The fallacy of averages

A discussion with a portfolio company CFO yesterday reminded me that statistics are a dangerous thing and averages are misleading.

“There are three types of lies — lies, damn lies, and statistics.”

Skewed distribution

Most businesses analyze their performance using overly simplistic tools. For an extreme example, imagine a scenario where the average customer produces monthly recurring revenue of $10,000. Well, it is one thing if the MRR of each of the individual customers is scattered tightly in a normal type of distribution around the $10k MRR level. It is another thing entirely if the distribution is skewed like in the image here. For example, what if a small handful of customers are significantly larger than all of the others and are skewing the mean (or average) upward. In such a scenario it is possible that the company is losing money on every one of the smaller customers and making a boatload of money on the larger ones. Unfortunately, there would be many more small customers than large ones (ie the median is lower/smaller than the mean).

If management’s understanding of the business is limited to the average, they might be inclined to pursue a strategy of getting more customers regardless of customer size and profitability, which could result in the company recruiting many more small, unprofitable customers. Rather than looking exclusively at averages, I suggest it is important to look at the distribution in the form of a histogram. More often than not, looking at the histogram leads to conclusions that are obfuscated by the average.

Don’t make decisions based on averages unless you know the distribution around the average is normal. If you suspect the distribution is skewed, put a histogram together and make decisions based on the histogram.

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Basics of Unit Economics Analysis

When an investment passes our first-screen at Meritage Funds, the first deep-dive we typically do is on the unit economics of the business. Unit economics are the fundamental financial building blocks of a business. If you can pin down the unit economics, you can determine contribution margins, break-even points and perform ROI calculations all of which can help to determine whether a Company’s economic engine works. Without an understanding of unit economics, predicting whether a business can be profitable in the long-term is all guess-work.

I’m a believer that every business – no matter the scale – should have a point of view on its unit economics. That includes you startups. However, the concept is not as easy to apply as most hope and is frequently mis-applied. Here are some basic principles I use when thinking about unit economics.

What is your unit?

The following is a master of the obvious statement; building unit economics requires you to first pick the unit. I recommend picking a unit at which the company has its most significant level of marginal investment.

For example, for consumer focused businesses the best unit is typically as single customer. The investment at the customer level is customer acquisition cost (CAC) and for businesses that deliver a physical good, the cost to deliver the product. A customer-level unit also typically works well for enterprise focused businesses.

Some businesses require multiple unit measures. For example, an infrastructure service provider that has a geographically distributed physical infrastructure (data centers, cloud, wireless towers, etc.) have significant marginal capital investment for each new deployment. As a result, these businesses should use each unit of physical infrastructure as their core unit and within each, use a customer unit as a secondary unit.

Key unit economic model assumptions

Identifying the level of unit economics is the easy part. Getting the calculations right is a different matter. On the outflow side, the inputs are:

  • Capital Expenditures: The up front capital cost to create the unit. For an infrastructure style unit economic model, this would be the capital expenditures required to build the unit.
  • CAC: The initial, pre-revenue cost to acquire a customer. For a customer unit economic model, this is the fully loaded customer acquisition cost, including variable sales, marketing, and implementation costs that can be directly attributable to customer acquisition and on boarding.
  • Marginal Operating Costs: This is the ongoing marginal cost to serve the customer or to operate the infrastructure over the life of the unit.
  • Maintenance CapEx: Physical assets degrade over time. As a result, for an infrastructure business, it is important to factor maintenance CapEx into the unit economic model. This is the amount of CapEx required over time to keep the infrastructure operating at a suitable service delivery quality.

