Finance for Geeks
Summary: Eric Sink provides a geek-oriented overview of accounting and company funding.
On my weblog I write a series of articles entitled Marketing for Geeks.
The concept of these articles is that a lot of technically-oriented
people actually do end up involved in marketing decisions. Most
software startups are founded by one or more geeks, often without the
presence of experienced people in other areas like marketing. For these
people, a little marketing knowledge can go a long way.
The series has been quite popular, but marketing is obviously not
the only functional area that a geek entrepreneur might need to learn.
Several readers have asked me to write a similar geek-oriented overview
of accounting and finance. This article will highlight several things
that a geek in a small ISV should know.
Before I get started, let me offer a disclaimer or two. I am not a
lawyer, nor am I an accountant. I can't give legal or financial advice
to anyone, and nothing in this article should be construed as such. I
am simply a geek who has learned just enough about accounting and
finance to have an intelligent conversation with the experts who advise
SourceGear. I'd suggest any geek entrepreneur should do likewise. Find
some financial experts you trust. Learn enough about their field such
that you can talk with them. Hopefully this article will help with some
terminology and basic concepts.
I'll begin with a short summary of what accounting is all about.
Then I'll cover the concept of profit margins. Finally, I'll talk about
outside funding sources and the perils of building a company with money
from other people.
Three Financial Statements
If you are a geek who helps make strategic decisions for your ISV,
then you need to know how to read the three basic financial statements:
- Income Statement--A summary of revenue vs. expenses and total profit (or loss) during a specific time period.
- Balance Sheet--A snapshot of the company situation at a specific moment in time.
- Cash Flow Statement--A summary of receipts and disbursements of actual cash during a specific time period.
All companies report their financials to somebody. Publicly traded
companies like Microsoft are required to publish their financial
statements to the public. This means that many examples of the three
basic financial statements are available easily over the Web. Most Web
sites that give stock quotes can also show company financial
statements. For example, the latest Microsoft stock quote information
can be found at http://finance.yahoo.com/q/ecn?s=MSFT.
At the time of writing this article, the Yahoo! Finance Microsoft
Corp. (MSFT) Quotes & Info page has a sidebar on the left. At the
bottom of that sidebar are three links to the latest Income Statement, Balance Sheet, and Cash Flow
for Microsoft. Right now, the latest Balance Sheet says Microsoft has
around forty-nine billion dollars in cash (and "near-cash" assets).
Balance Sheet: How much is the company worth?
Every introductory accounting class teaches the basic equation on which all of accounting is based:
Assets = Liabilities + Capital
Assets: An asset is anything of value that the company owns or
has in its possession. Cash is the most obvious asset, but receivables,
inventories, laptops, chairs, and copyrights are assets as well.
Liabilities: A liability is a debt or other financial obligation.
Capital: Sometimes called "Stockholders Equity". This is the
residual interest in the company's assets after the creditors are all
The balance sheet is simply the expression of this equation. At the
top, it lists all the assets, with a total amount. Below that, it lists
the all the liabilities and capital, with a total amount. The two
totals are always the same.
The total amount of capital or stockholders equity on the balance
sheet is one way to describe how much the company is worth. However,
the actual fair market value of the company is often significantly
higher or lower than this number. Company valuation is a complex
subject that I won't attempt to cover here. Suffice it to say that the
information on the balance sheet is an important part of determining
the value of a company, but it is only a small part.
I like to paraphrase the accounting equation like this:
Everything the company has (assets) either belongs to somebody else (liabilities) or to the company's owners (capital).
The first thing I check when I'm reading a balance sheet is how much
cash the company has. This is near the top of the page, sometimes in a
subsection called "Current Assets". As the old cliché goes, "Cash is
king". If nothing else on a balance sheet interests you, it is always
critical to know how much cash a company is holding.
Another important thing to remember about a balance sheet is the
date at the top. A balance sheet is a snapshot of just one moment in
time. For example, it tells you how much cash the company had at that
moment. It tells you how much debt the company had, but only at that
The balance sheet says nothing about how much money is being made or
lost. It can't tell us anything about the performance of the company
over time, since it merely describes the company's condition at just
one moment in time. To understand what is happening over time, we turn
to the income statement.
