Cash Flow and Investors

I am occasionally asked to provide guidance to developers on how best to structure cash flows and how to present the information so that their investors can see what is happening.  Unfortunately, GAAP is somewhat weak in this area so we fall back on good old fashioned sources and uses statements.

Of course, these become a little more challenging when the project has multiple classes of ownership, each with their own return on investment (ROI) expectation.  And they become really hard when the cash flows are no where near expectations.

Naturally, developers don’t turn to the accountant when things are going well – invariably we are asked to weigh in when things are not working as expected.  In the most recent case, the investors are bothered by cash being paid to the developer and they think it should be paid to them.  This is a pretty common theme.

Changing the facts and circumstances a little, lets say you developed a commercial building.  To keep it somewhat simple there are 3 investors and a lender, A, B Developer and Bank.

  • A invested $5,000,000 with a guaranteed 10% return and is supposed to receive the first $500,000 in cash annually after debt service
  • B invested 5,000,000 with a guaranteed 15% return and is scheduled to receive their payment after a $100,000 developer payment to Developer
  • Developer receives their $100,000 payment and then can receive any residual cash
  • The developer predicted about $1.5 Million in annual cash flow after debt service

Cash flow after debt service is $900,000.   Obviously this is somewhat disappointing, especially for B.  According to the accounting,

  • A receives their $500,000
  • Developer receives their $300,000
  • B only receives $250,000 out of their $750,000

B thinks that developer is taking more money than allowed for.  From B’s perspective, Developer received $300K when they should have only received $100K and the other $200,000 belongs to B.

In the course of trying to explain this, we had to dig a little deeper.  We identified that Developer also invoiced for maintenance – $200,000.  The bookkeeper inadvertently recorded it to the wrong account but the damage is done.  B is threatening to sue for failure to perform.

This is where a good sources and uses statement comes in handy.  We were able to lay out how funds came in and how funds went out.  We started from the accrual basis  and created columns to eliminate the various transactions to get to the pure cash in and out.

By identifying how first funds, and then cash, were handled, B was able to understand that the transaction was first recorded incorrectly and second was not a cash transaction.  We actually pointed out that the invoicing for the maintenance was agreed to by the members and could have been paid out as an ordinary business expense but Developer felt it best to try and satisfy B first to the extent possible.  The remaining cash was actually being held onto as a reserve for some defects that were noticed

As powerful as full GAAP statements can be, sometimes it is the simplest statements, like a sources and uses that can make people understand what is actually going on.  Yes, had B read the full financial statement they might have seen what was going on, and yes B could have handled it better than assuming improper behavior on the part of Developer, but the truth is, when you think you are not received your due one tends to see only things from your own perspective.

So the next time you are facing a question over how money and value are coming and going from your activity try a sources and uses statement.  I think you will be surprised how well it might help the situation.

Have a great day.  If you have any questions about this topic or anything else related to business or management, feel free to contact us through our website.  We are here to be of service to you.

Improving the odds

Some days, it is challenging to write on topic.  For instance, today for this blog, I am on topic number 4.  And frankly, number 4 is just wing it.  So many things to discuss and I am not quite certain how to frame the issues or put them in context.

We had several meetings last week, not the least of which was the meeting to discuss a private placement strategic plan.  That did not go quite as well as I would hope.  The concern is valid – I mean, the plan calls for changing how certain software is licensed.  It models out but we all know models only go so far.  To change direction will cost a ton in marketing dollars and face resistance from the current marketplace who do not want a shift in power.

The shift will happen; it is whether this group wants to be the driver.  Actually, that isn’t it, they want to be, but the hard reality is that it takes a lot of resources to upset the current way of doing business.  With no guarantee of success.

Not that there is any guarantee of success by following the same model as the other developers in the marketplace.  But that channel is well known and understood.  The licensors will likely be open to incremental change which means that the cost to land a subscriber will be substantially lower than trying to go directly to the consumer.

Sorry, I know this seems somewhat vague but I am working under an NDA so have to be extremely generic.  But the strategic business problem is not unique – it is one faced by every business that decides to sell.

Who is the customer?  And how do you improve your odds of success within a sales and distribution channel?

If you are a handyman service one way to go about this would be to get door hangers and go to a mature neighborhood and hang them.  If you do up 2,000 you will likely end up with 40 new customers.  It won’t happen immediately but that 2% is pretty much cast in stone.  You will spend a bit on advertising but it will likely pay off rather quickly.

But, what if you wanted 10% new customers?