On the in-flow side, the inputs include:

  • Revenue: No need to explain, although I do advocate that companies put together a fairly detailed set of revenue drivers in their unit model; a topic for a different post.
  • Duration: When building a unit economic model, it is important to know the usable life of the unit. In an infrastructure model this is the useful life of the asset, factoring in the maintenance CapEx. In a customer unit model, this is the average customer life. Duration or Average Customer Life in a customer-driven unit model is the flip-side of churn-rate, where the relationship between the two is captured by the following equation:

1/churn rate = average customer lifetime

It is important to note that the average customer lifetime will be in whatever time period you use for your churn rate. Input a monthly churn and get a customer life in months. The churn rate required for this calculation is a customer count churn rate, as opposed to a revenue churn calculation. I could spend several posts solely on how to calculate churn.

  • Growth/Decline: You may believe that revenue per unit will increase or decease over time. This is critical to reflect in your unit model.

Each of the inputs require their own set of calculations. Setting aside the details, what we’re driving toward is a unit economic model that helps us perform some business model viability calculations.

Does your unit hunt?

Once I have the unit economic model inflows and outflows set, I like to lay them out in a time series, showing each inflow and outflow on its own line item. Sum them all up and you get to contribution margin. Contribution margin is the amount of cash that a unit contributes to covering corporate overhead expenses. I look at is the number of months it takes for the unit to produce a positive contribution margin and the number of months it takes for the unit to return whatever up-front investment that was required to produce it. The month in which a unit generates a cumulative positive contribution margin is the payback month.

With some additional math you can calculate the number of units that are required to bring the entire business to profitability. To do so, simply divide the company’s fixed overhead by the unit contribution margin. Finally, for capital-intensive businesses, particularly infrastructure businesses, it may be useful to calculate a return on investment for a unit.

Again, each of these calculations has its own set of detailed mechanics behind it. The point I want to make here is that you can’t begin to know whether your business economic engine works until you’ve built a unit economic model. If you are considering raising growth capital, start building your unit economic model today. You’ll be thankful you did the work when a prospective investor asks to see it. Any growth stage investor worthy of investing in your business will surely ask.

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You missed your numbers. Now what?

By now, you should know where you stand relative to your 2013 budget. Hopefully, you made it or beat it. For some, the finally tally will show a “miss to the downside”. When i say miss, I’m referring to performance against the original budget – the one you put together in December 2012. Performance against the 2013 re-forecast you prepared mid-year (hopefully not multiple times throughout the year), isa separate matter. The fact that you had to re-forecast because of  downside miss is a signal in and of itself.

So, you missed; now what? The first thing you should do is ask yourself: Why?

There are too many reasons companies miss plan to list in one blog post. Some are legit; many err on the side of “excuses”. I think it is important to attribute misses to reasons over which management had some measure of control. If you can’t control it, you can’t make a change in your execution strategy that adjusts for it. All the other “reasons” are interesting, but aren’t particularly useful, with the exception of black-swan style macroeconomic shocks, which aren’t excuses but are facts of life.  To simplify, I break down reasons for missing plan into two categories – forecasting error and execution error.

Forecasting error

A budget is a forecast with a lot of moving parts. Sales productivity, unit prices, churn, cost of goods, sales and marketing expenses, headcount, compensation levels, the list goes on. I think it is a good discipline review your budget and determine which specific assumptions (if any) are at variance with actual performance. Forecasting error will show itself when there is an assumption in the budget that is at variance with actual performance, management could not have know that the forecast was wrong and the error can’t be attributed to execution error. For example, the fact that your sales reps produced 50% of the bookings per rep that you budgeted is more likely execution error than forecast error, particularly if you had good reason for setting the forecast at the chosen level. Some might argue that forecasting error isn’t within a management team’s control, to which I’d respond:

If management didn’t prepare the budget, who did?

Forecasts are entirely within management’s control. No-one knows more about the assumptions that go into building a budget than the management team that is steeped in the business. That said, a company’s performance against a budget may be affected by factors beyond management’s control, however, that type of miss is probably a different type of error. Forecasting error will happen at a higher rate in earlier stage businesses or businesses where a new management team has been brought in. In both cases, the process of developing the drivers for a forecast/budget may not have the benefit of significant historical data. In the absence of historical data, forecasting is a process of making informed guesses, many of which may turn out to be wrong.

