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Efficient Markets?
We recently received market feedback that a commercial landscaper we had looked at ultimately transacted at 16 times adjusted EBITDA with multiple buyers competing to do the deal. I’ll reserve comment on that and simply say that here are 10 of the several hundred U.S. public companies trading at a lower valuation with better margins:
Alphabet
Berkshire Hathaway
Pepsi
Caterpillar
Disney
Nike
Starbucks
John Deere (shoutout my Gator)
3M
Kimberly-Clark
Now, far be it from me to predict which outperform from here, but recall that each of these companies has decades of track record, a well-established market position, scale, redundancy, audited financials, and daily liquidity. So a question to ask yourself is: Would you rather own 16x Landscaping or one of these?
With that, season four is going to take a brief intermission. Have a great weekend and see you in a few.
– Tim
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Paranoid Optimism
We showed up at the office on the morning of October 1 to learn that (1) 47,000 East Coast dockworkers were on strike (with union boss Harold Daggett having previously declared ominously to the country that “I will cripple you); and (2) Iran was set to imminently launch a barrage of ballistic missiles at Israel (which it proceeded to do). Further, this was happening amid a consequential presidential election with Vice Presidential candidates JD Vance and Tim Walz getting set to debate later that evening (fortunately with no mention of invaders eating pets, though there’s apparently a real problem in San Francisco) and on the heels of a Hurricane Helene decimating parts of the Southeastern United States.
“Happy Q4!” Emily declared.
Not long after that I learned that one of our portfolio companies was contemplating making a multimillion dollar investment, which made for an interesting juxtaposition of how to think about long-term capital allocation amid uncertainty.
The fact that the S&P 500 stock index is up about 70,000% since its 1957 inception is one good reason to remain long-term optimistic when it comes to capital allocation. After all, there have been a lot of crises between 1957 and now that have clearly been worth investing through.
That said, there’s a reason why there is an old investing saw that advises to never invest more than you can afford to lose. Because it’s precisely because of unanticipated events such as hurricanes, war, and labor strikes that any investment one makes can at any time decline in value.
Where does that leave us?
Back when I lived in DC I was told that if I was ever asked a politically charged question but wanted to avoid a politically charged discussion to reply that “I am cautiously optimistic cooler heads will prevail.” (Try it, it works!) And while that’s kind of a throwaway line in that context, the term “cautiously optimistic” struck me as a clever and pragmatic turn of phrase. I thought it nicely described the idea that if you stay engaged with the world on honest and fair terms that while bad things will happen, you should stick around because most outcomes are pretty good.
But as I’ve gotten older and gained experience (I also learned on October 1 that I have been six years (!) with Permanent Equity), I’ve come to understand that cautious optimism is probably too passive of an approach. Instead, I’d describe myself now, at least when it comes to capital allocation (and maybe some other things), as paranoid optimistic (though always being careful to never let that optimism become skepticism, cynicism, or pessimism because that would be no way to live).
What’s paranoid optimism? I think it’s the idea that if you stay engaged with the world on honest and fair terms that while bad things will happen, you should stick around because most outcomes are pretty good but that when bad things do happen, a lot of them are likely to happen all at once so in order to be able to “stick around” you better take time on the front end to structure your downside protection so at any moment you can withstand a pretty big broadside.
“Happy Q4!” indeed.
– Tim
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Represent Reality
The Permanent Equity Investing Team has a channel in Slack called investingteam where we mostly post snark and memes and occasionally talk about topics relevant to our investment process. That’s where I came across a memo our CEO Brent got his hands on from one Lead Edge Capital that he shared in that space because he thought the rest of us would enjoy it (and we did). Called “Types of Reported Information,” it, not inaccurately, lays out the “hierarchy of information included in company decks.”
To wit…
If companies have good cash profits they report those
If companies don’t have good cash profits, they report on adjusted profits
If companies don’t have good adjusted profits, they report on gross profits
If companies don’t have good gross profits, they report on revenue
If companies don’t have good revenue, they report on adjusted revenue indicators (like Gross Merchandise Value - GMV)
If companies don’t have good GMV, they report on Monthly Active Users
If companies don’t have good Monthly Active Users, they report on Subscribers
If companies don’t have good Subscribers, they report on Downloads
If companies don’t have good Downloads, they report on Pageviews
If companies don’t have good Pageviews, they report on that they were voted the “Best Place to Work in XYZ City”
And people call me cynical!
When I looked up Lead Edge Capital, I saw that they call themselves a “growth equity firm with substantial assets in software, internet, and tech-enabled businesses,” so I am sure they have seen their share of pitches that blurred the line between putting the best foot forward and taking liberties with reality. After all, if you’re raising capital for a business that’s not really yet a business, which many tech-enabled start-ups are, you have to report on something. But as we well know, start-ups aren’t the only ones in the investing world who blur the line between putting the best foot forward and taking liberties with reality.
That said, one of the pieces of advice our managing director Emily gives to businesses looking for investors is to “represent reality.” That’s because deals are thoroughly diligenced and if what is marketed upfront is not representative of reality, any deal negotiated on the back of that representation runs a very great risk of falling apart, which ends up costing everyone time and money. Further, sometimes it’s even better to lead with the challenges because many investors earn better returns by being helpful to the businesses in which they invest, so if they can see from the get-go how they might add value, they might be more excited to do a deal.
