Cash Flow Traps

Happy Day! 🥳

A Foole and his Money is Soone Parted.
-Dr. John Bridges, 1587

In my regular career, I came to abhor the corporate wastefulness that I saw in every company I worked for, and all the other companies I visited. In my opinion it is a national disease caused mostly by the dissociation between the user of funds and its source. Employees can quickly lose their sense of accountability when the money is not coming out of their own pockets.

Employees are usually so far removed from the source of the funds that they can show little if any frugality in how they use them. The farther down the hierarchical pyramid, the more people seem to squander. Most of the time no one stops it, and then every few years there is a recession, and the same people who were so careless with their company’s cash are the ones who bleat when they are downsized.

Cash-flow Trap: Expense Cheating

It is not just the dissociation between the source of funds and user that is an issue. Many employees develop over time a sense of entitlement. For various reasons the idea that “The company owes me,” begins to infiltrate their minds and that leads indirectly to business expense abuse. Expense cheating is endemic in most companies.

In a 2002 study by Ernst & Young and Ipsos Reid, 17 percent of respondents said they knew people who inflated expense accounts. The study showed that junior employees under 35 who have been with their companies more than three years are the most likely to commit fraud. But managers tend to get away with larger amounts. According to a survey published in 2008 by U.K. expense management provider GlobalExpense, 30 percent of adults viewed exaggerating expense claims as acceptable, and 20 percent admitted to having done so themselves. Company systems tend to forgive expense cheating because it costs more to investigate and police, and so it becomes habitual in some companies.

Common expense cheating includes asking taxi drivers for blank receipts and inflating the cost, claiming recreational dining as business meeting costs, automobile mileage falsification, client entertainment claims, and false lodging and travel claims. Most companies accept it goes on, and most employees accept it as a way of life. It can become a mindset that while not harmful for the large business is catastrophic for the new entrepreneur. No small business can tolerate this drain of cash from any employee, contractor or the owner. For the owner of a start-up every single expense must be questioned. If the thing or service being considered for purchase is not absolutely vital for the stability and growth of the company then it does not get bought.

Cash-flow Trap: Compensation
A tricky question to consider in any start-up is how much to pay yourself. One of my pet hates as an investor is to receive a business plan in which the business owner wants a high salary that he or she expects to be covered by the investment. When I review the financial spreadsheet and see that the salary is a significant percentage of the investment I am immediately put off. Investors call these proposals lifestyle deals meaning the entrepreneur does not expect to have to make sacrifices in his or her lifestyle while building the business.

No investor wants a starving entrepreneur to run the business. By the same token any investor expects a business owner to “put some skin in the game.” When the business owner has no money of his or her own to invest the minimum they would be expected to do is live minimalist until the business can justify drawing down cash for living expenses.

As a new entrepreneur you simply cannot expect to maintain the same level of lifestyle at the start. You are expected to work without a salary and benefits for a while and at least until revenue flowing in exceeds cash flowing out. Ideally the start-up owner would forgo any salary at all at the outset and only take compensation from profits. Remember that revenue is not profit, and actual profit may not be apparent for several months. We have to be prepared to make sacrifices at the beginning. If you think you can start a company and immediately pay yourself the same as you were earning in a regular job, you need to think again.

Another friend of mine started a media company. Because his lifestyle includes a large mortgage for the family home and tuition costs for his college kids he withdrew $200,000 a year from the company profits. With a turnover of around $1 million and expenses close to $750,000 there is very little profit left for marketing and the business has remained pretty much the same size for the last decade. As I write this the owner is considering bankruptcy.

The owner has often asked me for help with the business strategy, but he refuses to consider changing his lifestyle in the short-term to release money for business growth. If he could cut his personal compensation in half I know he could double his subscriber base and then exit the business through a strategic sale for significant gain. He is, however, in a lifestyle trap. With so little profit showing on the books and with flat subscriber growth for many years the business is simply not financially attractive to a purchaser as it is.

Once the bumpy years are over you will enjoy the fruits of your frugality and can make up for that sacrifice. A start-up is not a substitute for employment. The longer you can go without drawing much cash out of the business for compensation the better it will be for the cash-flow and your chances of survival.

I sold my home during the start of my first company and used the equity to live on until the company was producing solid profits. It took two years before I drew down cash for living expenses. My wife was unable to work through that time so there was considerable pressure to succeed. Having a small cash cushion through the bumpy period certainly helped, but I still had to do some moonlighting consultant projects to keep our heads above water.

If you don’t think you can make such lifestyle sacrifices for a period of time that could be 1-2 years, don’t even think about starting a company. The statistics don’t lie. 82% of failures are due to this one issue. I am sure one of the reasons students have built such great companies is that they already lived in a miserly fashion.

Cash-flow Trap: Company Feel-good
In addition to the issue of expense fraud, most larger companies have an in-built tolerance for using cash frivolously. For the start-up company any cash that is spent on anything other than trying to increase revenue and profits is frivolous in my opinion.