Forecasting error also occurs when a management team “misses” a plan to the upside. This type of forecasting error is forgivable, but is equally important to correct over time.

Execution error

The alternative to forecasting error is execution error. By default, no matter the stage of your business, you should suspect execution error before forecasting error for any miss, unless you can prove to yourself beyond a shadow of a doubt that you executed well. Execution error takes many forms, all of which require corrective action. Where execution error is present, it is critical for a management team to be honest with themselves and to take corrective action. 

Differentiating between forecasting error and execution error?

You know it is forecasting error if:

  • There was little to no historical data to back up an assumption in the forecast;
  • You made efforts during the year to improve performance against the assumption, but without success; and
  • The miss can’t be attributed to execution error.

You know it is execution error if:

  • There was good historical data or sound reasoning to back up the assumption in the forecast, but you missed anyway;
  • Efforts to improve performance against the assumption had a positive impact during the year, execution improvements made an impact; and
  • Team members responsible for performance against the assumption are viewed as under-performing.

Is one worse than the other?

For me the answer is yes. I’m much more forgiving of forecasting error than I am execution error. The caveat being that, over time, management teams should be able to increase their forecasting accuracy (reduce forecasting error) with the accumulation of experience, knowledge and data about the dynamics of their company. Management teams that are unable to close the gap between forecast performance and actual performance over time aren’t learning and forecasting error and execution error become indistinguishable.

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Growth Equity Investors are Hedgehogs; VCs are Foxes

Growth equity is increasingly being recognized as an investing discipline that is separate and distinct from venture capital. That being the case, how does one distinguish between a venture capitalist and a growth equity investor. In my mind, growth equity investors are hedgehogs; venture capitalists are foxes. Allow me to explain.

Ever since I read Jim Collins’ book Good to Great, I’ve been fond of Isaiah Berlin’s parable of the Hedgehog and the Fox. The story of the Hedgehog and the Fox revolves around a quote fragment attributed to the Greek poet Archilochus:

The fox knows many things, but the hedgehog knows one big thing.

Long-story short… the fox is cunning, sly, creative, etc. and out to get the hedgehog. By contrast, the hedgehog is – on the surface – mundane, plodding, un-inspiring and looks like easy prey. However, every time the fox tries to attack the hedgehog, the hedgehog responds consistently and effectively by turning into an impenetrable ball of quills, rebuffing the fox time and time again. No matter what tactic the fox tries, the hedgehog “wins”. Hedgehogs don’t do a lot of things; they don’t have the broad repertoire of skills that foxes have. However, they do turn into an impenetrable ball of quills really, really well.

Collins applies the parable to a business context, arguing that companies that are Great (as opposed to good) have hedgehogs as their leaders. Those hedgehogs are able to make a complex world simple, by creating a unifying view of the world and driving single-minded execution in their organizations. Long-term success in these hedgehog businesses comes from relentless and effective pursuit of that execution focus.

Venture capitalists are foxes

Venture stage businesses experience significant uncertainty. That uncertainty necessitates frequent strategy shifts and changes in execution focus. Rare is the case where an early stage business gets the formula right the first time. The skill-set and mindset of venture investors must accommodate this reality. I’d make the case that successful in venture investing requires a skill-set and mindset that is more akin to the fox than the hedgehog. It’s all about broad experimentation, trial-and-error, pattern recognition and connecting dots. It is a gut instinct driven process. Act, evaluate, re-calibrate, repeat…

Growth Equity Investors are Hedgehogs

By contrast, growth stage investing is about backing companies that are developing a successful, growth-generating formula and consistently and maniacally pursuing execution of that formula. Growth stage businesses need to do a few things and do them at a world class level. For the sake of capital efficiently, it is equally important for growth stage businesses to know what they are not going to do in order to maintain a narrow focus on the few things that will move the needle. Execute, execute, execute is the mantra. As a result, growth equity investors have to be hedgehogs. Growth equity investing is all about data driven decision-making and focusing management teams on a narrow set of objectives that generate profitable growth. This isn’t to say that growth stage businesses don’t experiment, they do. Their experimentation is just more data driven and graft onto a growth formula that is already working. The experimentation can’t distract from the core execution focus.