One question we get a lot is how many of the deals that we get under a letter of intent (LOI) actually close. The answer is most, but not all, but that 100% of the deals we had under LOI that didn’t close were the result of us being told upfront that something was true that turned out not quite to be the case (the most egregious example of which was a firm that said it had generated $4M in free cash flow but had actually burned $17K). So represent reality. Because we all have to be on the same page eventually.
– Tim
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How We Hired a Qualified CFO
After I wrote about your next hire, I heard back from Kevin who asked if I might provide an example of what the lists I wrote about might look like and how they might work. As a reminder, I said that when it comes to building an organization and figuring out who should be in what role, it’s helpful to keep four lists:
What needs to get done, ordered by importance.
What people are doing, ordered by time spent doing it.
What people are good at, ordered by ability.
What people like to do, ordered by how much they like doing it.
As for an example, here’s a simplified version of the framework I used back when I was our chief financial officer (CFO) when our chief executive officer (CEO) Brent and I were discussing hiring Nikki to take over as CFO in order to move me into being our chief investment officer (CIO).
I wrote previously that in an ideal world, these four lists are nearly identical, so you can see the incongruity in this example. I was spending the most time on internal financial management, which was neither the most important thing that needed to be done nor something that I was good at or particularly liked to do. And the reason that was so is because it was important and I wasn’t good at it (hence being the most under qualified CFO in America). So I had to spend a lot of time getting up to speed on everything that went into it in order to be competent at it. That’s a problem.
Another thing to point out is that these lists don’t exist in a vacuum. Obviously at an investing firm investing is very important, but at that time what needed to be done in investing was a very high priority for Brent and Emily. Yet the responsibilities associated with that area also came with opportunity costs for Brent, so if he wanted me to make investing a greater priority (which I would welcome since I like it and am, let’s say at least for the sake of argument here, good at it), something else had to give.
So what this simple exercise showed clearly is that our next hire needed to be someone who was good at and liked porto financial oversight and internal financial management because then their lists would be nearly identical and then so would mine! And I don’t mean to speak for Nikki, but I think we got that hire right.
That, in its simplest form, is how I use lists like this to inform hiring and structuring decisions. And I say in its simplest form because there is much more nuance and complexity. For example, underlying each of Investing, Capital Markets, Portco Financial Oversight, and Internal Financial Management are myriad roles and responsibilities. For example, Capital Markets includes both writing investor letters and also regulatory compliance. As you might guess, I am much more the former than the latter, and my role and our team are structured to reflect that. Similarly, Portco Financial Oversight includes both budgeting and expense management as well as long-term capital allocation decisions. You can probably guess where I am more likely to be involved.
In other words, as organizations grow in scale and complexity these lists can act like nesting dolls as you define roles and responsibilities. But by striving to align what needs to be done with what you’re doing with what you’re good at and, of course, and perhaps most importantly, what you like, you, too, can end up with a qualified CFO.
– Tim
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Be Wary of Relaxing
The idea that businesses that offer customers small, but critically important products or solutions benefit from superior economics was one that hit home with many of you, so I think that lends it credibility. I heard from Joe R., for example, who was once CFO of a semiconductor fab. He said that while he was constantly on the lookout for cost savings, he never dreamed about not buying filters from Entegris because it wasn’t worth the risk of screwing up the entire manufacturing process in order to save a few hundred dollars per week. So Entegris charged them whatever they wanted, which helps explain that company’s very healthy 40% gross margins.
Spencer, another CFO, agreed 100% with the idea of small, but important suppliers, but pointed out how many vendors try to get away with acting like they are small, but important even when they’re not, calling out Cintas and Waste Management specifically. If you’re not paying attention, he said, these guys will try to increase prices and auto renew their services to no end, so “know your contracts and costs, and be wary of relaxing!”
And that’s good advice.
Indeed, if you’re a small business, or really anyone with a budget, it’s important to keep an organized and shared list of anything you pay for with a renewal tied to it, such as leases and service agreements, including calendar alerts for key dates or events. This is to ensure that you don’t inadvertently become a forced actor when it comes to renewing or canceling said contracts (because I can say from experience that landlords in particular love it when a tenant forgets about a renewal option).
Which brings up a broader point…
I’ve said before that I don’t believe business is a zero sum game, but it is competitive and actors aren’t benevolent (nor should they be). Further, that advantages are both relative and fleeting, so you need to press them when you have them. A corollary is that if you are to be successful in business given those circumstances, you need to be ruthless about avoiding errors of omission that turn a supplier, customer, employee, or other stakeholder into something they’re not. For example, if you forget to renew the lease on your warehouse after a few years where rents have been rising faster than, you’re going to find yourself behind the proverbial eight ball with regards to negotiating new terms since your business probably isn’t prepared to move and what happens as a result might change the entire economics of your business.
In other words, and I really can’t put it any better, “know your contracts and costs, and be wary of relaxing.”
– Tim
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Generational F-Word Wealth
My daughter and I were driving home from town on I-70 at night recently when we came up behind a state trooper. Seeing him from a ways back, I dutifully pulled into the right lane and set my cruise control at the speed limit.
Not long after a car passed me on the left at a pretty good rate of speed. It startled me, though, because it didn’t have its headlights on. Then, as it passed, I noticed that it also didn’t have license plates.
“Well, this should be interesting,” I said to my daughter.
“What do you mean?” she asked.
“That guy is about to blow by a cop, without his headlights on, and with no license plates.”
You can probably figure out what happened next.
And this happened on the same day that our CEO Brent had forwarded me a voicemail he had received from someone calling himself the “Hole-Poker” who was an “oil man” and a “very serious person.” The Hole-Poker was asking for “10, 20, or 200 thousand dollars” of capital to bring a project home and create “generational [f-word] wealth.”