One way to attract more customers would be to offer free yard debris removal, for example.  People love a free deal and chances are, many more would look at your service offering after having a positive experience with you.  You will spend more money than on just advertising alone but, it might pay off.  Again, no guarantee that you will substantially increase above the 2% but there is lots of evidence to support the conclusion you will get above 2% new customers.  Your costs will most certain go up though.

Freebies, giveaways, basic services with the opportunity to license premium services.  These are ways to build trust with your product and service but they are not free to you and oftentimes are quite expensive.  Are they still worth doing?

Perhaps.  And that is what I am facing this week.  Do we redesign the offering to make it compelling to the existing channel?  It is going to be expensive either way – either by spending a ton of money on marketing and advertising to go around the existing purchasing channel or on giving away revenues while we work to entice users through free use.

Part of me, of course, loves the idea of challenging the status quo.  It would be awesome to completely upset the applecart and win this my way.  But, the reality is, it is probably more risky to take that approach than it is to work within the existing channel – even if the existing channel is ripe for challenge.

More on this another day.  Have a great Monday.  If you are ever in the market for a thinking accountant who loves marketing and sales, feel free to contact me for a free consultation.  I am here to be of service to you.

 

GAAP and Projections

I have a new project which I started at the end of last week and which must be ready for discussion by Friday.  I need to pull together a projection for a start-up company, determine its capital requirements, figure out how it should be structured by debt and equity class and then make sure that, given a certain range of possibilities, what the ROI is going to be.

Did I mention this has to be done by Friday?

It is interesting and I have a great model I have developed over the years (in my humble opinion) that helps me focus on the big picture while also making sure I cover the necessary ingredients.  One area I have spent a lot of time updating is the revenue projection side.  First, I am trying to design a revenue model which takes certain assumptions, like lead generation rates through sales close rates and figure out how many sales will happen.  And then from there how many sales support people are needed.  And then…

Sorry, I was going to slide right in and describe why I like modeling this so much but really, today I am writing to discuss how Generally Accepted Accounting Principles (GAAP) are causing a serious headache for me in this projection.

Naturally, my first irritation is the requirement of recognizing stock awards as compensation expense, although I know intuitively that it is something the employees earn.  It is still a challenge because the only “cash” part of this is the amount paid in taxes to gross up the award.  Why am I worried about it?  Because I am thorough and don’t want anyone to say they were “Unaware” that earnings were going to be lower than projected because GAAP treats stock compensation differently than cash models.

The bigger concern is the new GAAP on revenue recognition.  You remember, the one I have blogged about here recognizing that this particular headache was coming.  Well, this projection is impacted by it because, naturally, it is a software company that licenses its program on an annual subscription and offers free, unlimited tech support.  Love it.  Revenue recognition side?  Not so much.

I spent about 6 hours last night after the game (nice to see the Saint’s work hard to try and lose but they managed to survive until next week – not much hope there) updating my assumptions page and working through the model to address control and amortization of revenue.  No, I am still not done but I am getting closer.  What I can tell you is, I don’t like the results.

On a cash basis, this particular start-up should get to positive operating cash flow in about 14 months; right now it takes about 52 months to get to profitability under GAAP.  I am also seeing about $8,000,000 in deferred revenues.  That is, by the way, cash collected from customers that the company cannot claim as revenue.  Yes, it is software and there is no right to refund but still, under the control principles in new GAAP, the revenue is unearned.

How I get there is to make certain assumptions about purchasing patterns and I am making a rather aggressive assumption that most purchases will happen in the first part of the year.  It is more intuition at this stage but my research indicates that this is the likely time when this sort of software is installed – something about New Year resolutions.  So, this is only a few months of overall deferred revenues but it is enough to throw off accounting ROI.

Don’t get me wrong, I think the most important information comes from cash flow.  How quickly cash is burned through, minimum cash levels, marketing expenditures are absolutely essential to figuring out minimum equity positions, acceptable leverage, target interest rates; all that delightful CFO stuff that can make or break a project.   But still, I think that potential investors have a right to know everything about the project they are taking under consideration and GAAP is one of those things – because at the end of the day, if the goal is to go public, then GAAP is the beast to tame.

Like I said, I try to be thorough.

I will keep you updated, probably at the end of the week when I meet with the ownership to review what I have and start changing assumptions and figure out what to add.  They want to start pitching by the end of the month so I have my work cut out for me – because I am doing this on top of everything else I do!

If you are looking for an accountant who might be able to help you get to that next level, either by acting as your controller or CFO (or combination) feel free to contact me and lets schedule a time to talk.  I enjoy being of service to growing entities and risk-takers.ready for discussion

Have a great day.