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Do You Understand Revenues and Profits? A Primer

“So how did the meeting go?”

My friend was in the process of hiring a private banker to help find a buyer for his business.

“I thought it went really well. He liked what we’ve done so far and felt that there’s some interest in the market. However, he feels it’s really important to improve our EBITDA before we can get a good deal.”

I almost fell out of my chair hearing this. No, not because buyers would like a good EBITDA but that my friend actually said this. The previous two years – we’ve known each other for 20 years now and he’s been in business longer – I’d struggled to get him to clearly state what his gross margins were and what was preventing him from having consistent profitability.  My friend by no means is alone. Of course, younger entrepreneurs – many of whom come from technology backgrounds don’t have much exposure to matters of finance (or accounting). Yet having rudimentary financial literacy is critical for I’d argue all of us, entrepreneurs or not. But particularly for entrepreneurs, especially those NOT bootstrapping their businesses should understand the basic concepts and some key terms. As I’ve argued elsewhere, you should then be able to write out each of these, at any time, on a blank piece of paper – so that you have your important numbers at your fingertips. So here goes – with the warning, that these definitions are intended not for compliance to accounting as much to have a realistic image of where your business ACTUALLY is.

Of course, younger entrepreneurs – many of whom come from technology backgrounds don’t have much exposure to matters of finance (or accounting). Yet having rudimentary financial literacy is critical, I’d argue, for  all of us, entrepreneurs or not. Entrepreneurs, especially those NOT bootstrapping their businesses should understand the basic concepts and key terms. As I’ve argued elsewhere, you should then be able to write out each of these, at any time, on a blank piece of paper – so that you have your important numbers at your fingertips. So here goes – with the caveat, that these definitions are intended to provide you with a realistic image of where your business ACTUALLY is, rather than for compliance with accounting standards.

Revenue – this is the money customers pay you. The simplest case is when you sell a product (an app, a book or a sandwich) for $0.99, $1.99 or $4.99 that’s your revenue. If you sold 1000 apps a month, your revenue that month would be $990 (1000*0.99) and for 1000 sandwiches it would be $4990. (Let us not in case worry that when you sell sandwiches you seem to make more money. Conceivably you could send millions or even billions of copies of your app – a little harder to do with sandwiches (or not if you are in India :). This is commonly referred to Gross Revenues for clarity.

Net Revenue In the case of selling sandwiches (directly), the entire $4.99 comes into your pocket. However in the case of the app, only 70% of the $0.99 makes it to you (after the app store aka your distributor, takes its 30% off the top). So the reality is that those 1000 apps you sell make you $693 (70%*$0.99*1000). This is a significant difference to keep in mind – for when we plan with revenue in mind, and not gross revenue, that 30% difference (or $300 in this example) is likely to come and bite us in the ass. This is even more important, in the case of marketplaces or services, where your business is essentially acting as a distributor – in which case you get to keep the 30% (or 15% or worse yet 7%) of the revenue and pay your principal the 70% (or 85% or 93%) of the revenues. Given the recent “hot” status of food-delivery companies (can anyone explain what’s tech about these) or any of the e-commerce companies, it’s important to not confuse gross revenues (or GMV – gross merchandise value as they call it) with net revenues. Before we all switch to selling sandwiches, it is important to keep in mind, that software or e-books have practically no incremental costs whether you sell 100, 1000 or millions of units. However, for each sandwich, we incur the costs of those slices of bread (or wraps) and all that you put in between them. This is termed as the cost of goods. So in conventional businesses Gross Revenues – Cost of Goods (- Channel Costs too if they are non-zero) is termed Net Revenue.

Gross Margins (or profit) Gross Margins are essentially the difference between (Gross) Revenues and Net Revenue – often expressed as a percentage. This is a particularly critical measure as the profits of your business are constrained by this value. And yes Dorothy, profits are why you are in business. The higher your gross margins, the higher profit potential your business has. Often gross margins tend to operate in bands for specific industries or businesses and this is a good thing, for you to be able to measure where you are relative to others. In the above examples, for the app business, your gross  margins are 70% and in the case of the sandwich business, assuming the cost of goods for your fancy sandwich are $2.00, then your gross margin is 60%($4.999-$2.00)/($4.99). In these examples, if you sell your apps directly to users – on your website – your margins can increase to say 90% or use cheaper ingredients in your sandwiches (or leave out the cheese) you can increase margins. Such gross margin increases often translate directly to your bottom line. Again keep in mind, we make money in dollars and not in % dollars – so knowing both gross margins  in % terms and absolute dollars is important. Do you know what your gross margins are and how you can increase them?   Can you increase your gross margins to be so high that it can hurt your business? Yes, you can but that’s for another day.