Further, he promised that if one invested in his opportunity one would have their money back “within the week,” their kids’ college paid for “within the month”, and after a year, have created “generational [f-word] wealth.”
This, you probably don’t need to be told, is securities fraud.
I recount these anecdotes here to point out that while the actions of these two individuals seemed somehow advantageous to them at one time, rarely does brazen flaunting of the law work out well for anyone. Moreover, lest that seem like an obvious point, here are two individuals doing just that, in my small corner of the world, within hours of each other on the same day. You have to wonder what other ridiculous things went on in the world that day.
So as you head into the weekend, if you’re presented with the opportunity to do something brazenly illegal, don’t. It’s poor risk management and certainly not the way to create generational f-word wealth. I wish no one had to be told that, but at the risk of making another obvious point, here we are.
Have a great one.
– Tim
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You Have a People Problem
After he read about the fire at the fire station, our managing director Mark Brooks shot me a note saying that the idea that context matters reminded him of this piece that he read recently about how there is no such thing as an “A-player.” Citing Ron Johnson’s successful stint at Apple followed by his disastrous one leading JCPenney as well as other examples, it argues that “an A-player for one organization is not always an A-player for another.” That’s because “transferring what you know from one context to another is difficult and unreliable.”
And I’ll concede that point. After all, history is littered with examples of people who have both succeeded and failed. So if the definition of an “A-player” is someone who always succeeds at everything, yes, there is no such thing.
But if an A-player simply refers to someone with high ability who is crushing it in his or her role, it’s helpful to know what to call that. Further, I think it ignores reality to not admit that there are some people we’d all recommend ahead of others absent any context at all.
See, years ago I was part of a small group that met with former GE CEO and erstwhile management guru Jack Welch. We were each supposed to bring with us an organizational challenge we were facing and Jack was going to help us figure it out. One of those came from a woman in my cohort who said that her business was opening a new geographic market, but wasn’t getting the anticipated traction or momentum.
“Let’s start with the basics,” Jack said. “Is the person in charge of opening that market for you an A-player?”
The woman hesitated before starting to say yes. But Jack cut her off.
“Clearly not if you have to think about it. You have a B-player or worse leading and that's why you can’t get traction or momentum. You have a people problem. If you want this new market to succeed, solve that if you can and care to.” Then he moved on to the next organizational challenge.
After the meeting I asked the woman if she thought it was true she had a B- instead of an A-player filling that role, and she said it probably was. The person was qualified, she insisted, and long-tenured, but probably fell short of being a true A, which is why she had hesitated.
When it comes to roles and responsibilities, leaving aside all of the jargon and value judgments, it boils down to two things: ability and fit. And people who excel at something or are likely to are typically not only checking both boxes, but benefiting from the two reinforcing one another. As for whether that makes anyone inherently an A-player or not, or if their success is fostered by their context, that’s a complicated and nuanced discussion. What is less complicated is recognizing who is crushing it.
Because if someone is crushing it, you shouldn’t have to think about it.
– Tim
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Routine Chaos
I mentioned last week that my son recently started high school, and I can say with 100% certainty that the time and place in this world that gives me the most anxiety right now is the high school parking lot during morning drop-off. It’s chaos. There are all manner of signs and cones and every form of transportation you can think of: buses, cars, bikes, motorized scooters, skateboards, roller skates…even the maintenance guy is zipping around in a golf cart. And of course it goes without saying that the crowds of high schoolers are ignoring those aforementioned signs and cones and behaving unpredictably. I’m sure at some point I’m either going to hit something or get hit, so I’ve learned to take it pretty slow.
And learning and dealing with that made for a pretty frustrating first week of morning drop-off. See, my son is on the swim team and they practice before school and since we live a ways out of town, we had to develop a new routine to get him to practice and then showered, fed, and back to school on time (does your teenager eat as much and as often as mine?). Developing this new routine was a challenge relative to the established routine we had for middle school drop-off. That routine, honed over three years, enabled me to drop him off, write these missives, run, and shower all before 8am every day.
The first week of high school drop-off was not nearly as productive. We were hurried, stressed, and late because neither he nor I were allocating our time efficiently and there was even one day when he had to wear my shoes to school and I went barefoot to the office because someone dropped the ball.
So he and I sat down at the end of the week and held a retrospective. I said, I don’t think this new routine is working well for either of us and here’s what I need from you for it to work well for me. Then I asked him what did he need from me for it to work well for him? With new agreed upon standards and procedures, we tried again the next week and it got better! We’re not a finely tuned machine quite yet, and I still need to figure out how to fit some things in, but we’ve both been consistently on time, less stressed, and wearing our own shoes, which I consider a win.
The lesson, of course, is that new systems and routines never work well right out of the gate and that if you expect them to, you might end up frustrated and barefoot. Instead, whenever you implement anything new, you also have to commit to putting in the time and energy to iterating and improving. And that’s the mindset we’re asking everyone involved to have with regards to implementing our new boards of directors and annual planning process at our portfolio companies. I think what we’re doing now is better than what existed before, but it’s certainly not perfect, and so we want everyone to feel empowered to speak up to help it work better and better for everyone over time.
– Tim
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How Returns Are Made
Somewhat related to the concepts of Spreadsheet Value and Real World Value, one of our Partners recently asked me what her returns were, which is a totally fair question. And the simple answer to that fair question, and the one I gave, was to look in our most recent audited financials where that Fund reported, and an outside accounting firm had signed off on, a since inception internal rate of return (IRR).