Income Statement: Is the value of the company going up or down?
The income statement is sometimes called the profit and loss
statement. Unlike the balance sheet, this statement describes what
happened during a range of time. For example, it might contain a list
of all the income and expenses during a given month, or a given year.
The income statement tells us where money is being spent and how
much. Just like the balance sheet, this statement is merely the
expression of an equation, and a rather obvious one at that:
Income = Revenue - Expenses
The income statement appears to be the easiest of the three basic
financial statements. Everybody thinks they understand it. Revenue is
shown at the top, following by expenses. Below that is the
oft-mentioned "bottom line", also known as net income or net profit.
But the income statement can be deceiving, since it usually contains
a whole bunch of numbers that have nothing to do with cash. It says
nothing about how much cash we have in the bank right now. Even worse,
the income statement can sometimes obscure important details about cash
that management wants to know.
This brings us to the most important thing that all non-accountants
should learn about accounting. Money and cash are completely different.
Cash Flow Statement: What's happening with cash?
The third of the three basic financial statements is the statement
of cash flows. This one is critical. It covers a specific time period,
and provides answers to important questions like:
- How much cash did we receive, and from where?
- How much cash did we disburse, and where did it go?
- What was the change in our cash balance during the given time period?
This may sound like it is the same as the income statement, but it
is are very different, and the distinction is quite important. I am
being somewhat facetious when I say, "Money and cash are completely
different". Nonetheless, in one sense it is quite true.
All the numbers on the income statement are in dollars (or whatever
applicable currency you use). However, not all of those numbers
correspond to actual cash. Just to be clear, note that when we speak of
"cash" we are not talking about physical paper currency or coin. In
corporate finance, the word "cash" refers to money in the bank that
could be spent.
The income statement tells us how we gained or lost anything of
value, but those gains or losses may not have cash connected with them
As a silly example, suppose we agreed to sell a license of
SourceGear Vault, and as compensation we accepted a cow. (Those kinds
of deals happen quite a bit here in the Midwest, you know.) That cow is
definitely income. For our financial statements to be correct, we have
to assign that cow a dollar value. It must show up on our income
statement as revenue. It needs to show up on our balance sheet as a new
But it is not cash. Cash is a very special thing in a company. It is
by far the most important asset, since it is the only thing our
creditors and employees will accept when it is time for them to be
paid. Salaries are paid in cash. Our lease is paid in cash. Our company
credit card bill is paid in cash. And all of these expenses and debts
have strict deadlines associated with them. No matter how bright our
future looks, no matter how much our customers like our products, if we
run out of cash, we will go out of business.
These facts are the reason why we commonly say "Cash is king".
Companies monitor cash very closely. If the most critical issue in
financial management were cows, then we would have a Cow Flow Statement.
Setting aside my silly example, there is a more important reason why
the Income Statement says very little about cash. Most businesses
practice a concept called "accrual accounting". This basically means
that income and expenses are recorded when it makes sense to do so, but
not necessarily when the corresponding cash moves in or out of the
This is best explained by way of example. Suppose that a corporate
customer places an order with SourceGear for one copy of our product.
Here's what usually happens:
- The customer sends us a purchase order
(PO), usually by FAX. The PO describes exactly what they want to order
and includes a commitment to pay within 30 days.
- We run a
credit check on the company to find out if they have a reputation of
paying their bills. This isn't necessary for all companies, but for
little known companies like Microsoft with a mere 50 billion dollars in
cash, we like to verify payment history before we extend credit.
ship the customer their product, along with an invoice reminding them
that they owe us money. On the day we ship, the sale is recorded as
income. The balance sheet for that day contains a new asset called a
"receivable", indicating that somebody owes us money. However, the cash
for this purchase won't be received until 30 days later.
the company pays our invoice with a check. No income is recorded that
day, but we now have more cash and less receivables.
Accrual accounting is the major reason why we need a cash flow
statement. Non-cash income and non-cash expenses can give us a false
impression of how the company is doing. The cash flow statement filters
out all the fuzziness that arises from accrual accounting and
agricultural barter, giving management a clear picture of cash.
