Take this test to predict your success:

Your success must be based upon data that is solid and sometimes flexible enough to pass several critical tests if it is to guide a business enterprise to greatness.  Here in brief are ten tests for your successful vision.  Try these on for size, and test yourself for attractiveness to the marketplace, to investors and to history.

Ten tests for your business success:

  1. Is your market identifiable and accessible? Test yourself as to whether you can identify the size of your market niche, and whether you can overcome the many barriers to access customers within your niche.
  2. Where in industry life cycle? If your vision is for a product or service that fills a need in a mature industry, you may be flying against the prevailing winds as a market shrinks over time, taking your business with it.  Conversely, a fast-growing industry lifts most all good participants, making excellent companies excel even more and grow even faster, like a small plane flying at 150 knots with a 75-knot tailwind.
  3. How large is your total market? If the total market for your niche is under $100 million per year, it is going to be difficult to build a $50 million business, even if not impossible. If the market is ten times that size, there is probably room for competitors to fight for dominance and still succeed if you are not number one.
  4. Can you dominate that market? The dominant player in any niche controls pricing for all those under it, and often sets the risk profile for new entrants into the niche if the dominant player’s products or services fill the needs of customers at reasonable prices and quality.
  5. [ Email readers, continue here…]   Have you created high barriers to entry? If your business is a “me too” entrant into any market niche, even the smallest success will soon attract competitors that will sap some degree of your potential growth. What can you prove as a barrier to entry for competitors?  Is it the advantage of time – years of development ahead of any competitor? A core patent or “thicket” of patents protecting your offering?  A strategic relationship with one or more of the largest customers?
  6. Are margins high enough? Some great ideas just can’t make money and ultimately die for lack of profit potential.  Profit margins are higher for unique products or services early in the life of an industry niche, or for products protected by patents that prevent others from undercutting you simply by releasing a cheaper product.  High profit margins are a sign of high barriers to entry and attract investors and ultimately good buyers for your business.
  7. Can this business grow to above $20MM to $50MM in annual revenues? This is a basic test for investors, separating your business from those with smaller visions.  There is nothing wrong with a vision for a smaller enterprise if not in need of professional investors to make it a reality.
  8. Do you have a world-class management team? The best way to protect against failure is to attract a team with members who have experienced success and failure and can recognize the ways to manage toward success and avoid the pitfalls previously experienced from past failures.  From a professional investor’s perspective, the team should be able to be flexible, coachable and experienced enough to get a business through breakeven and beyond the next level of outside investment, greatly reducing execution risk.
  9. Can you translate an idea into a compelling product? Some great ideas just cannot be made into a product at a reasonable enough price to attract customers.  And some attract early adopters but cannot pass into the mass market.  Sometimes, an idea is just too early for the available technology to make it attractive.  Early cell phones were large bricks that required a large carrying case and cost up to a dollar a minute to use.  As technology caught up, allowing miniaturization and light weight, mass adoption drove the price down and allowed the building of infrastructures everywhere to support the use of inexpensive minutes.  Do anything you can to develop compelling products or early prototypes as proof of ability to reduce your technology risk.
  10. Is there an exit strategy for the investor(s) over time? There are many professional services businesses that make fine lifestyle opportunities for architects, doctors and dentists.   But these types of businesses are not attractive to potential buyers willing to pay a premium for businesses that are worth millions more than their asset value.  Building a great business to create wealth for the entrepreneur at exit, means thinking of the exit strategies from the beginning.  Who or what type of buyer would be attracted to this business if successful?   Great wealth is made from selling great businesses at immense profit for the entrepreneurs and investors who took the journey.

Note: All images created for this blog by Dave using AI prompts with Microsoft Designer (DALL-E).

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To directors and advisors: “Noses in; fingers OUT!”

Many of us have someone who reports directly to us and who supervises others in return.  Well, this one is for you. And it is one of the most important lessons you can learn as a manager, board member, or advisor of a company or even a non-profit enterprise.

Where did this statement come from?

I first heard this in a governance seminar for a non-profit higher educational board upon which I sit, over 25 years ago.  It made an impact and stuck with me through the years.  I have repeated it often to boards deliberating action and to individual board members seeking to get their hands dirty inside the corporation by giving advice and helping at levels beneath the CEO.  (And it is interesting to hear it returned from various unrelated sources, even quoted as “Noses in; hands out.”)

