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2003-11-24 16:58:52

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:

  1. Income Statement--A summary of revenue vs. expenses and total profit (or loss) during a specific time period.
  2. Balance Sheet--A snapshot of the company situation at a specific moment in time.
  3. 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 paid.

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 moment.

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:

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 right now.

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 asset.

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 company.

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:

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.

Profit Margins

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:

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 for it.

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 same:

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 margin.

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 funding.

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:

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 idea.

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 billion dollars.

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 software.

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 https://ericsink.com/.

This article originally appeared on the MSDN website.