OK, that's enough about accounting. I've only scratched the surface
of this topic. If you remember nothing else, do grab onto the most
important concept here:
Cash is king. It is possible to consistently make a profit and still run out of cash.
It's 2003. It is no longer appropriate to pigeonhole individuals and
make assumptions on the basis of their gender, race, or religion. We
are an advanced and civilized society, and we have outgrown that kind
of narrow thinking about people.
However, it is still perfectly acceptable to pigeonhole companies according to stereotype and make the corresponding assumptions. In fact, it's kind of fun.
Personally, I like to broadly categorize companies according to
their gross profit margin. This is a really important concept when
thinking about any business. Let's define some terms:
- Revenue is what you get when you sell something.
- Cost of Goods is the cost of the actual items being sold. This is sometimes called Cost of Revenue.
- Gross Profit is revenue minus the cost of the goods.
- Gross Profit Margin is a percentage, and is equal to gross profit divided by revenue.
For example, let's suppose I am buying sweaters for $12 and selling
them for $24. My gross profit per shirt is $12, and my gross profit
margin is 50%. This is a standard markup level in the apparel industry.
The price tag on clothing is usually twice whatever the retailer paid
Note that "gross profit" is quite different from the "net profit"
figure that shows up on the bottom line of the income statement. Net
profit is what you get when you take gross profit and subtract all the
other costs of running the business. Except for the old joke about the
guy who loses money on every sale and makes it up on volume, gross
profit is always a positive number. On the other hand, net profit is
positive only if you do a good job running your company.
Gross profit margins tend to vary widely across industries. The
lowest margins are in markets where all the products are commodities. I
define a commodity market as one where all the products are basically
- The bananas and milk at one grocery store are not much different from the bananas and milk everywhere else.
Amoco's valiant attempts to convince me otherwise, I'm pretty sure
gasoline at Amoco is the same as gasoline anywhere else.
These are commodities. As a consumer, I might accept small price
differences, but any time the gap grows too large, I will choose the
cheaper item, since the products are the same anyway. In commodity
markets, gross profit margins are usually quite small.
Let's talk about these ideas in the context of a small ISV. Many
software products sell for a gross profit that seems ridiculously high.
For example, our SourceOffSite product sells for $239 per license, but
the actual cost of the CD is just a few dollars. The gross profit
margin on this product is somewhere in the ballpark of 97%. Note that
our net profit is a lot lower, since we have to pay the programmers who
develop the product. Programmer time for a software product is not
included in "cost of goods". If we sell a hundred copies of our product
or a million, the cost of developing that product is essentially the
same. Software product companies usually operate at a high gross profit
In contrast, custom software development or consulting has a lower
margin, because programmer time is included as cost of revenues. For
every hour of time we charge, we have to pay an hour's wage to the
developer who performed the work.
Gross profit margins are obviously not established by any authority.
They simply tend to settle at the lowest level where people can be
successful. Some industries have higher operating costs or higher
risks, and these industries tend to operate at higher gross profit
margins. For example, the gross margin on sweaters might be 50% while
the gross margin on milk is 4%. There are many reasons for this, but
one of the important ones is that the clothing retailer has to assume
more risk in carrying inventory. Grocers carry inventory too, but they
don't tend to get stuck with lots of excess milk and bananas that won't
sell because they went out of style.
Why Open Source Business Models Are Hard
Like I said above, you can understand a lot about a company if you
know roughly what its gross margins are. For example, understanding
gross margin is the key to explaining why most open source companies
tend to struggle. Fanatics can argue all day about whether or not open
source business models work. Clearly they can, as there are several
very impressive companies whose products are available as open source.
However, just as I mentioned last month,
this is a situation where the typical programmer's black-and-white
thinking doesn't help us find smart answers. The wrong question is "Do
open source business ever work?" The right question is "Does an open
source approach makes the business of software easier or harder?"
From a strictly financial perspective, I think open source makes
things harder. An open source product is a commodity. Your version of
Linux is essentially the same as mine. If you try to charge too much of
a premium, I will undercut you on price, and people will start getting
Linux from me instead. Open source companies tend to operate at lower
gross margins. That doesn't mean that open source can never work as a
business model. However, no matter what anybody says, if two companies
have the same risks and operational costs, the low-margin company is a
lot harder to manage than the high-margin company.
