Wednesday, October 31, 2007

Rich Price

As some of you know, my brother Rich is a wonderful singer-song writer.

Embedded is one of his new songs, Change, and I love it.

Tuesday, October 23, 2007

DuPont Models and How to Determine KPIs?

Data driven management is a popular concept and with good reason. CEOs, management teams, and board of directors gain tremendous value in defining and managing to key performance indicators (KPIs).


KPIs provide insight into the underlying mechanics of the business model that help teams manage departmental functions and focus the company on the building blocks of future success. The concept of KPIs as powerful intra-period (day, week, month, quarter) barometers of company performance is well understood.

However, traditional mechanisms for financial management, GAAP financials and the operating plan, are necessary, but not sufficient tools for data driven management.

Start-ups are exercises in prospective thinking and both GAAP financials and the operating plan generally fail to provide insight into the upstream metrics that drive financial success.

GAAP financial statements are backward looking records of the past, and they often fail to provide insights into how the company will perform in the future. Start-ups all develop operating plans, however, in my experience 3 year plans, while necessary, are often highly abstracted summaries of a hoped for future that tend to be more academic than operational. They tend to be the product of the CFO's office with little day to day value for the team.

How then should one bridge the gap between GAAP financials and the high level financial projections? As a CEO, VP, director, or individual contributor what data points matter to you? When you come in in the morning, how do you know what to focus on with some sense of certainty that your particular KPI is a key part of the broader company's goals?

In 1919, DuPont's F. Donaldson Brown was tasked with turning around GM after DuPont bought a 23% stake. In order to help drive clarity and transparency into the state of GM's finances, Brown developed a model that broke down the company's ultimate goal, high return on assets, into an easy to visualize set of critical building blocks.

The standard DuPont model follows:
Return on Equity = Net Profit Margin * Total Asset Turnover * Equity Multiplier

Each component can then be broken down into its constituent parts.

For example,
NPM = Net Income/Net Sales
TAT = Net Sales/Total Assets
EM = Total Assets/Common Equity

One can now see that higher profitability, higher asset utilization, and higher debt levels can all lead to higher ROE. Further, each child node can be further analyzed to understand the key levers that drive the parent node.

Net Profit Margin can be influenced by unit volume, unit price, fixed costs, variable costs, and so on.

Now, how does this apply to start-ups?

Well, start-ups can develop a custom version of the DuPont model that 1) transparently states the formula for value creation and 2) makes visible key value-creating levers that are themselves the "Is" in KPIs.

For example, the search business can be defined by the following formula:
Revenue is no longer an abstract concept but a goal with clearly defined indicators that departments can execute against, such as driving more queries per user, maximizing ad attach rates per query, optimizing click through rates, driving higher ecpms....

A team's ability to develop a relevant DuPont model that maps out the key components of revenue and profit is critical in developing material KPIs. To bridge the gap between Quickbooks' financials and Excel operating plans, I suggest that a team whiteboard a model that drives both revenue and costs.

As a planning exercise:
  1. develop DuPont formulas relevant to the business that define the material components of revenue, costs, and profit
  2. drill down on each node until there is no marginal benefit of further granularity
  3. analyze the impact of moving each indicator, or formula argument, on the desired result and identify the most impactful indicators to manage
  4. assign each department indicators, arguments in the equation, they can control, effect, manage, and report against
  5. the formula's arguments are now the organizations KPIs
  6. With the KPIs extracted from the company's DuPont model, data driven management is now possible. The company, departments, and individual contributors now understand how their daily work contributes in the aggregate to the model's efficacy
Are you struggling with identifying material KPIs? Is the operating plan a set of forecasts with seemingly little relevance to day-to-day operations?

If so, take the time to develop a company specific DuPont model and agree as a team on the formula's key arguments; assign each team member a set of arguments to optimize, and come to the team meeting with weekly snapshots and trends of the arguments' execution.

In may ways, laying out a DuPont formula is a precondition to building an operating plan, ie it identifies the key business model drivers. Moreover, aligning strategy with a DuPont model allows for orchestrated execution where the component pieces, ie departmental specific activities, sum to a larger whole.

Monday, October 22, 2007

Aria Systems Raises Series A - Leave the Billing to Us!

The below is a guest post written by Lars Leckie of Hummer Winblad.

Last week, Hummer Winblad Venture Partners announced the Series A funding for Aria Systems, the leading on-demand billing and customer management provider.

HWVP’s investment in Aria is the firm’s fourteenth SaaS investment (others include Omniture, Adforce, Employease – some of which date back to 1998).

The investment in Aria is a double down on the SaaS market – Aria is not only itself a SaaS ISV, but also the company is a core component of any SaaS company trying to efficiently scale. RBC Capital Markets predicts that the SaaS market will grow at 43% CAGR to be $28bn by 2010. That’s a lot of billing.