The problem cannot be overstated.

Once a board member reaches beyond the CEO into the corporation, especially without the approval of the CEO, incurable damage has been done to the CEO’s ability to govern.  Even if not the intent, there is an instant change in dynamic once this line has been crossed.

There is even a gray area that illustrates this effectively.

As chairman of a company in an industry where I have extensive experience, I elected to attend a regular meeting of the management team with its middle managers on a Monday morning, a practice I had not done in the past.  The meeting was tame to say the least. The CEO spoke, shared metrics, spoke of issues to be addressed during the coming week, and did a fine job of pointing the assembled troops in the right direction. I could not have been more pleased.

My lesson learned about this mantra:

[Email readers, continue here…]   After returning to my office, I received a call from the CEO. ‘Would I please (oh, don’t take this wrong, Dave) not attend these meetings anymore?’  What I took for unusual silence was a complete disruption of the normal give and take of the management group because of my presence.  The chairmanship carries unstated power even if not overtly demonstrated, since the CEO reports to and is accountable to the board, and of course its chair.  I learned from this that there are times when members of the board are appropriately brought into an operating group, and certainly times when the board should hear from vice presidents presenting their issues in a board meeting.  But the position of CEO is absolutely to be reinforced at all costs, never to be undermined by any member or by the board as an entity.

So, what is the proper behavior?

Therefore, it is appropriate to ask tough questions, request help in understanding issues, seek permission from the CEO to interview others.  But a board member or advisor should never react to statements heard by issuing directions or hints of action in return.  It is appropriate to state that the advisor or board member understands much more after the briefing and will be able to address the problem with the board and CEO.  It is not appropriate particularly for a board member to promise any action to anyone beneath the level of CEO.  Noses in; fingers OUT.

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Are your board members as valuable as you?

Perhaps this is the natural conclusion from the several insights previously explored.

While the CEO and management offer the vision, strategies, and tactics as well as the proposed budget, it is the board that controls with its votes the execution of strategy, the expenditure of cash, the taking on of debt or new equity, the very direction of the company as well as its ultimate health. Surprised?

Then who is most important?

The most important person in a corporation usually is and should be the CEO. This person, often the founder in early-stage companies and beyond, is the originator and keeper of the vision, leading all others below and the board above as willing believers in the vision advanced.  But the board is responsible for providing resources to fulfill that vision, which may include new cash infusion or assumption of new debt.  

Does this ever happen?

Yes, but… In extreme situations, it is the board that must step up and replace the CEO, assuming the responsibility for finding and integrating a new leader quickly and efficiently.  Sometimes this means having a board member step in for a short time as CEO for continuity.

A true story…

[Email readers, continue here…]    One of the CEOs in a round-table who had been active and vibrant for years in both his company and the round-table, died suddenly of a heart attack.  His board met in emergency session and managed a smooth transition to a new leader within a month, during the most traumatic of times for all employees and the board itself.

Remember the most important duties of a board member?

For non-profit boards, the two most important duties under the duty of loyalty and care are the oversight and eventual replacement of the CEO, and maintenance of the entity over its infinitely long lifetime.  I have been a member and even chair of presidential search committees and can attest that board members (and other designated stakeholders) spend hundreds of hours in the recruiting process, all without pay.

It’s all about continuity of the organization.

It is because the continuity provided by the board is the one thing shareholders must count on above all else to protect investment, that the board rises in importance to at least equal stature as the executive cohort.

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Should board members be elected “for life?”

No board member should be grandfathered, guaranteed a board seat forever.

Practically speaking, this is an impossible goal.  We have investigated the restrictions imposed by investment documents and the obvious need to keep continuity on the board with the retention of the CEO position at the very least.  But it would be the best of form to require in the bylaws of a corporation that all seats are re-elected annually.

How about loss of institutional knowledge?

Well, here’s a problem that needs a bit of thought.  If you elect your board members annually and for some reason aggressively change members, you will experience the steep learning curve required to get the newest board members up to speed to contribute with deep knowledge of the company and of your management style.  And that’s not good.  Re-electing board members again and again is not a problem – if those re-elected members contribute effectively as they fill their seats.  But annual re-elections signal to all that a board seat is not permanent or even long-term.

How about non-profit boards?

