Part 1!

As some readers of Business Angel Blog might gather, I enjoyed reading Economics at University (too many years ago to recount) and that passion for the subject has never left me. We are living in fantastic times. Having a background in Economics helps make some sense of the current turmoil and in this blog and the next, I would like to talk about the forces that will shape the landscape for the next two to three years in an Economic sense.

In the US and the UK, consumption is the driving force in the economy accounting for over 60% of economic activity. In China by contrast, it is very much investment and export led. As economies have contracted (negative growth), governments and central banks have tried to reduce the cost of money, otherwise known as interest rates to encourage people not to save but to spend.

This may seem odd, but Keynes wrote about the paradox of thrift in the 1930s. Saving is of course a good virtue. But the problem is that if everyone saves, it is bad for the economy as activity will grind to a halt as no one is buying and who will want to borrow all of the money saved up if no activity is going on?

Hence interest rates are coming down to encourage people to spend (or at least spend the savings from lower mortgage repayments) and to not save. If interest rates come down to near zero, I could see negative interest rates being applied to savings. In reality this means that banks might charge you for using their facilities to hold cash. That would be an incentive to spend!

The problem is the spectre of deflation. In an earlier blog, I wrote in defence of inflation, and it seems prophetic that what the bank is now looking for is a bit of inflation! If people perceive that prices are falling rapidly, why would you buy? I think this will be one of the worst Christmas shopping seasons ever. Consumers are expecting massive price drops in January so it does not make sense to buy now. If the expectation of falling prices takes hold though, it is rather like the paradox of thrift, and whilst it may be good for an individual to defer purchasing something, if everyone does it is a bad thing as it ends up feeding itself.

If you believe that prices are going to be cheaper the next month, if you can, you will delay your purchase. This is the problem facing the housing market at the moment. Although interest rates are down to 1951 levels at just 2%, even if you could get a mortgage today, would you buy a house thinking that prices could fall 10%? (I would – but that is a different matter as I think the difference between rent and interest payments is now so wide, that even allowing for a 8% drop in property prices, you would be better off buying than renting).

So we need a bout of inflation to get the whole thing kick-started again. If prices are rising, people will engage in activity again. The problem for Japan for most of the 1990s was deflation. We need to learn from that very painful experience.

In the next blog, I will continue with an explanation of the link between inflation, interest rates and a currency. With the pound being at low levels, such an explanation I hope would be welcomed.

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Most of the world has recently moved from taxing income and wealth to taxing consumption and expenditure. Last week, the UK government temporarily (for the next 18 months) decided to bring the rate down from 17.5% to 15%. Many critics have attacked the move as not being bold enough and wanted direct tax cuts (on income) instead. I feel this criticism misses the point and in this business angel blog I want to defend the action taken by the UK treasury.

VAT (Value added tax) is a tax which countries within the European have to apply on a range of products. The standard band is between15% to 25%. Your standard VAT rate cannot go below or higher than those limits.

So, the most the UK government could do is reduce the VAT rate down to 15%. This point has been sorely missed from many of the commentators criticizing the move.

A point I have made in my previous blogs is that what we really need to see is consumers spending again. During a recession or any period of economic uncertainty, the savings ratio tends to rise. In the UK and the US, the ratio has recently been as low as 2% to 3% (By contrast in Germany it has been around the 10% mark). If consumers were given direct tax cuts, the likelihood is that they will use this extra cash to pay off debt. Again, as I mentioned in a previous blog, whilst that may be good for an individual (managing my debt down is certainly my priority for next year!), for the economy it is a bad thing.

Therefore the only thing the government can do is cut the main tax on expenditure which will result immediately and directly in lower prices. That is what they have done.

The flip side to this is though that of course it brings down inflation. That is an undesirable side effect. To play devils advocate for a bit, what if rather than reducing VAT the government announced that it was going to increase it to 20% from the 1st of March 2009?

I would have thought that this would not only help balance the government books, which look simply awful (Government debt will be 57% of GDP – up from around 40%) and it might actually induce people to spend a lot ahead of the VAT increase. Assuming people are rational, if you know that prices will be going up in a couple of months, you will no doubt try to save money by bringing forward your planned purchases. This is the exact opposite to where I fear we are heading which is the built in expectation of lower prices.

As I have argued over many blogs in the past, what we really need in the UK is a good dose of inflation!

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May I start off this business angel blog by apologizing to regular readers of this blog for the absence of new postings over the last few days. Being an Englishman in North America – I confess to going down with flu (lets be honest, men don’t get colds – we always get the flu!).