When I first came to America, I worked for a Fortune 100 company. Within days I attended a sales managers’ meeting at a luxurious resort in Arizona. With the support staff and fifty managers, there must have been seventy people who took over a hotel for a week. Every night there were attempts at team-bonding exercises, and the handing out of gifts and prizes. I ended up with a Stetson, a pair of cowboy boots, sunglasses, and a glass paperweight in the shape of a cactus. Having never owned a pair of cowboy boots before, I walked around with my jeans tucked inside the legs. I must have looked like an extra on an episode of Star Trek, but my colleagues were either too polite or too cruel to tell me.

Every night the attendees ran up large bar bills. At home they probably restricted themselves to a couple of glasses of cheap wine at mealtime, but at these meetings it was common to purchase and drain $100 bottles of wine and whiskey. The company executives fooled themselves into believing it all aided employee morale. It was, however, simply a frivolous use of cash.

I can only imagine the cost of these meetings to the company. They were held every quarter, and our group of managers was one of fifty such groups in the different divisions of the company. Throughout the company the employees had developed a sense of entitlement and that spilled over into how they used corporate resources.

The company made so much profit that these excesses were never noticed. In the end the customer pays for the abuse with the price of the product or service. My point is, however, that most new business owners come from careers and companies where this culture of excess and abuse is accepted as a way of life. Then they start off in their own ventures with a similar carefree attitude to cash. It simply can’t be that way.

Cash-flow Trap: Human Resources

At company Lozt, where executives spent almost all of December filling out performance and appraisal forms, the Human Resources department had built a fiefdom. The company had been in existence for nine years, and had used up four rounds of funding totaling nearly fifty million dollars. They were no nearer a breakthrough invention than when the company started. They had not generated one dollar in revenue, but they were as careless with cash flow as any company I had known.

When I met the senior management team, I asked a simple question: “What is the company’s biggest achievement to date?” Quick as a flash they told me “We have grown to fifty-six members of staff.” The Human Resources Director and his many assistants beamed proudly. That was how they measured their success, and that is all too common in corporate America. Everyone in the company repeated the same proud statistic.

In my career I had never heard a Human Resources Department leader recommend a freeze on hiring or decrease in staff. I had never had a head of Human Resources come to me with a proposal that was designed to increase company profitability or customer satisfaction. Rather, I had been frequently pestered to add more staff to assist the ever stressed human resource specialists. I had been begged to invest in programs aimed at improving staff morale, corporate culture, company branding, internal communication systems, information technology systems, sensitivity training, and the ever changing, performance and appraisal management system.

I have never seen any of those systems make employees feel more satisfied, loyal, or productive. I have never seen evidence that matches expenditure on human resource systems and staff with increased profit. In fact, more often I saw those burdensome systems achieve the opposite and become a major source of distraction and expense. To be successful, a company needs to keep looking outward at their customers and market, but these practices cause companies to focus internally. All those resources are sucked into an internal whirlpool that drains the company of resources and energy, and if most employees can be honest they will admit most of the systems designed to improve their morale have the opposite effect.

Cash-flow Trap: Hierarchy Reporting

Like most companies, Lozt had a hierarchy of decision-makers with six executive-vice-presidents, four vice-presidents, and a dozen directors. Other than the title on their office doors, I could not tell the difference in leadership ability between any of them.

The Lozt CEO believed that giving people big titles was a way to keep them in the company. The problem with his strategy was that once they got the fancy title they simply hired directors to replace themselves, and then the newly-promoted directors hired associate-directors. What they ended up with was the corporate mid-management girth.

Every decision was made by consensus. First, the junior employees huddled in a meeting room for half a day every week. The nominated leader passed their recommendations to a supervisor who would discuss it at the middle-manager level get-together of associate directors. Eventually, any surviving ideas or recommendations would make it to the Wednesday afternoon director’s summit. Final reports were made at the Friday executive team assembly. For some reason that I never figured out, the executive team always held their meetings at an off-site location, which incurred the extra costs of a hotel meeting room, presentation equipment hire, and dinner.

The executive team was afraid to make any kind of decision that risked upsetting the CEO, and in turn the CEO lived to keep his board members happy. Project reports first went to the advisory board meetings that were held every quarter at the added expense of flying the advisers first class across country. The advisory board existed simply because the board of directors expected a company to have one. The CEO expended all his energy to get them to agree to the recommendations in the reports. With their approval, any recommendations then made it to the twice-yearly board of directors meeting where a team of ten people, each representing an investor company, would take a vote.

To anyone who has never worked in corporate America this all sounds like madness. It is, and it is endemic. As the Lozt board of director’s meeting loomed, the CEO, his executives, human resources, and two personal assistants to the executive team spent two weeks writing, reviewing, and proofing a one hundred-page document called the ‘Board Book.’ No other work task was attempted during its production, and it was impossible for any of the staff to get the attention of the executive team in those times.