There are three types of members on non-profit boards, and the balance is critical.  There are those with money to give or get, necessary for all non-profits.  There are those with great community and industry contacts for finding honorees for events or bringing onto the board.  And there are those with deep knowledge of the non-profit itself, always able to help when members without that experience make suggestions that may be impractical or tried before.

How about staggered four-year terms?

[Email readers, continue here…]   That’s appropriate for non-profits for the reasons listed above. But I’d revert to the annual re-election habit for all but non-profit boards.

Why the difference?

For non-profits, this allows for the creation of a board development committee to find and recruit outstanding new board members and find ways to unseat those who are no longer contributing or even attending board meetings.  Such a policy further reinforces the duty of care for the corporation by its board.  Unseated board members with longevity and a history of participation can be invited to become “emeriti” members of the board with observation rights but no vote.

The annual shareholder meeting:

Although not required by all corporate bylaws, all companies should hold and document an annual shareholder meeting in which the shareholders are notified at least 10 days in advance and given the right to submit a proxy vote for their choice of officers and for any other issues that will come to a vote, including expansion of the stock option plan to include more available shares.

The bottom line is that good corporate governance calls for a skill set within the board that is not often present, but for the protection of members and the corporation itself, necessary.

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Fight for balance on your board!

Picking up where we left off…

In my last insight, I described the CEO who stacked the board with two friends, making a majority for control purposes and relegating the investor representatives to insignificance.  There were no outside board members with industry experience, no members the CEO trusted with governance backgrounds, no scientists to evaluate the technology that is the core asset of the corporation.

A recipe for failure.

If the CEO does not fight for balance of the board, outside board members must fight for this to protect the corporation.  If for no other reason, this protects the members of the board from making decisions without rising to the standard of careful deliberation under the “reasonable care” test.

How about the size of the board?

[Email readers, continue here…]   Some board members find themselves debating whether there should be an expansion from five to seven, from seven to nine or more to allow for such a mixture of protective seats created by the investment documents and balance with outside board members.

What about multiple investor rounds?

Sometimes, as in one board where I sit today, there are so many classes of investors, each with one or more seats, that a seven-person board is not enough.

I am not for large boards.

There are social studies that reinforce the notion that a group of six or seven is far more likely to arrive at reasoned decisions effectively than larger groups.  Look at the example of most non-profit boards, where the number of members often exceeds thirty, requiring the creation of an executive committee to get the work done.

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Your need for a board grows with complexity.

 Start-ups with one founder rarely have or need a board of directors. 

In fact, such a board would seem out of place in a one-person company.  As soon as any outside money is ingested into the corporation, others have a vested and legal interest in the behavior of officers entrusted with the best use of funds.  Money from friends and family usually is offered in a casual manner with much less restriction than professional investors, so that a formal board is a logical step but not often created upon this event.

Then along comes either money or contracts from strategic or financial investors or partners.

The operations of the corporation become more complex. Ownership is spread among

several classes of investors.  The number of employees grows.  Bank loans with restrictive covenants are taken on.  These events, one or all, usually are triggers for the founders to seek to create a board for oversight and guidance.

And then company grows…

Once the company hits high growth or larger size, it is logical to follow the standard practice in the creation of two standing committees composed of outside board members (not employees or executives) – the compensation committee and the audit committee.  Compensation’s charter is to approve stock option grants for any employee, no matter how small the grant, and all salary and benefits for at least the CEO if not the next level down, to avoid conflict of interest with the CEO.  All actions of the committee are in the form of recommendations to the full board for a vote and are not binding until that event.

[Email readers, continue here…]    Second, the audit committee is responsible for hiring an outside auditor as appropriate, reviewing the accounting practices of the corporation and making sure that laws are followed relating to recognition of revenues and expenses.  Good audit committees also review the corporation’s insurance portfolio, risk protection policies such as email and computer use, disaster response and recovery policies and any other area where the corporation’s very life could be at risk from inattention.

Yet another personal story…

Let me tell you the story of a company on whose board I sat for several years.  The CEO insisted that between husband and wife, over half the stock always be in their hands, refusing new offerings or any other form of dilution, and controlling the majority of board seats in the process.  After replacing two board members with two other friends who were a bit less independent, during that first meeting with all of us present including the two new board members, I suggested that the corporation then form the two committees – audit and compensation.