It got me thinking about the issue of absence from work and in particular entrepreneurs being off ill. Firstly, I should state that I did manage to go to all my business engagements and nothing was cancelled. I was suffering and when I got home, I did not have the energy to write a blog.

I invested in a business a couple of years ago and after about ten months the entrepreneur decided to take two weeks off on paternity leave. I have to say that along with the other investors; I was a bit upset about this. Being an entrepreneur carries with it special responsibilities that in the first few years you should not seek to ‘escape from’.

I have written previously about the need to take a break – and I hope that I am not contradicting myself by now appearing to be attacking leave which you are entitled to. And if the former Prime Minister, Tony Blair, can take paternity leave, why can’t entrepreneurs?

For me, the answer is about scale. As a small start up with a management team of just two, the entrepreneur taking paternity leave for two weeks, in the anecdote above, did have a significant and negative effect on the business. If you want to take leave (and there is nothing wrong with that desire) you have to put in place a structure that can cope without you.

This is not always possible in the first few years if you are the main driving force and putting in very long hours. Having said this, I would be nervous about investing in a business that was so dependent on just one person.

The lesson for entrepreneurs is – if you want to be flexible with your time and want to be able to take paternity leave (and this is not a judgment call for me to make), then you should either only seek investment from family and friends or you should raise enough money (and therefore have a strong enough business) to hire a good management team to look after things when you are not there. Investors should also learn from my mistake and only invest in businesses which are not utterly dependent on just one person.

Happy breaks!

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Firstly, I would like to take this opportunity to say thank you to you all for reading business angel blog. I have been writing this blog now for over five months now and it has been great to see the readership increase every week. It seems appropriate at this stage to ask for feedback from you the reader.

For example, I have no idea who the readers are and what kind of articles you like reading. I am hoping that I can take your feedback to make the blog more relevant to your needs.

I am also looking to get sponsorship for the blog and knowing a little bit about the readership can hopefully make the blog more attractive to potential sponsors. Your help in giving me this feedback would be really appreciated

As always, your comments are welcome

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I recently wrote a blog about controlling your costs. I got a few emails pvalia@businessangelblog.com (thank you) asking me about salaries for the management team in a business plan. I hope you find my response below helpful.

There are two types of money you can earn; Income and Wealth. Entrepreneurship is about generating wealth for yourself and your investors in the business. If your primary objective in starting a business is to generate an income, there is nothing wrong with that. Please recognize though that this is what I would call a lifestyle business and it is not an investable proposition for external investors (friends and family may still wish to invest).

In business plans for start ups where the entrepreneur does not have a great track record, the salaries have to be very modest. I simply will not tolerate a situation where the investor is seen to carry all the risks and the so called entrepreneur carries on with a great lifestyle irrespective of the fate of the business.

I do see business plans, where the Entrepreneur puts himself down to earn over £60,000 per annum. I find this figure a tad high for a start up situation. They should recognize that till the business starts delivering a profit, they need to earn enough to just keep going. They should be motivated by generating a huge amount of wealth for themselves rather than income.

The defence they (owners seeking high salaries) often cite is that they are very talented and could earn a much higher salary in the market place. I hear that, but I think they have missed the central point about wealth v income. And if they value an income so highly - I would urge them against being an entrepreneur - as it really is probably not for them. They should stay in a highly paid job.

As an interesting aside, I looked at the businesses I have invested in over the last few years and found out that the average salary of the CEO’s I have backed is around £40,000. Interestingly (and not scientific at all), businesses that have failed for me tend to have much higher CEO salaries (average in this bunch has been £60,000)

I am working on a new start up at the moment, and I will not take a penny as a salary until the business generates revenue. I accept this happily as I have a 75% stake in the business. My attitude is simply - sod the income - think of the wealth if it succeeds!

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I am reducing costs by running a new business from here

Most of the businesses that I have backed which have then succeeded have one thing in common; they have really controlled their costs until they start generating cash and are making a profit

From personal experience, one of the earlier businesses I backed which was involved in Prizes for Puzzles went horribly wrong because it failed to control its costs. I have to take some responsibility for this business as I was a Director - I cannot wash my hands of it and say it was them - I was part of them!

We had won our first contract with a daily newspaper and that was it - we were off. We hired a great office near Reading and we recruited a junior member of staff to help us in our business.

