to attract talent, incentivize employees and build long term employee loyalty for your business.

Some companies prefer to grant them only to senior management.  But, I am a fan of distributing them through the entire organization, so everyone feels invested in your success together.  Plan to set aside 10-20% of your equity value for your expanded team (e.g., 1-5% for senior execs; 0.5%-1% for middle managers; 0.25-0.5% for entry level staff). This is assuming they are normal salaried employees, and not a co-founder, where equity values could be materially higher (re-read this post on how to split equity between co-founders).

There are typically four types of incentive plans for you to consider, with various rules and tax consequences for the company and the recipients, as summarized below:

1. Non-Qualified Stock Option Plans (The Most Typically Used, Given Advantages Below)

Who Can Receive:  Anyone (e.g., employees, directors, partners)
Waiting Period to Exercise:  No restrictions.  Exercise anytime after they vest.
Exercise Price:  At any price, but taxable to recipient if less than fair market value (FMV)
Transfer Rights:  May or may not be transferable, depending on how you set up the plan.
Term of Options:  Exercisable anytime, provided plan is not set up otherwise.
Value of Underlying Stock:  No limit at time of exercise, provided plan is not set up otherwise.
Taxes to Company:  Deductions allowed from grants, at time recipient recognizes income, provided the company fulfills its withholding obligations.  This ordinary expense is equal to the ordinary income declared by the recipient.
Taxes to Recipient:  No tax at time of grant or exercise.  The recipient receives ordinary income at time of exercise for the difference between sale price and strike price. (So, people don't typically exercise until close to a known liquidity event where they will receive proceeds to cover taxes).

2. Qualified Incentive Stock Option Plans (Not Typically Used, Given Restrictions Below)

Who Can Receive:  Employees Only
Waiting Period to Exercise: One year.
Exercise Price:  At least equal to fair market value (or at least 110% of FMV for 10% holders)
Transfer Rights:  May not be transferred to anyone.
Term of Options:  Exercisable no more than 10 years after grant.
Value of Underlying Stock:  Cannot exceed $100,000 at time of exercise (in one calendar year).
Taxes to Company:  No deductions allowed from grants.
Taxes to Recipient:  No tax at time of grant or exercise.  Capital gain on sale of underlying stock (provided they hold the stock for at least one year after exercise, ordinary income if not).

3. Phantom Stock Option Plans

For some companies, the founders do not want any dilution to their equity.  But, they want to incentivize their employees with the same economic value they would have realized by owning equity.  In this scenario, you would launch what is known as a Phantom Stock Option Plan.  Instead of given rights to purchase stock, you are giving rights to receive the same economic value they would have made by owning the stock, without actually owning the stock.  These cash payouts are typically tied to a liquidity event or exit for the company. For tax purposes, phantom stock is treated the same as deferred cash compensation. Phantom stock payouts are taxable to the employee as ordinary income and tax deductible to the company.

4. Profit Sharing Plans

Another way to accomplish the same incentive, is to establish a profit sharing plan for the company.  So, instead of splitting up the equity and ownership of the business, you simply split up any profits that are generated each year.  The benefit to the individual is getting more control (easier to influence driving profits, than sale of company), in a more timely fashion (paid out annually, instead of at unknown time of sale of the company).  The problem with this route is early-stage businesses should not be distributing cash to its employees, it should be reinvesting that cash into accelerating the company's growth during its early-stage years.  So, if you plan on being a heavy cash user for growth, I would avoid this route.

Vesting, Acceleration & Other Key Terms

In all of the above cases, it is important you put a vesting schedule in place for the recipients before they are able to exercise their options.  Most vesting schedules are set over a four year period of time, to create long term hooks for retaining employees.  Typically, 25% vests per year, where it is a cliff vest in the first year (you have to wait all 12 months before first 25% is earned).  That ensures if an employee is not working out, you can terminate them without losing any equity.  Then after the first year, 1/36 of the 75% is earned monthly, over years two, three and four.  In the event there is a change in control of the business, you would typically accelerate the vesting to 100% earned, so the recipient can get the value created in the sale.

In addition, you want to make sure the company has a mechanic to buy back the underlying stock at the then fair market value and does not allow the recipients to transfer equity to other third parties outside of the company, without your written approval.  You typically don't want equity in the hands of strangers or "unfriendly" parties.