But! What are returns and why do we measure them?
For example, that Fund’s audited since inception IRR is calculated using the amount and timing of Partner capital contributions (which are known values), the amount and timing of capital distributions to Partners (which are known values), and, since its holdings are private and not public, the fair market values of those holdings were they to be liquidated (which are estimated).
A good question to ask is: who estimates those values? And the answer is: we do! Our auditor signs off on them, of course, and I believe they are reasonable, but are those values exactly what those holdings would sell for in the open market right now? Probability would suggest that no they are not.
Yet we do this because everyone agrees that investors deserve to know how they’re doing and also that they’re not invested in a Ponzi scheme. To achieve this shared aim, when accountants are accounting and regulators are regulating, they have a process (called GAAP) by which they try to be precise about ambiguity (and good luck with that, though I appreciate that someone has to try). Because returns, when they are measured prior to an exit and particularly when they rely on estimates of fair value, are a construct akin to any other that attempts to be precise about something that defies precision. In other words, they may be approximate, but they are almost assuredly wrong. And while that may seem obvious in this example of illiquid level 3 (to use GAAP terminology) assets, I would posit that it is also true of liquid assets like public stocks when a dude in an orange headband can tweet some memes and start a frenzy.
Accountants and regulators know this, which is to say that they know that all of the returns being reported are wrong (or at least impermanent). So the defense mechanism is to be wrong low rather than high. That’s because being wrong by being low has become known as being conservative while being wrong by being high has become prosecuted as securities fraud. But whether you’re being conservative or a fraudster, you’re wrong either way.
So the two questions to ask whether you’re measuring or analyzing returns are (1) What? and (2) Why? (which actually are always two good questions to ask about anything).
In terms of what, what returns are being measured, over what time series, and what are the drivers/contributors? More importantly, did the thing generating these returns have agency over any of it. For example, a strategy that saw multiple expansion thanks to a meme may (or may not!) be as sustainable as a capital investment that led to growth.
With regards to why, why are these the returns being measured and presented at all? It could be for accountability, but it could also be to reduce tax liability, increase chances of a future fundraise, buy time, take fees, or because there was no other choice? I’ve seen all of those scenarios, with GAAP auditors signing off on each even though the numbers could have been very different depending on a different why. So I guess what I am saying is that when it comes to how returns are made, despite reading the books, I still have puzzlement and curiosity. But I’m fascinated by the subject even though I don’t have a clear answer about this vital aspect of investing.
Maybe someone should write another book…
– Tim
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The Fire at the Fire Station
Columbia, Missouri, is typically a pretty quiet place, but occasionally something crazy happens and every once in a while something really crazy happens. It was the latter when I heard honking and yelling only to look out my office window to see a multi-colored minivan speeding down 10th Street with a flaming bundle of bamboo tied to its roof. As for why the minivan had bamboo tied to its roof and why that bamboo was on fire, I couldn’t tell you, but the reason it was speeding down 10th Street was because the city’s fire station is located about a block down from our office.
Curious what was going to happen next, I left my desk, went outside, and started walking toward the commotion. Stopped by a police officer who was setting up a safe perimeter I said, “How crazy is that?”
“Had to happen,” he replied. “Big fire hazard.”
So that’s one example of poor risk management. Because the longer you add to a bad situation with no consequences the bigger the consequence when it inevitably goes bad (shoutout 2008–09 financial crisis).
And with that takeaway maybe I could end this Opinion here. But!
Something else interesting transpired that day. And that’s that it turns out that one of the places firefighters are least prepared to fight a fire is at the fire station.
See, I’ve worked down the street from the fire station for six years now and never seen a fire. That’s because firefighters typically go to the fire. The fires don’t come to them. So when a multi-colored minivan with a flaming bundle of bamboo on its roof shows up on the fire station’s doorstep while the fire fighters are playing a friendly game of HORSE on their basketball hoop in the driveway and said minivan further parks in front of the garage blocking anyone’s ability to pull the fire trucks out and into service, well, it turns out that that pattern of facts makes it really difficult for them to fight a fire.
That said, it seems like it would stand to reason that if you have a fire, you should take it to the fire station. After all, that’s where all of the resources, skills, and expertise to extinguish a fire reside.
What that reasoning misses, however, is that everything about a fire station is designed to come to you. So context matters. By taking a fire to the fire station, you render those resources, skills, and expertise obsolete.
What ended up happening here is that the minivan burned up quite a bit while the firefighters kicked aside their basketball and figured out how to use the fire trucks while they were still inside of the garage at the fire station (and they did put out the fire and thankfully no one was hurt including the dog stuck in the minivan). And while that makes for a bit of an ironic outcome if you were to post it on the Internet, it makes perfect sense when you think about it. They were trained to respond to a fire, not have a fire respond to them.
Why is this relevant? Because context matters. You can spend all of the time and money in the world on resources, skills, and expertise, but if you deploy them in the wrong context, your return on that investment won’t be as expected. So no matter what you do, do it in context.
Also don’t keep adding kindling to the roof of your car. That may seem like an obvious point, but here we are.
– Tim
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The Adult Coed Division
They held a soccer festival recently to kick off the new season and in addition to signing up the u13 girls, there was an opportunity to play in the adult coed division. That sounded like a good time, so I organized a team (shoutout Nikki and Holly), and we did so.