“Never!” was the single word as I recall the CEO’s immediate outburst.  I made a motion to bring it to a vote. The corporate attorney was present, recommending this as a relatively safe move for the CEO.  I called the question after a drifting discussion. You can guess that the three friends voted down the measure, perhaps as a sign of unison, since this was the first vote by the two new members.  It was the final nail for me.  I engineered the extraction of the outside investors, even at a near total loss.  At least the investors could then take the loss against ordinary income under rule 1244 of the IRS code, worth something to each, rather than being locked into what was a slowly failing lifestyle business with no effective oversight.

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Your board should protect you!

All other board functions are secondary.

Even venture capitalists who sit on boards where they have significant investments often forget this point.  They write in their investment documents that they will occupy a seat on the board for as long as they are invested in the company, thinking of this as a protection for their investment and tool for them to influence growth.

Actually, there are two legal duties of board members. 

They are: the duty of care, and the duty of loyalty.  Everything else is a self-imposed duty or responsibility.  The duty of care is to care for the corporation’s asset itself, not the shareholders whom they represent.  Each corporation, when chartered becomes a live person in the eyes of the law, independent and subject to the care of its board of directors.  Shareholders such as investors are granted few rights by law. They can elect directors for their class of stock, approve mergers and acquisitions; approve increases or changes to the capital structure of the company and other more minor actions.

[Email readers, continue here…]  It is the board, made up of individual members, that is responsible for the care and maintenance of the corporate person.  Sometimes, there will be a conflict of interest between the people representing the various shareholder classes on a board.  This happens often when one class would be quite satisfied with the outcome of a sale of the corporation because it has lower expectations of exit value and a lower cost of shares, while another later investor class would see little relative gain in a sale and veto’s the proposed transaction.    The duty of care is the legal responsibility of each board member and cannot be shed because the member was elected to protect a particular class of shareholder.

Second is the duty of loyalty…

…Loyalty to the corporate person, not to the shareholders who elected the board member.  Once again, there is a need to educate board members that in conflict of interest cases, the corporation comes first.  Some investor board members are also member of boards for companies that may overlap in markets or even compete directly, although rare.  Either way, I have seen many instances over the years of my board service with VC’s on the board, which the VC’s have had information about other firms that would be classified as confidential – that they offered at least piecemeal in a board meeting of another company where they serve.  There are issues that stress the loyalty of board members such as placement of employees or recruiting of executives from firms where the VC or board member has inside knowledge.  These are rare, but each stresses the duty of loyalty to the corporation on whose board they sit.

Well, how far should a board member go?

Should board members therefore withdraw and not participate in corporate planning, coaching the CEO and other issues not related to the duty of care or duty of loyalty?  Of course they should not.  A board, in exercising its duty of care, must do everything it can as an entity and each member as an individual to become acquainted with the issues, problems, opportunities and threats that overhang the corporation.  In fact, there is a legal concept (not a duty) of “reasonable care” that board members must meet in order to be protected by the insurance carried by a company for directors and officers.

Reasonable care means that members deliberate issues in depth, attract expert advice when appropriate, attend meetings regularly, stay current on corporate issues and hold regular sessions of the outside directors without management present. None of these requirements are by law, but the sum of these add to a powerful statement of commitment by board members and therefore a protection under the law when a group of shareholders sue boards or members for irresponsible actions.  Most every court will side with the members of the board under the rule of reasonable care when these behaviors are in evidence.

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Hire a consultant; ignore the advice!

The ideal use of consultants…

At one time or another, most all businesses use consultants to fill the gaps in knowledge or to provide guidance for management.  Consultants are good in that you can sample their work with short projects, change to other consultants quickly, and stop using them when a project is completed.

A personal story of ignorance of good advice.

I have a partner in a consulting practice that specializes in the travel industry.  Several years ago, we were hired by one of the largest companies in the industry (yet another Fortune 50) to perform a top-to-bottom audit of their processes across 27 facilities, and recommend measures to increase efficiency, increase income, better the customer experience, and of course, decrease costs while also increasing the quality of service.  We were quite confident that our services would yield great, measurable results.  The work continued for about eight weeks between the two of us as we visited the 27 locations and worked with employees in departments across all disciplines within each location and at central offices that performed services for all locations.