And, worth mentioning, you don't typically grant stock outright, as you do not want to trigger any immediate compensation tax consequences for the recipient or the company.  And, if you don't want to have the expense of setting up and maintaining a formal stock option plan, there are ways to motivate specific individuals, by granting them individual warrants to purchase stock, often with the same economics and vesting you would see with a stock option plan for many.

Hopefully, you found this high level education useful.  But, these are really complex issues.  So, as always, when setting up your plan, seek the counsel of a good startup lawyer to help you avoid the many known pitfalls (here is a good list of startup lawyers in Chicago).

For future posts, please follow me on Twitter at: @georgedeeb.

Lesson #179: Reduce Customer Churn to Accelerate Revenues

Customer churn is one of the most important metrics a startup can measure and reduce over time.   Churn is basically the percentage of customers that stop shopping with you in a given period, typically calculated for businesses with recurring monthly revenue streams.  The higher your churn, the poorer job you are doing at retaining your customers.  And, worse yet, instead of getting lower-cost marketing efficiencies from retention marketing to current customers, you are back fishing again in expensive pools of fish for new customer acquisition.

As a benchmark, I would try to keep your monthly churn rate below 2.5% of lost customers per month, since it is unreasonable to assume you will keep 100% of your customers in perpetuity, with a 0% churn.  So, put the tracking in place in your business to measure this key metric, to see how you are performing each month.  And, then optimize it accordingly.  And, why does this matter?  The difference between a 2.5% churn and a 5.0% churn, could be the difference in building a 50% larger business in a five-year period of time.  So, although you may not identify an immediate problem today, it certainly adds up over the years, if left unchecked.

So, what causes churn?  Customers are obviously unhappy with your product or pricing.  So, to reduce churn, you need to be surveying your former customers to figure out why they left.  And, then put a plan in place to address those issues in your current offerings, so current and future customers stick with you, and you can more quickly grow your business with the lower churn rate.

There was a really great blog post on this topic written by David Skok , a serial entrepreneur and VC at Matrix Partners, back in 2012.  It has some great case studies worth re-reading today.  More importantly, he introduces a concept called “negative churn”, which basically means your upselling and cross-selling from retained customers, offsets any revenues lost from customers who cancel services.  I thought that was very good wisdom, as “landing and expanding” with current customers, is obviously a lot easier than trying to drum up new customers from scratch.  And, the difference between a negative and positive 2.5% churn, is building a business that is almost 3x larger in a five-year period of time.

So, it is critical you are always talking to your customers, looking for areas for improvement, especially as it relates to long-term client happiness and retention.  Fix what they don’t like.  And, deepen what they do like.  And, where you can, look for ways of increasing the stickiness of your product or service, making it painful for customers to leave you.  Maybe it’s your data, or analytics, or simple integration with their other systems, or whatever else, that keeps them wanting to drink your Kool-Aid. 
 

In addition, make sure you are doing everything you can, operationally, to help reduce churn.  This includes structuring longer term contracts to reduce monthly turnover.  And, it means training your call center reps on how best to turnaround a “cancellation call” into a “retention call”.  And, if they are unsuccessful at doing that, at least turn them into focus group managers, to learn why the clients are leaving, so they can pass that information on to the product team.

If your revenues and growth rate and customer satisfaction were not enough impetus for you to fully embrace the importance of lowering your churn rate, I offer one additional reason:  smart investors are keenly focused on these metrics.  If you don’t know your metrics, you will not look smart to your investors.  And, if you do know your metrics, but they are too low, you can kiss your venture capital financing good bye.

For future posts, please follow me on Twitter at: @georgedeeb.

Lesson #146: Pitfalls Around Earnouts (and Why They Rarely Payout)

Following up on Lesson #145, issues to consider before selling to big companies, I wanted to drill down deeper on earnouts, and potential pitfalls to avoid, as earnouts rarely payout as expected.

First of all, what is an earnout?  An earnout is typically a performance-based payment that has been agreed to be paid to selling shareholders, above and beyond any payments received upfront at closing the deal.   So, for example, let's say a buyer is willing to pay you $1MM upfront at closing, and up to $4MM additional proceeds if your EBITDA exceeds a certain level within one year of closing.  That $4MM part of the deal, is the earnout portion, tied to future performance of the company.