When Brent heard that this was happening he stopped by and said “You know you’re going to get hurt, right? I can’t have you out on short-term (or long, God forbid) disability.
“Don’t worry about it,” I said. “It’s going to be fun.”
And it was…until the third (and thankfully last) game of the day when I attempted a fancy backheel shot that high school me absolutely would have hammered home. Instead, as I swung my leg in a manner I hadn’t in a long time in order to generate enough force on the shot, I felt my hamstring roll up and that was that.
Still, though, it was a respectable showing by Main Street FC (yes, we were sponsored by the upcoming Main Street Summit...don’t miss it!). Our team of geezers plus Holly finished fifth out of 10 and we had a lead in every game we played before running out of steam in the second half against people half our age. Indeed, it might have been an even better result if the games had been 18 minutes long instead of 36.
The u13 girls, of course, did better, winning their way all the way through to the finals before getting outmuscled by a team of older girls. That was funny because a few hours before that happened they’d been consoling me by saying we’d done a great job competing against people so much younger than us and now here I was saying that they’d done a great job competing against people so much older.
All of this goes to show a very important point of competitive advantages: they are both relative and fleeting. In other words, the very things that might have you in an advantageous position today may be gone tomorrow or – worse – become a massive disadvantage. So push your advantages hard when and where you have them and steer clear of situations where things you can’t change will make it hard to compete (though Nikki, Holly, and I are absolutely ignoring this advice signing up for the adult coed division again next year…provided my hamstring is rehabilitated).
Have a great weekend.
– Tim
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More of What You Like
My son started high school a few weeks ago (I’m as shocked as you are), so naturally he is getting more and more questions about what he’s going to do next. “Where are you going to go to college and what are going to study” his friends, cousins, neighbors, grandparents and, yes, even his parents want to know?
His unsatisfying answer to this and many other things asked of this 14-year-being is some form of “Uh, I dunno.”
Now, it’s tempting here to blame him for being 14 and therefore not putting in the effort nor having the conviction to have a clear plan (the Ennui character in Inside Out 2 really hit home), but it dawned on me the other day when hearing someone else ask it of him that perhaps “Where are you going to go to college and what are you going to study?” is not a helpful question. That double-dawned on me when I read Henrik Karlsson’s post on Unfolding.
Henrik’s epiphany is that all of the things that have turned out well in his life are the result of paying attention to what he liked to do and finding ways to do more of it. The reason this is so is because these things were good fits between form and context and so therefore felt natural and were predisposed to good outcomes. Other things that turned out less well were visions, which while aspirational were neither natural nor enjoyable and therefore not achievable.
You can read Henrik’s post for more ideas around how to embrace and accelerate unfolding on your own, but I think a complementary idea is that we all shouldn’t expect others to be able to bear the burden of unfolding on their own. And further, that we can be counterproductive to that cause if we ask questions that force others to vision rather than unfold.
“Where do you want to be in five years?” is such a question.
So is “What’s your target growth rate?”
And “Where are you going to go to college and what are you going to study?” is as well.
But all of these could be replaced by asking “What do you like to do and how might I help you do more of it?” And I think that’s a better question. So I’m going to ask my son that, though since he’s 14 I’m pretty sure the answer will still be “Uh, I dunno.”
– Tim
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Here’s a Different View
There’s an old saw in life that where you stand, depends on where you sit. In other words, someone with a vested interest in something is more likely than not to support and represent ideas beneficial to that interest. And that’s what crossed my mind as I began reading “The Relationship Between Deposits and Net Working Capital,” an article that Emily passed along to me over the summer.
Because “Aha!,” I said, as I read that “During transaction negotiations, buyers often argue deposits on a seller’s balance sheet should be treated as debt. This perspective is seldom accurate.” The person writing this article must be on the sell-side having represented customers who take customer deposits. And yes the author Brian Basil works for investment bank Crewe Capital, “understands all of the nuances of working capital,” and invites readers who might be selling their businesses to contact him.
The question here is around what assets and liabilities stick with a company after a transaction and which remain with the seller. But rather than start by getting bogged down in accounting terms and definitions, let’s start from first principles. Our view is that whether we are buyers or sellers, when it comes to balance sheets, companies should retain the assets and liabilities necessary to create the value for which the seller has been compensated and that the seller should retain that for which it has already been compensated.
Let’s start with an easy one…
Consider a seller that took out a $5M loan and then used the proceeds from that loan to pay itself a $5M dividend. In the event of a transaction, since the seller received the value of that debt, the seller should retain the obligation to retire it. Easy, like I said.
Now, take a payroll obligation. Basil argues that “payroll is not considered debt in the context of a transaction because it is incurred as a normal part of business operations and settled at regular intervals. Thus, payroll is almost always included in the definition of NWC.” While that may be the experience of Crewe Capital, it’s not our experience. We never include payroll in the definition of net working capital.
See, a good way to test the validity of an argument is to see if the logic of it holds at extremes. For example, let’s consider a company where payroll (like, say, a performance bonus) is accrued, but only paid out every year, and let’s further assume that a transaction occurs one week before that payroll is to be paid. Should the buyer be responsible for retiring that obligation?
Our answer, using a first principles approach, is clearly no because all of the value generated from accruing that payroll obligation went to the seller in the form of inflated cash flow. Therefore, the seller should use the proceeds from that inflated cash flow (or the deal) to pay it off. While the argument that payroll is a normal part of business operations settled at regular (usually lesser) intervals, makes this typically a less material amount, since the seller received the benefits of the work, the seller should ultimately pay for it.