OK. We've covered a bunch of fundamentals, so let's talk about a
topic that is dear to the heart of every entrepreneur: How to get
Actually, scratch that. The topic of "how to get funding" is
extremely well discussed in lots of other places. Over and over, I see
seminars and workshops being offered to help entrepreneurs find the
money they apparently need to start a company. Much more rare is the
seminar which helps entrepreneurs figure out if outside funding is
appropriate at all.
I realize what I'm about to say is heresy to some, but I think new companies should spend less time figuring out how to get funding and more time deciding if
they should get funding. There are other ways to get a company started.
Getting money from investors is not always the best approach.
I fully admit that many types of companies simply cannot be built without significant start-up capital. However, there are always pros and cons involved in the decision to have investors (or creditors), and I'm not sure the cons get enough attention.
When building or growing a company, you face two basic choices:
- Build the company slowly, and fund its growth using its own revenues.
- Get money from other people and try to use it to make the company grow more quickly.
Like I said, there are pros and cons. The "pro" side of funding is obvious. Cash is king.
The "con" side of funding is the fact that the criteria for success are different for companies with outside funding.
A company with no investors or creditors has a simple definition of
success. The company can stay in business as long as it is not losing
money and never runs out of cash.
For a company with investors, the bar of success is higher and
harder to jump over. If the company merely breaks even, making no
profit and incurring no losses, there will be no way to repay the
investors. This brings me to Eric's Law of Company Funding:
For a company that was built with somebody else's money, operating at break-even is failure.
It doesn't matter whether your investors loaned you money or used it
to buy stock in your company. Cash always comes with strings attached.
Debt comes with different strings than equity, but both come with
obligations that cannot be ignored. Eventually, your company has to
make enough profit to repay your investors or creditors. The more money
you took from other people, the more profit you have to make. If your
profit margins are low, you've got a big problem on your hands.
My favorite example of a funding disaster is Webvan.
The basic concept of this dotcom was to be an online grocery store with
same-day delivery. Visit Webvan's Web site to place an order. A few
hours later, somebody shows up at your door with milk and bananas. Cool
The problem was not with the idea, but with the implementation.
Webvan built an enormous distribution infrastructure. The total amount
of outside capital invested in Webvan was in the neighborhood of a
Stop and think about that for a moment. We're talking about a
business that sells food. Food is the ultimate commodity market. There
is no industry that has tighter margins than food. It is unlikely that
Webvan could have ever repaid a billion dollar investment from the profits on selling food. What were these investors thinking?
As they say, hindsight is 20/20.
Even though the Webvan example is rather large, we can apply its
lesson in the small. Before taking investment money, think long and
hard about how your investors will get their money back.
I'll close this edition of the "Business of Software Cliché Festival" with the reminder that there is no free lunch.
The cash you get from funding can increase the likelihood of success,
but the obligations you get from that funding also increase the
likelihood of failure.
The Perils of Getting Advice from Experts
Like I said at the start of this piece, nothing here should be
construed as financial advice. Every entrepreneur needs to find a
financial expert to give advice, and that person is definitely not me.
But even as I observe that it can be foolish to make major decisions
without consulting accountants and attorneys, I must admit that getting
advice from these folks can involve a different kind of risk. I will
close this article with one final caveat.
There is often a big impedance mismatch between the world of
accountants and the world of software. You don't fully understand their
world, and they don't fully understand yours. Depending on your
geographic region, there is a good chance your accountant or attorney
is more familiar with traditional industries than with the business of
If your legal or financial expert does not have a software
background, move carefully. Consider his or her advice and decide
whether it makes sense in a small ISV. Explain the special constraints
of software businesses and how they differ from selling corn, cars, or
carpet. This may slow you down a bit, but there's no point in paying
for advice that isn't applicable to your situation.
Eric Sink is the non-legendary founder of SourceGear,
a developer tools ISV located in Illinois. For recreation, Eric relaxes
by moving golf balls from various retail establishments to the bottom
of water hazards on the second hole at the nearby golf course. His
weblog is at http://software.ericsink.com/.
This article originally appeared on the MSDN website.