Earnouts typically never pay out they way a selling company is hoping they will, emphasizing the importance of making sure you are 100% content with the upfront proceeds only, in the event the earnout payout ends up being zero.  The reason earnouts rarely payout as planned are numerous, including:  (i) the way it was actually written, which can end up benefitting the buyer; (ii) the buyer is not naturally motivated to have their behavior drive additional proceeds to the seller; (iii) typically, the pace of business post a sale is materially slower than life before the sale; and (iv) unexpected things can happen, that may or may not be in your control.  I will address each of the points below.

The devil is in the detail, in terms of how an earnout gets written.  The first issue is whether it is driven by future revenues (which is in seller's benefit) or future EBITDA (which is in buyer's benefit).  Revenue is 100% clear and clean, but buyer's do not want sellers to load up marketing losses tring to juice up revenues to get a higher payout.  And, on the flipside, sellers should be wary of an EBITDA based earnout, because after they sell the company, there could be a lot of corporate expenses which may be pushed down to your divisional level, that hurts EBITDA and the earnout.

In addition, earnout payment calculations can be manipulated by other things, like making adjustments for any net working capital changes of the company.  And, balance sheet movements are a lot harder to control than income statement movements.  For example, you can't control how fast your vendors pay your accounts receivable owed to you, meaning any inflation in your collection time, could decrease your earnout payment.  Same type of thing around any capital expenditure based adjustments, where any monies you spend on needed asset purchases to drive your growth, could also end up hurting your expected payout.

And, let's face facts, a buyer is typically more than happy to wait a year before investing a lot of their promotion support in your business (which you are most likely hoping for to drive the earnout).  From a buyer's perspective, why pay $5MM for a business, when they can pay $1MM, with no additional earnout payments made.  So, unless you detail otherwise in your agreement, don't expect the buyer to be doing a lot of sales or marketing favors for you doing the earnout period. 

Or worse, protect yourself from the buyer loading up a lot of expenses during the earnout period, which can hurt your payout.  For example, sales & marketing expenses today, which will help long term growth of the buyer, will typically come at a loss during the earnout period until the future revenues are driving for the buyer well after the earnout period has ended (great for them, horrible for you).

And, as mentioned in Lesson #145, when selling to big companies, don't expect the way things operated for your company will be the same after the sale.  Typically, the pace of business will get a lot slower, based on both new corporate tasks required and the slower decision making process of bigger companies.  So, you may not be swimming in a pool of water any longer, you may be swimming in a pool of molasses.  And, any slowdown in pace, could impact your ability to maximize the earnout payout.

Then there is the list of all the unexpected things that could happen during the earnout period, which can hurt the payout.  Perhaps there is a big hit to the economy, like there was around 9/11/01.  Or, some hurricane wipes out your home office in New Orleans.  Or, your salesperson is "cooking his books", to drive more commissions, to only find out the contracts were never real too late in the earnout period to actually make up for the unexpected shortfall.  This last point actually happened to one of my businesses, during its earnout period, costing the shareholders around $3MM of additional proceeds!!

So, as you can see, I am pretty bearish about earnouts.  But, sometimes you have no choice, in order to get your shareholders a reasonable way to acheive their ROI objectives.  So, when you use an earnout structure, make sure: (i) it is "iron clad" in its drafting, so no confusion and no opportunities for the buyer to manipulate the calculation; (ii) negotiate for the buyer to bring full promotional support day one, at no impact to the payout calculation; (iii) make sure you are realistic on what life will be like post the sale, to make you are still happy with the deal with slower growth assumptions; and (iv) make sure the business is largely run as-is until the earnout period is ended, to prevent any unexpected buyer expenses, decisions or process from negatively impacting the earnout.

For future posts, please follow me at:  www.twitter.com/georgedeeb.  If you enjoyed this lesson, please click the social sharing buttons to share with your social networks.

Lesson #139: How to Calculate Equity Split Between Founders in Startups

The other day, I got asked a question about how best to divide up the equity stake in a new startup, between the founders.  I told him that was a very big question, with lots of variables that go into to calculating a fair equity split.  So, it inspired me to write this post on the topic, to document my answer for all of you.

To me, the key variables that need to be considered here, include: (i) whose original business idea was it; (ii) who is funding the business; (iii) how important is this person's role within the company; and (iv) is this person taking a salary, or deferring compensation.  Let's tackle each of these points below.

In my opinion, there should be a big premium placed on being the originator of the idea.  With all other things equal, that means that a 50/50 split between two co-founders, could be 66/33 based on the premium for coming up with the original idea, and for starting the initial development efforts and sourcing the original team.