We then came up with some great ideas on how we were going to expand and grow the business and therefore recruited some more people. We also assumed that we would be able to secure prizes for free (through sponsorship) and apart from just a two week period, we had to pay for all of our prizes.

We never did get the additional contracts and the whole thing came to a crashing conclusion. As you can see from the above short explanation, we made lots of mistakes and I have made sure I have learnt from them.

One of the great earliest lessons I learnt from a successful entrepreneur was to not worry about delivering - but to focus on winning work. What I had done in the above scenario was forward plan for delivery of a service that we never won a contract for. It killed the business. We would have been far better off, keeping costs to a minimum and expanding the team once we had won new contracts.

My advice to entrepreneurs and business managers is to always keep your costs in line with where you are today - not where you plan to be. The Fund that I manage is often involved in buying companies where they have a very high fixed cost base, the revenue they had hoped for doesn’t materialize and therefore they need to be rescued by our Fund.

I do mention the Amano business a lot - I apologise but I am a big fan of the management team there. When a business looks for me to back them, I like to take them to the head office and show them the head office. It is the best example of parsimony I can find. The office has no windows and it houses six people in a very small place. It is not somewhere I would like to work for too long - but they have made an implicit contract with investors; we will be careful with your money until we have delivered a profit. I wish more businesses I saw had that attitude.

I should mention that my business partner in the above case remains a great friend and we have just started another business. This time he works from his shed and we have not recruited any additional people. We are on the cusp of winning a few contracts - we go live next week. We have made a decision though that we will not recruit any additional people - we feel honour bound to first pay back all the investors who lost money on the first venture (including me!) and then look to expand - and only if we really need to.

Control your costs - or trust me - they will end up controlling you!

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All out of words today but I spotted this and quite liked it. Simple but certainly a neat way to look at your price point or product value …

No such thing as price pressure

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If you believe in the theory of efficient markets you would accept that it is not possible to consistently beat the market. And yet many people consistently do that - including my hero Warren Buffet. How do they do that?

Many successful investors take a very long term view and are prepared to take a contrarian view to the rest of the market. Buffet is perhaps the best example of that. Most of us realise that when cab drivers start telling you to buy shares, property or gold - it is time to get out of that market. Buffet seems to have a sense of picking up on this before it gets to the ‘cab level’. Having said that, many of us can get the timing wrong. The current UK property market is a good example. I along with many others (including The Economist!) thought that the market had peaked four years ago. In the last four years, prices have gone up at least 40%. Even allowing for the worst predictions of prices falling 25%, most people who stayed in the market will still be better off than having sold off when clear signs were available that the market was overheating.

As with all things, it is never as easy as following ‘six easy steps’ to investment success. Nonetheless, my advice to investors in start ups would be

1) Always take a very long term view - with start ups you should be looking at a five year time span at least.

2) Follow your own judgment. You may be wrong (and you are more likely to be wrong more times than right!) But you will be able to live with that. Trust me, the investments I have hated are the ones that have gone wrong when I trusted someone else

3) Do your own research. A day visiting a business and talking to managers and customers is a brilliant start - don’t outsource this to someone else.

4) Look at who else has invested. Even if I think something is brilliant - I need to know that at least one other person has also been persuaded (this does not conflict with point 2!)

5) Develop a set of criteria that works for you (readers familiar with my blog will know what mine are).

6) Above all, make sure you understand what the business does, how they make money and make sure you trust the management team

Happy Investing!

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Is it possible to manipulate your balance sheet and profit & loss statement?

There are three Financial Statements that comprise a set of accounts but as an investor you should only pay very close attention to one; cashflow. If you are pitching to a bsuiness angel - make sure you have complete mastery over this statement.

The Profit and Loss Statement and the Balance Sheet can easily be manipulated to show the numbers you want to and will always be subjective (within reason - unless you work for WorldCom or Enron!) Cashflow should be a 100% objective statement that really allows someone to understand the cash cycle of a business quickly.

“Lack of profits is like a cancer, it will eventually kill a business unless cured. Lack of cash though is like a heart attack - it can kill a business straight away”

This quote is very apt. Most people still don’t realise that most businesses which go bust are profitable. What made them go bust was a lack of cash. Any Entrepreneur pitching to me must demonstrate to me that they understand the difference between cash and profits. There are many people who don’t understand this difference. (If you want an explanation please ask)

The Fund which I am a cofounder of Flight & Partners, takes advantage of being able to buy companies which are profitable but have simply run out of cash - so in a sense, one of my businesses does rely on cashflows going wrong.