As the SaaS market grows, the need for ISV’s to make bespoke investments in data center operations, billing infrastructure, and other core, but non-differentiated, functions is lessening by the day. Providers like Aria allow ISV’s to focus 100% of their human and financial capital on differentiated application logic, while using best-of-breed platform vendors for infrastructure services. The company puts it best when it tells customers it will help them, "get customers, get paid, get control."

Why invest in Aria? Simply put, traditional billing solutions, independent of expensive on-premise software, are not well suited to subscription and usage based billing models. New revenue models bring about the need for new billing architectures. Emerging SaaS companies who don’t use Aria can either choose to build a billing system themselves, thereby diverting engineering resources to a non-core engineering function, or they can use existing on-premise solutions with a myriad of spreadsheets and manual accounting. Aria is a solution that can scale and provide the best infrastructure through a strong focus on the billing market.

The Aria solution is a complete turnkey SaaS (single instance, multi-tenant) solution to manage recurring revenue billing. They manage the quote-to-cash system for a company including hosted customer sign-up, customer service, provisioning of service, dunning and all the other components needed for a full billing solution.

Aria is already in the market with strong customer traction and key partnerships in place. The vertical markets that Aria addresses today are SaaS, On-line Gaming and Telco. A few of their partners in these markets are Opsource and GNi but you can see the full list of over 25 partners here.

Congratulations to Ed Sullivan and the rest of the Aria team - Welcome to the Hummer Winblad family.

Friday, October 12, 2007

Burn the Boats

As a venture capitalist, I am fortunate to meet with people brimming with ideas for new products and new companies. You can feel the excitement build as ideas percolate and mature from insights quickly scribbled down in the middle of the night, to application mock ups, late night Starbucks brainstorming sessions, and early team solicitation.

Often, however, the ideas never bear fruit and the excitement subsides and the spark of creativity dies. This week, I met with several good friends who suffer from both the blessing and the curse of a surfeit of choices and options. The blessing is that talented people are always in demand and there are many avenues of opportunity available to them. The curse is that they often sit stalled at the cross-roads of choice - start-up, large company, start my own gig....

Mark Gainey, the founder of Kana, once told me that the hardest step on the road to entrepreneurship is the first one. Once committed, the iterations come fast and furious and the pressure to make it work allows for moments of genius and insight simply not possible before diving in head first.

I continue to regret that so many brilliant people that I know, full of energy and ability, sacrifice their passions on the alter of safety or indecision.

The conquistador Cortes provided a model for all intrepid souls....that is to burn the boats on the shore and ensure no way back and the stark need to make the expedition succeed or go down trying.

In facing choice in a sea of opportunity, I think that Frost's road less taken is inherent in the spirit of the Valley. However, it often requires a moment a bit like sky-diving....i.e. to willingly jump out of a perfectly good plane and make the most of the free fall.

Like Cortes, it is often necessary to burn the safety boats in order to finally realize the promise of late night ideas and the passion that gets you jumping out of bed in the morning.

Investment Models as Risk Acceptance Criteria

In many ways, investing is an exercise in decision making. In order to ensure consistent decisions, firms develop investment models with which to evaluate opportunities.

The models (both qualitative and quantitative) provide a framework for evaluating risk and return. The model defines the strike zone and helps shift investment decisions away from debating the merits of a class of investing, ie. do we want to deals like this, to the merits of a specific investment. The class of investment, what type of deals do we do, is defined by the model, the object, ie discrete investment decision, is the output of the model in action.

Another way to think of a model is as an articulation of the risks the firm is willing to take. For example, Hummer Winblad's model is to invest in Series A, enterprise software start-ups, and to back capital efficient plans at reasonable post-money valuations. Explicitly in the model is a checklist defining our focus, and inherently in the model is a level of risk acceptance, i.e. we are wiling to accept certain risks subject to appropriate pricing, capital investment, and overlap with our expertise.

If a firm's risk asset acceptance terms are well defined, ie what a strike looks like, then the firm can focus on sourcing and executing to the model. Also, to the extent an investment is outside of the model, the exceptions (ie areas of misfit with model) can easily be identified and analyzed. The investor can say, "I recognize that this deal is off our curve in the following dimension, however, the exception and added risk is worth taking for the following reasons."

Defining acceptable risks and a target profile creates consistent decision making and increased productivity. It also helps quickly flag execptions and puts the onus on the deal champion to explain the logic in swinging out of the strike zone.

Models are tools for decision making, but they also provide a logical framework with which a team of individuals can use to maintain a common cadence and definition of risk. The moral is not to never to go off the model, but to always know when you are off the model and to ask if the potential return is worth taking the extra risk.