The result of the consulting project…

Finally, at the end of the project, we had identified nineteen specific issues, each of which would, if implemented, accomplish one or more of the goals outlined at the start of the project. The sum of the savings and increases in revenue were worth multi-millions annually, well worth the implementation of most or all of the recommendations.

[Email readers, continue here…]   On the final day of our assignment, I was responsible for the “reporting out” to the assembled twenty or so executives in the large conference room of this major corporation.  I started my presentation, which had been carefully documented in handouts and PowerPoint, with this story…

A unique description of the “ignore” lesson.

“I want you to all imagine that it is tomorrow morning, looking back upon today’s reporting of these past months of work by your consultants.  Imagine that today I build for you a beautiful sandcastle exactly at the water line of the ocean nearby.  Tomorrow, we both will visit that beach and look at the water line, and find not a beautiful castle, but just smooth sand, just as it had been the day before building our beautiful sandcastle.  In other words, I would not be surprised if you accept our report today with enthusiasm, but then in the overwhelming rush of daily business, fail to implement few if any of these recommendations that you so enthusiastically received.”

The story is true, and the results were as I predicted.

A few of the recommendations were implemented over time, one with great effect and even a national advertising campaign behind it (that you surely saw on TV).  But most were just ignored.  I imagine that our report sits today on someone’s shelf, filed with others from past and from following months and years.

Unfortunately, it is human nature to enthusiastically ignore to act upon recommendations of third-party consultants. There are many, many exceptions, but far more instances of this in the business world.  Not all consultants give advice worth taking, of course. But when they do so, it is only as good as that which you implement.

 

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How to cheat legally on your tax return.

When do you cross the line between honesty and dishonesty in tax planning? 

Is it ethical to allocate income between periods to take advantage of tax breaks?  Can expenses be put off until the next period to increase income, or accelerated into this period by prepayment to decrease net income?  Where do you draw the line, assuming no intent to defraud?

Revisiting corporate vs. personal tax rules

First, corporations are usually on an accrual accounting basis, meaning that income and expenses are accounted for as earned, not when the cash is received.  (You, on the other hand, account for your individual income on a cash-accounting basis, counting the cash not the date of your earning or accrued expense.)  The difference:  If you earn pay due December 31st and it is paid January second, you pay income tax on those earnings in the following year.  But the corporation that pays you accrues the expense and takes the deduction in the year in which the income was earned or expense actually incurred.)

Where do we draw the line here?

[Email readers, continue here…]   It is perfectly legal to hold delivery of goods until after the start of the next period and take the income next year rather than this.  It is a bit murky if you accelerate payment for incomplete services or even for products not yet received into this year to take the deduction from income early.  In either an IRS audit or an accounting review or audit, the accelerated costs and payments will show as an accrual – a balance sheet item – that does not change income, just cash and an asset.

In other words, for the usual accrual-based business, there are fewer ways to affect the outcome than for a cash-accounting individual.  There are lots of caveats here and certainly if the issue is critical to you, an accountant (rarely a bookkeeper) should guide you to the action that is both legal and strategic.

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Do you really need an accountant?

First, let’s be sure we define our terms.

Accountants are trained, certified and usually quite experienced in financial analysis, both creating and reviewing data.  Bookkeepers are often trained on the job although sometimes more formally and handle the physical work of accounting for the transactions.  To expect a bookkeeper to provide analytical planning is to ask for something they often cannot provide, except in a cursory way.

We need to repeat this distinction on occasion, because there is a considerable difference between the cost of a bookkeeper and an accountant.

Why bother with this?

[Email readers, continue here…]    Many early-stage founders and CEOs believe they can delegate design and creation of metrics, flash reports, analytical reports and more from their bookkeepers.  And at some early stages, a bookkeeper can prepare such information.  It does not take long for a growing business and a knowledgeable CEO to quickly outgrow the lack of depth and sophistication such reporting usually offers, looking instead for deeper analytical tools.

On the other hand,

Many early-stage CEOs are not trained and ready for such tools even if available.  The lesson here is twofold.  There is a benefit to using a good accountant to help devise critical reports for a corporation; and CEO’s must quickly become financially savvy in the analysis of financial statements and metrics that measure the health of a business.  To fail to have this skill is to reduce the corporation’s capability to discover problems early and take advantage of growth opportunities.

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