And that brings us to customer deposits, which I’ll agree with Basil is a nuanced issue. By establishing the straw man that things that are a normal part of business operations settled at regular intervals should be included in net working capital calculations, he goes on to posit that deposits meet those criteria. But think about deposits from first principles…
Deposits are money a customer pays a company in advance for a product or service. The company can then use that cash to deliver the product or service and keep the profit. But if it distributes all of the cash that it needs to deliver that product or service, it can’t deliver that product or service and is therefore bankrupt. And no one wants to invest in a bankrupt company.
So our middle ground view on customer deposits is that the seller can keep any expected profit associated with the deposit since it originated the sale, but that the company should retain any cash necessary to fulfill the product or service obligation, since it has to do the work. In other words, the seller keeps the value, but also retains the obligation. There’s no fair world in any situation where you keep the value and shed the obligation (other than some recent public policies, but I digress).
A good question here is why are these things different from typical working capital items such as accounts receivable, inventory, and accounts payable? Our answer to that is that unlike deposits, which create obligations in the future, and payroll, which clearly created value in the past (and both to the benefit of the seller), AR, inventory, and AP are liquidity related items that happened in the past but that roughly offset one another in the future as determined by the observable cash conversion cycle of the business. To put that another way, they are known knowns that can be estimated and quantified and are retained by a business in order for it to operate in normal and ordinary course going forward.
Another counter argument I’ve heard (and that Basil makes) is that if customer deposits are part of the business model then deposits from hypothetical future work should be able to fund historically obligated work. And while that math can look good on a spreadsheet, those are, well, the mechanics of a Ponzi scheme. And no one wants to invest in a Ponzi scheme.
– Tim
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Five Secrets to Swag
We get a lot of compliments on our swag around these parts (because we don’t skimp!), and I thought it might be helpful if we open sourced how we think about it.
So I asked our resident guru James what he might share with others who want to up their swag game…
Don’t skimp! If you wouldn’t replace something you currently own with the swag you’re ordering, don’t bother. Because if you feel that way, everyone else will too and so no one will use or wear it.
Be tasteful. How you decorate your swag can make or break it and there is an inverse relationship between how big you make your logo and how often someone will use or wear the item. Design accordingly.
Customize. Your stakeholders (customers, employees, suppliers, investors, and the world) all have very different use cases for your swag. Optimize accordingly. Consider who the swag is for before slapping your logo on it.
Take advantage of wholesale and bulk order discounts. If you want to customize a premium product, reach out to the brand directly. If they don’t personalize, you can always receive the goods and then have a local business personalize the item. This is much more cost-effective than engaging a middle man (and you’ll get exactly what you want).
Perceived value is king. You don’t have to spend a fortune (particularly if you order in bulk) to impress your target audience. Look to up-and-coming brands to find affordable, high quality items and your curation in finding those brands will speak volumes about the thoughtfulness you put into your own business.
So that’s that: Five secrets to swag that will have people wearing and using your stuff without breaking your budget.
– Tim
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The Problem with Nice and Kind
Being high-performance kind instead of low-performance nice was an idea that resonated with a lot of you. I know that because I received a number of responses with thoughts on the topic.
J., for example, said that in his experience, when it comes to hard situations, the kind thing to do is almost never the nice thing to do. And that’s interesting because if you think you’re being nice, an interesting question to ask is what are you actually being?
Then Russell (Hoya Saxa!) said the story reminded him of the radical candor approach to feedback, which is something he has “tried” to bring to his workplace (and I assume his attempts were met with resistance since direct challenges are generally considered not to be nice). My experience is that radical candor is neither nice nor kind, but that it is interesting.
Also Matthew sent me to Adam Grant’s 19 words of feedback wisdom, which I hadn’t seen before but found spot on and useful: “I’m giving you these comments because I have very high expectations and I am confident you can reach them.” This is not a framework I’d encountered before, but I appreciated it. Tough love is an interesting concept in that it’s an oxymoron that also makes sense. It’s important not to be paternalistic in a professional environment, but it is ok to be demanding (but if and only if you also demonstrate what it means to be accountable). To that end, and at the risk of digressing, another interesting thing I was sent over the summer was Ravi Gupta’s defense of confrontation…because when there is no confrontation, there is only mediocrity.
Finally, Jason weighed in and said that “very often the recipient of the hard truth probably already sort-of knows” and “There’s a good chance…that they will end up feeling relieved, and it could actually improve their performance.” This was interesting to me because telling someone exactly where they stand if it’s not great, could potentially destroy a relationship. But not telling someone where they stand, could destroy their career. So which is nice and which is kind? And which is easier/harder on you/them?
I don’t know that there are crisp, clean answers in situations like these, but as Gupta concludes in his missive, something could not be your fault, but could very well still be (or become) your problem. And if that’s the case, I think it makes sense to be kind, not nice, even if it seems harder at the time.
-Tim
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Your Next Hire
I had a conversation recently with someone who is building a venture firm from the ground up and after telling me a bit about what she did and ultimately wanted to do she finally said, “Hey, can I ask you a question?”
“Of course,” I answered.
“You guys aren’t big, but manage more money than I do and have a bigger team, and that’s where I think I’m heading next, so my question is: How do I get there? And more specifically, who is my next hire?”
“Because right now,” she went on, “I lead everything. I’m sourcing, negotiating, diligence, operations, finance, compliance, investor relations, accounting, you get the point…”
And I did.