Operating Expenses Simply put, all the expenses you incur, regardless of whether you make a dollar of revenue or not, are your operating expenses. And should you be lucky enough to make revenues, these are only likely to grow. So the cost of paying your engineers or employees, your rent and utilities, the cost of maintaining a website (and that fancy domain name you bought), advertising and trade show expenses are all operating expenses. In an ideal world, you’d try to keep your operating expenses low – but not so low that you are not able to ship product or deliver services that generate the revenue. And depending on the nature of your business, for instance, if you do drug discovery or build semiconductors, your operating expenses are likely to be high – even without R&D costs. Operating expenses too, like gross margins tend to operate in bands for specific industries, so you can benchmark yourself – allowing for where you are in the life cycle of your business (early, steady-state etc.). By nature operating expenses have some non-negotiables such as salary, rent, and utilities – you can decrease them only so much or not at all and others such as market or R&D expenses that are more amenable to adjusting.

Operating Margins This is your Net Revenue minus the Operating Expenses. This like the gross margin is a critical metric of the health of your business.    When businesses talk about reaching operating profit, they are essentially saying that their operating margins are higher than zero. In your app business, if you are spending $4000 a month and bringing in $4500 in net revenues (70%*$6500 in gross revenues) then you have achieved operating profit. Operating profit does not imply that your business is profitable (yet) but is capable of being so. For instance, in the example cited, this doesn’t take into account the 1 year and $50,000 you spent already to get to develop your product and this run rate.

This operating margin is what the some bean counters love EBITDA – Earnings (profits) before Interest (on your loans), Taxes (yep those exists and you may have to pay them if you actually make a profit) and Depreciation and Amortization (lets not even go there). It’s a somewhat independent measure the ability to your business to make profits.

Net Margins In plain English this determines whether your business actually makes a profit – money you can put in the bank, or pay dividends with or better yet flow back into your business. So even though you may make real operating profits, if the interest on capital you’ve borrowed for instance is high, you may not have any net margins. This is why the cost of money or borrowing costs can make or break businesses that have high amounts of debt. Similarly, if you have to pay taxes (and you do if you make profits) this can drive your net margins down. At the end of the day, this is the ONE metric that will keep you alive and fund your growth. However, maximizing this requires you to manage every one of the above – increasing gross revenues and gross margins allows more money to flow into the company. Decreasing or managing operating costs and financial costs ensures you maximize profit and can fund growth.

The table below summarizes the terms discussed for a variety of different businesses

Revenues & Margins

Can businesses run without making operating profit or positive EBIDTA? Did not Amazon do this for years and Flipkart and others doing this even as we read this? Sure – all that means is someone (investors, founders, in rare instance public markets) is pouring capital and investment into the business – usually with the reasoning that you are capturing market share or leadership and therefore spending more than you are making. They are also operating under the assumption, that one of these days you will make a profit and enough of it to justify the investment.

Meanwhile, for the rest of us 99%, knowing and keeping a good eye on these numbers would go a long way to ensuring you stay alive and thrive.

3 Steps to Find Those First Customers

CustomersA question posted in the HeadStart Forum once again reminded me of how easy many of us find it to build the product first before figuring out how best to get customers. Having bootstrapped two startups and mentored several more, here are three tips on bagging the first (new) customer.

Your ex-employer if you’ve worked before you started up on your own, your ex-employer & ex-colleagues are the best place to start. They know you, hopefully don’t dislike you & you know how much money they have. They also likely can give you honest, even if not favorable, feedback on your product or service. Other than your mother, this is likely the most friendly reception you might get from a prospective customer.

Your ex-employer’s customers This is how I got my first break – when my employer turned down a customer who was deemed too small. I approached them with a request to be able to address their requirement and was given the go-ahead. This let me take the PO, a 30% advance and then start my first company, with a customer and cash in hand. Don’t hesitate to ask and don’t be surprised if your ex-employer and their customers are amenable to such an arrangement – as everyone prefers to deal with a known quantity.