The Board Book summarized all the company projects, as well as the financial statements, and was intended for the members of the board to read prior to the meeting. To produce the book, the junior employees had to write summaries of their work for their supervisors. The supervisors would write summaries of all their projects. The executives would produce a departmental document from those reports.

The CEO was proud of the quality of these productions, and felt future funding depended upon them. In reality, what the investors wanted to see was some actual work progress.

Copies of the book went to all board members, the board of advisers, and the executives. When the board assembled in the expensively appointed boardroom, the executives regurgitated the same data that was in the board book in presentation format. The questions that came from around the table showed no one had bothered to read any of the information. The meetings lasted all day and often into the night, and ended with a sumptuous meal at a fancy restaurant in town. At one meal, I sat back in amazement as a board member presented a plaque to the CEO in recognition of the company hiring its sixtieth employee.

In that particular company, I could point to many departments and areas of wastefulness, but no one wanted to hear it. Most people just want to keep their jobs and there is sometimes a greater effort to appear busy and productive than there is to be profitable. Everyone worked hard, kept long hours, and they were fun to be with, but so much of their effort was for internal benefit.

This sort of waste of resources, what I think of as an internal whirlpool sucking away money, is repeated at thousands of companies throughout the world. Everyone has always behaved this way so no one seems to think to change the pattern. Keep in mind that like many research-focused companies, this one had not generated a single dollar in revenue, and all this cost was coming from the venture capital. Venture capital has usually come out of the pockets of high-net-worth individuals, not one of who got rich wasting money that way.

The final straw for me at this company came when I sat in on a meeting with the CEO and all the executive team for four hours while we debated whether the previous day’s spotty attendance, which was due to a snow storm, could be taken by employees as a free ‘snow-day’ or whether they had to deduct it from their vacation allowance. I took the risk of pointing out the cost to the company in employee-hours of the distracting conference we were having, and how it outweighed any cost of lost production from the snow day. I would have caused less consternation if I had danced naked on the table.

A few months later, the company finally used up its remaining funding. The investors, who had been promising another round of financing for over a year, simply grew weary of the whole thing. The staff was stunned and blamed the investors for having a lack of faith in the scientific data. No one mentioned the fifty million dollars that had been spent building a company that generated zero revenue, but had what the local biotechnology support group called “the best-run human resources department in the city.”

When you are a single-person owner you have to avoid the madness and it is not as easy as you might think. Even the greats like Henry Ford failed to grasp this topic at first:

A different cash-flow trap involved Henry John Heinz who started his first company in 1869 selling horseradish, pickles, sauerkraut, and vinegar. In 1875, the company filed for bankruptcy due to an unexpectedly productive harvest. The farmers had to be paid or they would starve, but the harvest was so good that more farmers were hired for longer hours. That used up too much cash, and then there was insufficient left over to get the harvest turned into finished goods and onto the shelves. The lesson here is that even in a good situation with high customer demand, not having the money to bridge the gap between expenses and income can result in the same thing… cash-flow failure.

Today we often see that play out when companies expand too quickly in response to market demand or opportunity. If they do not have sufficient capital reserves to manage the expansion and buy time until the new revenue catches up to the costs of expansion, they can quickly spiral into a cash-flow crisis. Recently the west coast grocery chain Haggen filed for bankruptcy just eight months after it acquired 146 new stores through the merger of Albertsons and Safeway.

Cerberus Capital Management, the private investment company that owns Albertsons, received approval from the Federal Trade Commission in January 2015 to buy Safeway (Vons’ parent company) for about $9.2 billion. Cerberus had to shed 168 of the stores in order to be in compliance with antitrust regulations. Haggen scooped up 146 of them, transforming the company from an 18-store regional grocer to a 164-store chain with locations in California, Arizona, Nevada, Oregon and Washington.

The transition period used up lots of cash reserves, and soon after the newly acquired stores was up and running the company began cutting worker hours and instituting layoffs to conserve cash. Then in mid-August Haggen announced that it would be closing 27 stores.

That spurred legislation to protect grocery employees from being fired because of changes in store ownership. Rick Icaza, president of the United Food and Commercial Workers union said, “Instead of creating a long-term sustainable business plan that would have benefited workers and shareholders alike, Haggen instead took the greedy route of quick, short-term profits and ended up harming our community and neighborhoods. Haggen leaves behind a mass of broken lives and stores all because they couldn’t see beyond the end of their own quarterly report.”

The message is clear. Small, mid-size and large companies are managed by people who all too easily fall into the cash flow traps.

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Talking about failures can be a bit depressing but too many entrepreneurs bury their head in the sand when it comes to being sensible with cash-flow. Most of the new entrepreneurs I have encountered have simply recreated the traditional structure and habits they learned in the old job. It is crazy. I think the biggest challenge for many first time business starters is the fact that they have to change lifestyle. They cannot pull down the same salary as before. They have to fund medical insurance etc. Have you considered this?