A cashflow statement should simply show on a monthly basis for the first two years of a business the following;

1) How much cash is coming in from where and when

2) How much cash is being spent, on what and when

As an angel investor in a start up, your only short term concern should be can the business survive for the first two years? (Most failures occur within this period.) Don’t worry about things like profit at this stage!

You should also always ask to have the cashflow forecasts sent to you via email. You need to flex it - in particular you need to see what would happen if

1) Customers take an extra 30 days to pay

2) Any additional investment monies take an extra 3 months to come in - again a lot of businesses fail between fund raising rounds

3) Revenues take twice as long to build up

4) Costs are 25% higher

If the business can survive the above, it has a good chance of making it. You can then turn your attention to trivial matters like profit!

As a final anecdote from experience, I did invest in a business which did not raise enough money to survive more than six months. What it showed though was that it wanted to raise money again depending on hitting certain milestones and that if money was not raised, it could simply hibernate and carry on operating on minimal funding (£1k per month). Given these facts - I was happy to invest.

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Unchecked inflation not a good thing

I have now written two articles which seem to defend a position which most people like to attack. I have defended banks (with a heavy heart) and political correctness (with integrity and heart felt beliefs) and today I would just like to hear the case being made for a bit of inflation (cheekily). So I accept that unchecked inflation is not a good thing – but I would like to just put forward the case that perhaps there are one or two positive aspects to come out of it. And in these current times, inflation may not be a bad thing.

Briefly, inflation is seen as a bad thing as it erodes peoples savings (high inflation means your savings become worth less than in a years time than in a time of low inflation), it causes goods in a country to become more expensive and therefore less competitive as exports to other countries which have perhaps had lower inflation. It also makes business planning harder as there is greater uncertainty.

It is interesting to look at the rapid rise in food prices around the world recently. Four main causes can be identified for the rise in grain prices.

• Firstly, because China and India are growing rapidly, they are eating more meat as incomes rise. Something like seven kilos of grain goes into producing 1 kilo of meat – hence demand for grain goes up significantly as demand for meat goes up.
• because of the madness of promoting bio-fuels, many farmers (especially in the US) are producing corn for fuel rather than food. Filling a tank of an average family car with biofuel uses as much grain as to feed a family of four for a year!
• the price of oil has shot up, the costs of fertilizers has gone up and hence the cost of producing crops.
• Finally (and this is not meant as a political point – it really is not) but the growth of the organic food movement will mean that yields will drop per acre as less intensive farm methods are used. (A study quoted in The Economist stated that if the whole world went organic we need four times as much farmland as we currently use – which would have to be rainforest. Interesting quandary – you can’t be green and organic!)

The beneficial effects of inflation are

1) It erodes the nominal value of debt. In the past debt has been easier to manage as inflation has helped erode the value of it. Let us take the example of you owing £10,000 today with your salary being £20,000 and you were paying interest only on the loan. After something like 10 years, if inflation was running at around 7% per annum (and your salary kept up with inflation) your debt would still be £10,000 but your salary would be £40,000. Your debt has gone from being half of your salary to a quarter. Many have argued recently (although their voices have not been heard much) that what we need in UK and the US is a period of inflation to erode debt. Even if house prices were to fall, if salaries went up with inflation – it means the % of debt to income would improve.

2) Zero or negative Inflation encourages consumers to save money rather than spend it. As we know consumption is the main driver of Western Economies. If prices are falling, and interest rates are positive, it makes more sense for me to defer my purchases and save money. If I have £100 in the bank and I have the choice of buying something now or saving it, I will probably save my money if I expect prices to be lower in a year and I know I will get interest on my money. In a year I may have to only pay £95 for the product instead of £100 and my money after a year in the bank may be £105.

3) Rising prices also act as a signal for entrepreneurs to enter markets and innovate. An example of this is Alternative Energy. Setting aside, the harmful effects of carbon emissions (and by the way the number one cause of carbon emission are termites and the number two cause are cows – and 2/3 of a cows methane emission comes from its mouth not it’s behind!) the rising price of oil has acted as a massive incentive for alternative energies as they now become economically viable.

Keynes, the great Economist of the 1930s through to the 1950s focused his attention on solving the world of the problem of Unemployment. When his ideas were criticised as in the long run they would lead to inflation, his reply was

“In the long run, we are all dead”

Technorati Tags: inflation, grain prices, bio-fuels

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