If people are funding the business, they should get a premium, because at the end of the day, cash funding founders are acting no different than a seed stage investor.  That means a 50/50 split, with all other things equal, would need to be adjusted for the cash investment.  So, let's say that one founder puts in $100,000 in seed capital, that could be worth 20% of a seed stage company's valuation.  So, a fair split, would be closer to 60/40 in favor of the funding founder, when diluted for the cash.  Calculated as follows:  original 50/50 diluted down 20% to 40/40 for the financing, and then the one founder gets that 20%.

Key executives should get a premium stake over non-key executives.  So, a CEO or CTO, would get a much higher stake than an office manager or a graphic designer, as an example.  So, in this case, I would take your total ownership and divide it up by employee tiers.  Maybe something like 10% each for five C-level executives; 2.5% each for  10 VP level executives and 1% each for 25 director/manager level staff (adding up to a total of 100%, with all other things being equal).  Understand that not all of this will be granted day one, with everyone having higher stakes in the short run, but you will have an equity cushion to play with as the employee base scales.

People that are not taking a salary, should also get a premium stake.  To me, that is no different than financing the business.  So, if someone is deferring a $100,000 per year salary, this is like a 20% stake in a brand new startup.  So, with all other things equal, a 50/50 split, would be closer to a 60/40 split, with the same calculation and logic we used in the cash investor example.

And, please notice, I kept saying "with all others things equal" in each paragraph.  You need to collectively take all four paragraphs into consideration, in calculating a fair equity split between the founders.  And, keep in mind, there may be additional considerations to take into account, like contributing patents, sourcing investors or other value to the startup.  So, make sure to take a wholistic view of what a founder is bringing to the table, across the board.

But, splitting up the pie is only half of the exercise.  This lesson should be read in conjunction with Lesson #124 on Vesting of Founder's Stock.  So, in the event the founders split ways, there are mechanisms in place to get any unearned equity back into the hands of the company.

For future posts, please follow me at:  www.twitter.com/georgedeeb.

Lesson #136: Save Taxes With "Profits Interests" vs. "Stock Options"

I recently read an interesting article on how startup employees with material equity stakes can materially save on their long term capital gains taxes, written by Ken Obel, a startup attorney at GoodCounsel here in Chicago.  Ken was gratious enough to let me share it with all of you.

Many startups launch their companies as limited liability companies (LLCs), enjoying the flexibility and tax-efficiency that this type of entity offers (please re-read Lesson #56 for more details here).  A lesser known, but quite significant, advantage of LLC’s is the ability to provide incentive equity in the form of “profits interests”, instead of the more typically seen stock option plans used for incentivizing employees.  A profits interest allows an LLC to give service providers option-like equity without the need for these individuals to put money at risk in order to obtain long-term capital gains tax treatment.

Consider the following example.  In the traditional startup, a company issues options to a new employee priced at the company’s then-fair market value of $1 per share. Issuance of the options has no current tax impact, however, if the employee exercises the options when the company is later acquired at a price of $3 per share, the gain or “spread” of $2 per share will be taxed to the employee at short-term capital gains rates – which can be as high as 35% depending on your income. This is because the holding period for the equity starts upon exercise of the options, not their issuance. Wouldn’t it be better for the employee to exercise the options and hold the underlying equity for a year, in order to receive long-term capital gains treatment at the time of sale -- lowering their tax rate closer to 20%? Of course. But this requires the optionholder to come out of pocket to pay the exercise price (with cash they may not have) and to take the risk that during that year, the equity may lose its value. Few employees will take that risk, and will instead hold the options until a profitable exit is at hand, swallowing the significantly higher tax rate as the price of reducing the risk.

In an LLC, a profits interest is economically equivalent to an option. If a unit of LLC equity has a value of $1, a profits interest issued at that moment comes with a right to participate only in those proceeds of a liquidity event that are in excess of that dollar. (This “hurdle amount" is the economic equivalent of an option's exercise price – both serving to ensure that the optionholder participates only in the economic value he or she participates in creating.) But, unlike an option, which is not "property" (in the view of the IRS), the profits interest is property, and therefore, the capital gains holding period begins to run upon issuance – and the employee never has to come out of pocket with cash. In the previous example, when the company sells for $3 per share, the profits interest holder would receive his or her share of the proceeds beyond the $1 hurdle amount, or $2 per unit, and (assuming at least a year had elapsed between issuance and the sale) these proceeds would be taxed at the lower long-term capital gains rate.