When it comes to building an organization and figuring out who should be in what role, I find it helpful to keep four lists. List one is what needs to get done, rank-ordered. List two is what different people are actually doing, in order of time spent doing it. List three is what the people in your organization are good at. And list four is what those people like to do.
You can see where I’m going with this. In an ideal world, the four lists are nearly identical. But if they’re not, it stands to reason that what you should be hiring for and who you should be hiring are driven by items that are on list one, but not lists two, three, and four. And while keeping these lists can be complicated at large organizations, in the case of the woman building the venture capital firm, making them and seeing where they differ should hopefully be a pretty fast and illuminating exercise since it’s such a small shop.
Of course, hiring is a luxury, particularly at small organizations, and so if you work at one you may have to wear more hats than you care to for longer than feels ideal. But that doesn’t mean not actively knowing which hats you ultimately want and should wear. Because if you don’t do that, you’ll never wear them.
Have a great weekend.
-Tim
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Stupid Expensive Goldfish
I heard a funny story recently from a mom who went into Petco to buy two goldfish for her kids after agreeing to do so. She found them (the goldfish, not the kids) in a tank near the back of the store selling for 29 cents each and asked a salesperson to bag them up.
But hold on, the salesperson said, do you have a tank for them at home?
No, the mom said. I was just going to grab a bowl on the way out and fill it up when I got there.
You can’t do that, the salesperson said. You have to get a tank and then set it up, treat the water, and let it run for three days. After that, if you bring us a water sample and it passes muster, then you can buy the goldfish.
$125 later the mom had a tank and a filter, a collection of chemicals, a fake plant, a small castle and some gravel. Then, three days after that, after her water had passed muster, her kids had 58 cents worth of “stupid expensive goldfish.”
What is going on here?
Observation one is about the power of commitment to influence our behavior (shoutout Cialdini). The mom agreed to get goldfish thinking the cost was de minimis, but still did so even after the cost of doing so rose exponentially. So be aware of what you commit to and under what circumstances, because most of us have a hard time walking those commitments back.
Observation two is that rules make things more expensive. If Petco didn’t care about the well-being of their fish, this was a 58-cent transaction, but since they apparently do, it was a $125.58 three day slog. Is this a brilliant upsell (Petco is private equity owned)? Or do they truly care?
This is relevant because I’ve been thinking about the cost of rules a lot of late. See, Permanent Equity plans to begin experimenting heading into next year with something we never thought we would: boards of directors. The goal here is to regularly convene people with both inside and outside views of a business to discuss long-term objectives, report on progress towards achieving those objectives, and, to the extent that that business is or is not making progress, identify strategies that it might implement to improve performance. This sounds like basic blocking and tackling, and it’s not to say that we weren’t doing this, but absent rules around how and when to do it, we were probably doing it too irregularly and without all of the right people in the room as we’ve grown.
But board meetings are also really expensive. Not only does it take time to implement structure and abide by it, but the constraints imposed by objectives in and of themselves limit open-endedness. So we also don’t want our boards to be like other boards. Our intention is to keep them small, highly accountable, and responsible for making sure each business has a clear plan, but for the cadence of collaborations underlying the process for achieving that not to be regularly, but rather when necessary.
Because if you do things because they have to be done and not when they should be done, you end up with too onerous of a regulatory regime…and stupid expensive goldfish.
-Tim
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Performance and PKs
Christmas came early for me this year when I got a hold of Professor Geir Jordet’s new book Pressure: Lessons from the psychology of the penalty shootout. Because if there was ever a book written uniquely for me (soccer, cognition, risk, reward), this was it! And I offer no apologies in advance to the inevitably irate parent on the opposing sideline this season whose daughter is about to take a penalty kick against the u13 girls soccer team when our goalie inexplicably needs to stop the proceeds to tie her shoe (“The overall trend is that the longer penalty takers have to wait for the referee – typically because of goalkeeper delays – the worse these players perform from the penalty spot.”)
Jordet, a psychology PhD, has analyzed every major penalty kick shootout of the past 50 years and offers some ideas about how (and how not) to conduct oneself in this high stakes situation. A number of these tactics are specific to soccer, but others are relevant not only to soccer players, but to practitioners of almost anything where anxiety can influence performance. As for what those are, it boiled down to three things:
Have a repeatable process.
Don’t be a forced actor.
Prepare for stress.
The idea behind having a repeatable process is that it ensures consistent inputs no matter the situation, turning a thinking exercise where doubt can creep in into a reflex. For the penalty taker this might mean always setting the ball down, taking three steps back and two to the side, and two deep breaths before kicking. But it doesn’t matter what the process is, as long as it can be consistently deployed. This won’t ensure optimal results every time because outputs will be outputs, but rigorous quality control of inputs should mean better outcomes more often than not.
In our businesses, one way we think about this is as easy earnings versus hard earnings (with the acknowledgment that all earnings are hard). Easy earnings are what you get from doing the same thing over and over, like putting up fences. The process is predictable, reliable, and each time one does it, one becomes less likely to screw it up. Hard earnings are what you get when you have to reinvent the wheel every month. For example, if you have no repeat customers or every project you take on is new and custom. You can have a good business with those characteristics, but your results are likely to be more volatile if your process is not repeatable.