Wednesday, October 10, 2007

Capital Flows - The Implications of Yale's Asset Allocation

David Swensen, Yale University's Chief Investment Officer, is widely recognized as one of the world's great investors

For Fiscal 2007, Yale reported a return of 28%. Over the last decade Yale's return is 17.8% and assets have grown from $5.8bn to $22.5bn.

For 2008, Yale plans the following asset allocation:
  • real assets (oil, timber, real estate) 28%
  • absolute returns (hedge funds) 23%
  • domestic equity 11%
  • fixed income 4%
  • foreign equity 15%
  • private equity 19%
Read the numbers one more time - domestic equity is only 11% and alternative assets (real, absolute, and private) make up 70% of the portfolio.

Today's NY Times noted that pension fund managers plan to increase asset allocation to alternative investments from 14.4% to 19.4%, a 35% increase, over the next three years. The article cited a survey of 50 of the world's largest pension fund managers and found:

Current Allocation to Alternative Assets: 14.4%
  • 4.5% to real estate, 4.3% to hedge funds, 4% to private equity, 1.6% to other
Planned 3-Year Allocation to Alternative Assets: 19.4%
  • 6% to real estate, 4.6% to hedge funds, 6.3% to private equity, and 2.5% to other.
The incremental 5% allocation is equivalent to $1.2tn dollars flowing into alternative assets over the next three years. This is a staggering sum.

What is more is that the pension fund managers' planned19.4% allocation is still only 27% of Swensen's allocation to alternative assets. Too match Yale's returns, pension fund managers would need to increase their allocation by 3.6x. If a 5% increase is equivalent to $1.2tn, a 50% increase, ie matching Yale's allocation, would represent another $12 trillion dollars of allocation.

Where will this money go?

To compound the capital flow dynamic, Morgan Stanley reports that sovereign funds (gov'ts of China, Russia, Kuwait, Singapore, etc) are sitting on $2.8 trillion and that the figure will grow to $15 trillion by 2015. $12 trillion here and $15 trillion you are talking about real money:)

If the stewards of the world's capital look to Yale as a model there will be a massive flood of capital into non-traditional, alternative vehicles over the next decade. China's investment in Blackstone and Abu Dhabi's investment in Carlyle are harbingers of what is to come.

The chase for returns will continue unabated and Yale's approach suggests that relying on equity and fixed income markets will not suffice.

The recent sub-prime meltdown led many pundits to believe that institutional investors would shy away from private equity and hedge funds. The data above suggests that they will have no choice but to do much more investing with alternative managers, not much less.

Thursday, October 04, 2007

Prescriptions For Guaranteed Misery In Life

As some of you know, I really admire Charles Munger, Warren Buffet's partner. The clarity of his thinking, personal story, and professional success are worthy of study.

I recently read Poor Charlie's Almanac, The Wit and Wisdom of Charles T. Munger. The book is a fabulous collection of his thoughts, speeches, writings, mental models, and commentary on Charlie by Warren Buffet, Bill Gates, Bill Gross (Pimco), and others.

I particularly enjoyed the speech he gave at his son's high school reunion.

The speech borrowed from an earlier commencement address by Johnny Carson. Carson told the students that he could not tell the graduating class how to be happy, but he could them from personal experience how to guarantee misery! Carson's prescriptions for sure misery included:
  1. ingesting chemicals in an effort to alter mood or perception
  2. envy; and
  3. resentment
Munger goes on to add that if you desire misery that Johnny's suggestions were spot on. He adds four more certain ways to guarantee a miserable life to the mix...
  1. be unreliable
    1. do no faithfully do what you have engaged to do.
    2. if you like being distrusted and excluded from the best human contribution and company, this prescription is for you
  2. learn everything you possibly can from your own personal experience, minimizing what you can learn from the good and bad experience of others, living and dead
    1. the idea is to become as non-educated as you reasonably can
    2. do not stand on the shoulders of giants, who needs them
  3. go down and stay down when you get your first, second, and third severe reverse in the battle of life
    1. given the abundance of adversity in life...this will ensure that you will permanently mired in misery
  4. ignore disconforming evidence and remain certain in your views
    1. be one of those people who early achieve and later intensify a tendency to process new and disconforming information so that any original conclusion remains intact
Both Carson and Munger inverted the traditional graduation speech - they pursued the study of how to create X by turning the question backward and instead studying how to create non-X. Munger quotes the algebraist, Jacobi, who said, "invert, always invert." Many hard problems are best solved only when they are addressed backward.

Following all seven prescriptions will help ensure a life of non-felicity and abject misery. "Invert, always invert."