What should you consider before issuing profits interests? First, you have to be an LLC, so you have to be comfortable that this is the right entity for you, your business and your investors (remembering most VC's will most likely require you to be a C-Corp in order for them to invest). Next, consider that profits interests are not the easiest form of incentive equity to explain to your employees. The typical employee understands what an option is; odds are they’ve never heard of a profits interest. But, one view is, if their incentive equity grant is significant, their tax savings from a profits interest stands to be worth a great deal in long term tax savings to them – enough for them to take a few minutes to understand how this works for their benefit.

The most significant negatives arise from the fact that a profits interest holder in an LLC is considered an equity owner, and equity owners are ineligible to be paid as a regular W-2 employee. Instead, the company must report all compensation on a form K-1 (relating to the partner). This has negative ramifications regarding the employee's responsibility for paying their own self-employment taxes and the deductibility of company contributions toward healthcare and other benefits.

These are issues that should be discussed with tax and legal advisors before making a decision about the proper form of incentive equity.  But, in cases where you have a material equity-owning employee, looking to acheive material long term capital gains tax savings, and is willing to deal with the "equity owner vs. employee" tax treatment along the way, this could be a good road to pursue.

Thanks, Ken, for sharing your wisdom here.  If anyone has questions from here, feel free to reach out to Ken directly at 312-380-9406, or e-mail him at the GoodCounsel website.

For future posts, please follow me at: www.twitter.com/georgedeeb.

Lesson #133: How to Avoid Paying Taxes on Startup Investments

For this lesson, I solicited the help of Ira Weiss, a Partner at Hyde Park Venture Partners in Chicago.  He first wrote on this topic for BuiltInChicago, but was gratious enough to let me share his learnings with all of my Red Rocket blog readers.

Taxes are currently on the minds of many investors because of the recent increase in tax rates. However, while taxes went up significantly for most investments, taxes for startup investments just dropped like a rock… all the way down to zero!   Although no investor is going to decide to bankroll a startup just because of tax benefits, taxes do matter to them. And, if you are an entrepreneur searching for capital, you want to give potential investors every reason in the world to say yes. What could be a better excuse than avoiding taxes?

Starting January 1, 2013, capital gains taxes were raised significantly for most investments, from 15% to 20% for some investors.  In addition, capital gains are now subject to a 3.8% Medicare surcharge. This makes the new tax rate closer to 23.8% -- a whopping 59% increase.  Not to mention, ordinary income taxes on any interest income received, grew from 39.6% to 43.4% for the highest income brackets.  This takes a big chunk of the upside out of traditional stock and bond investments.

But, startup taxes went in the opposite direction. As part of the recent American Taxpayer Relief Act of 2012, capital gains on most early stage investments are effectively ZERO because the investment gains are excluded from income.  This gave investors a real incentive to put more of their monies into startup companies, as a real shelter from paying taxes on the gains.

This special tax provision for startup investments is referred to as Qualified Small Business Stock, and it has been around for many years in various forms. The two important criteria for startups are: (i) they must be a C corporation, and (ii) they must have less than $50 million in assets when the investment is made.   In addition to avoiding federal income tax, investors also do not pay any state income tax on this type of investment.  Why?   Because given the way in which this tax provision works, the investment gains on startups are completely excluded in calculating federal income, and therefore none of the gains are passed through to the state tax return.

This startup "tax nirvana", as Ira likes to call it, does have a few restrictions and limitations. An investor can only exclude up to $10 million in gains or a up to 10x return, whichever is greater.  And, the stock must be held for at least five years by the investor.  As a startup entrepreneur, there is nothing you need to do to get your company to qualify. As long as you are a C-corp tax-payer, just complete your regular annual tax return, and be sure to list the amount of company assets on your tax return form.

These favorable tax rules have only been extended through Jan 1, 2014, but any startup investments made in 2013 will permanently qualify for the tax savings.  So, tell all your friends and angel investor targets that 2013 should be the year they start to move more of the investment capital into startups, to enjoy the tax savings while they still can.

Thanks again, Ira, for sharing your insights here.  To follow Ira on Twitter, you can follow him at @iraweiss.

For future posts, please follow me at:  www.twitter.com/georgedeeb.