Not being a forced actor is all about moving on your terms rather than someone else’s. For example, one of the more interesting observations in Jordet’s work is that the length of time that elapses between when the referee blows the whistle signaling that the penalty taker may take the kick and when the penalty taker takes the kick has gotten longer over time. In other words, it used to be that when the referee blew the whistle, the penalty taker immediately took the kick. Now, the penalty taker tends to take a few moments to breathe before proceeding. As long as this delay is on the kick taker’s terms (and not because the goalie inexplicably has to tie her shoe), success goes up. Indeed, I’ve talked a lot about not being a forced actor in this space, and our entire firm and fund structure at Permanent Equity is designed with that concept in mind. The reason is simple. If you do something when you think you have to, it may not be the case that you should.
Finally, Jordet calls out France coach (and World Cup winner) Didier Deschamps a number of times for not believing that one can practice penalties simply because you can’t replicate the stress of having to take a penalty on the biggest stage until one is actually taking a penalty on the biggest stage. Jordet disagrees and recommends practicing penalties a lot (just like you would practice any high stakes situation a lot even if you can’t replicate the stress) and in situations where you introduce mild levels of stress i.e., have the entire rest of the team stand and watch as their teammate practices a penalty. The reason is that if you learn to deal with a small amount of stress, it makes you a lot better at dealing with a lot of it.
While we famously don’t use deal debt at Permanent Equity, that’s not because we don’t expect our investments to be able to perform under pressure. Instead, we don’t want them to be forced actors, but we still think they need to operate ruthlessly and efficiently in order to generate acceptable returns. One way we do this is by distributing excess cash regularly out of our businesses, leaving them only with what they need and/or can profitably reinvest.
Of course. that practice can lead to some uncomfortable conversations with our operators who might sleep better at night knowing their business has a so-called “green blanket” in place, but it stands to reason, and Jordet cites myriad studies that say the same, that if you’re used to some pressure, you’ll better handle pressure. Not always, of course, but more often than not.
-Tim
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Small But Important
A funny thing that happens when you’re living two thousand and twenty-four years after the start of the common era, but haven’t yet read everything written up until now, is that you can have an epiphany that you believe is novel, but turns out that many, many others have had before. So it went as I was reading Capital Returns, which was graciously gifted to me by one Michael Newton after he recommended I should read it (happenstance?).
A theme that keeps arising in the book (which is a collection of investor communiques published by London-based Marathon Capital between 2002 and 2015) is that companies that earn high returns are often ones that do a small, but important thing for their customers. In other words, they are a low cost, but critical part of a project or value chain or supplier to a company. Some examples…
August 2011: Another class of business whose weight in our portfolios has expanded…has been companies with annuity-like revenue streams…The common theme here is a longer-term commitment made by the customer, together with an element of inertia when it comes to renewals. These factors…make for significant barriers to entry and high and sustainable returns. This is particularly true where the cost of the service is only a small proportion of the customer’s total spending.
February 2013: Pricing power is further aided [when a component]...plays a very important role…but represents a very small proportion of the cost of materials.
May 2014: Sometimes a product is so embedded in a customer’s workflow that the risk of changing outweighs any potential cost savings…The very best economics appear…in a situation in which the cost of the product or service is low relative to its importance.
February 2015: Our preferred growth stocks undertake apparently unglamorous activities that are essential to their customers – so essential, in fact, that customers pay little attention to what they’re being charged…Here, reliability weighs more highly than price.
Marathon Capital is not wrong! (Though they got their Baidu bet wrong, but who among us has not been wrong about China?)
Anyhow…
One of my biggest learnings over the past five-plus years at Permanent Equity is that the place to be in business with your customer is small, but important (see for example among others waterproofing and commercial fencing). Because small, but important, businesses, for all of the reasons Marathon cited, have the best of everything: pricing power, margins, cash conversion, growth opportunities, etc.
The reason is that small, but unimportant businesses are undifferentiated afterthoughts, large, but unimportant businesses are commodities, large, but important businesses are highly scrutinized, but small, but important businesses have carte blanche. And carte blanche is some place to be.
-Tim
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Be Ruthless
You may or may not know this, but we’ve taken the best (relatively speaking) of seasons one and two (and soon three) of these missives and turned them into short books, Unqualified Opinions, You Can’t Buy All the Biscuits, and the forthcoming Don’t Skimp on the Swag, respectively. This gives us something to hand out to people who stop by the office (alongside our sweet swag shops), so if you want one (or more), come visit!
But a consequence of keeping these books on hand at the office is that I read them over and over again looking for (and finding!) things I might have done better. So it went the fortieth or so time I read You Can’t Buy All the Biscuits when I was about two-thirds of the way through and realized that the book was just too long. And that the reason it was too long was because past me told SarahBethGDub that I thought we should include some chapters that I liked, but that in hindsight really didn’t need to be there.
So I jumped on Slack and wrote to the team “Biscuits is too long and that’s on me. If we do another one, it should be as tight as the first one. Let’s be ruthless.”
(And hopefully the forthcoming Don’t Skimp on the Swag reflects that.)
See, a danger of having your own ideas is that (at least initially) you like them. A further danger is that it feels good when the world acts on your ideas and so you tend to be a little biased (subconsciously or not) about pushing for them. But the world isn’t about you or your ideas, it’s about utility and value, so optimize for that.
I had a writing professor in college who could be pretty ruthless. He said after giving us an assignment that after we finished writing it to then cut it by at least 33% because the world doesn’t have time for or care about at least that amount of what we think or have to say. That’s kind of a cold view, but probably also not wrong.
Yet it’s also in recognition that if you meet the world on its terms and not yours, you’re likely to enjoy much better experiences and outcomes. So be ruthless. It’s not as bad as it sounds.
-Tim