Reference customer Visualize who’d be your ideal customer and more importantly the customer for whom your solution would be ideal. Strike a deal – such as a free trial or finite number of units or one [week | month | year] of free product or service – whichever make sense depending on what your offering is – in return for a strong endorsement or further references. So if Amazon India or Procter & Gamble or some other name brand or market/channel leader is prepared to endorse your product or service, it can open the flood gates to more customers. This requires you to be able to articulate your value clearly to your prospective customer and explicitly asking them for a reference.

Of course as with looking for a job or in the Indian context, looking to get married, it’s a good idea to let everyone you know, that you are looking for customers. So trade shows, your website, entrepreneur community forums, family weddings are all fair game to chase customers. While this is more likely to result in business cards and contacts, it will be ripe for the picking once you have that first customer. Happy hunting!

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Indian Standard Time Warp

NYC: Dali at Time Warner Center - Nobility of Time

NYC: Dali at Time Warner Center – Nobility of Time (Photo credit: wallyg)

“I’ve already spent more time on this than this deal is worth to me.”

That’s what a prospective business partner said to me, complaining about the 45 minutes we had spent in a meeting together.

I was taken aback. I had just flown most of the previous 20 hours (from Bangalore to Chennai to Frankfurt then onward to Stockholm before taking my final transfer to get to Gothenburg, Sweden) to get to the meeting.

I had merely asked him to help me understand why I should pay $100,000 to represent his company in India (but that’s another story). While I did manage to keep my cool that day, it brought home to me how direct people can be in a business setting.

Having worked most of my adult life in the U.S. – most of that in California’s laid back Silicon Valley – I was used to plain speaking. However in the year I had been back in India before the Gothenburg trip, I had clearly lost the habit of being direct. I had acquired a more fluid sense of both time and speech.

The move to India opened my eyes to the way things are done in the Valley, sort of like watching an unflattering video of myself at a stag party.

While working in San Jose, I had never quite noticed how rude we were when we failed to return voice mails or in moved meetings at the last minute, even when people had flown in from overseas to attend them.

This was in stark contrast to Japan where a great deal of my business was coming from in the first years back in India. In my first business meeting in Japan, two managers from a $40 billion firm spent two hours with me (the marketing guy from a $5 million dollar Indian company) to understand why we were charging “so much more” than the competition.

Of course, many people have apocryphal stories of negotiating in Japan or China where indirection and opacity seem the norm. In one, two-day session I found out only at dinner that the guy that seemed to spend most his time taking pictures was actually the key decision maker and the two people we hadn’t been introduced to were competitors

India, in many ways, straddles these two very different business cultures. The almost unquestioning acceptance of seniority, the acute awareness of hierarchy and near-obsession with not losing face that Japanese businesses are known for can be found in Indian companies as well.

Still, the Japanese put much more importance on time schedules. In India you could never imagine a client instructing you to take the 7:52 express train to the transfer station where the client would join you at 8:24 to reach their office at 8:50 – the requisite ten minutes before your 9:00 a.m. meeting. I regularly get detailed directions like this from our Japanese clients.

In India “Let’s meet at 11” is generally a suggestion. It means “We should connect around that time and it’s likely that I’ll call you at 10:45 to tell you I am stuck in traffic and will be late by 30 minutes or more.”

This has been the biggest lesson for me about doing business in India. Time and communication (and even space if you try to drive here) take on a sponge-like quality here.

In my unending naiveté, I initially believed that the inability to stick to schedules was the fault of the sales and marketing folks or overburdened C-level executives. That illusion didn’t last long. I started to understand what really happens after sitting through a weekly customer call with my engineering team.

“How can the deliverable slip by a month when we were on schedule last week?” the customer asked. I could visualize the apoplectic look on the client’s face even without a webcam.

Our engineers, I found out, were well aware of the delay that was accumulating daily but had redoubled their efforts to crack the problem on time. They had been confident they’d solve the problem and recover the lost month and wanted to avoid causing anxiety to the poor client.

The most positive way I have found to look at this delivery dilemma is to figure we Indians are eternally optimistic. We are optimistic to a fault. We are certain that we will clutch victory from the jaws of defeat much like a Bollywood hero gets his girl at the end of the movie, just as the police drag away the dastardly villain. When we say the report will be done this evening or we’ll get there in 15 minutes, we believe it – the laws of physics be damned!

As with all understanding about India, there may be exceptions. You might meet an ex-military type or maybe a Bengali or Tamil gentleman who will confound you by always being on time. Worse still, they might expect you to be on time like the Japanese or direct and brash like the Valley types.

Fortunately India is so vast that such encounters are likely to be rare.

This article first appeared in the Wall Street Journal’s India Journal

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