Are you a Hedgehog or a Fox?

I’m not suggesting VC and growth equity investors are in an epic battle as in Berlin’s parable. I’m also not suggesting that one is superior to the other. Hedgehogs are not better or worse than foxes, just like growth equity investors are no better or worse than venture capitalists. But, hedgehogs and foxes are different as are growth equity investors and VCs. As with most things in life, it’s all about fit between skills and scenario. Growth stage businesses benefit from hedgehog leaders and hedgehog investors. They are focused, data driven, execution minded and consistent in their pursuit of a growth formula. Venture stage businesses benefit from having fox leaders and fox investors. They are instinctive, opportunistic, and willing to change tactics quickly, frequently and sometimes with little to no data.

None of us are 100% hedgehog or fox; we all have attributes of both. I tend to lean toward the hedgehog mentality in a business context. In part, and over time, this has led me to prefer growth stage investments. Growth stage investing is a better fit with how I frame the world.

Unfortunately, none of this helps answer the timeless and timely question: What does the fox say?

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After the honeymoon

Earlier this week, I participated in a panel discussion organized by Holland & Hart, a Denver-based law firm that has a strong practice area working with entrepreneurial growth-stage businesses. The topic of the panel was “After the Honeymoon”, focusing on investor/entrepreneur relationship dynamics in the critical period following the closing of an investment or acquisition transaction. Also on the panel with me were Matt Hicks of Excellere Partners and Flint Seaton, CFO of Accellos, an Accel-KKR backed business.

The discussion was principally focused on investor/entrepreneur relationships in the context of growth equity style investments. We had a wide-ranging discussion hitting on topics that included financial forecasting, strategic planning, executive team recruiting, and many others. Each of those specific areas matters a great deal. But no matter which element of the work that goes on between investors and entrepreneurs during the post-investment period the panel discussed, the conversation returned to two key concepts – alignment and trust. Alignment and trust set the tone for how investors and entrepreneurs work together. Investor/entrepreneur coordination works great when both are in place and poorly when either is not.

Alignment is a straightforward concept, the goal being to harmonize expectations between the investor and the entrepreneurs. But it doesn’t just happen. You don’t stick and investor and an entrepreneur in a room expecting that they are automatically “aligned”. Creating alignment takes work. Trust is a more nebulous concept. But suffice to say that once trust between an investor and an entrepreneur is violated, it is hard to recapture. There are more ways than you can count to violate trust.

So how does are investors and entrepreneurial management team’s supposed to derive alignment and trust? It is my strong opinion that if an entrepreneur is working to drive alignment and build trust with an investor (and vice-versa) after a transaction has closed, it is already too late. The time to begin working on the fundamental building blocks of a successful entrepreneur/investor relationship is before the transaction gets closed. The benefit… everyone knows what is expected of them day 1, day 30, day 100, … and there is no lag between the Company taking capital and management’s execution of an agreed to plan of attack.

We like to perform a strategic planning session with management teams we want to back before the investment closes. We expect that our management teams to use the results of the strategic planning to derive operating plans. We do this annually with each of our portfolio companies, but in the case of a new investment, we expect that the strategic plan be crystallized into a 30-60-90 day post investment execution plan before the investment closes. The benefit of going through this exercise (which is a lot of work for everyone) is that management and the investors know exactly what to expect of each other during the critical months following the investment. There is also a built-in trust builder baked into the pre-investment strategic planning process. It takes a lot of trust on the part of management to bring a prospective investor into the intimate thoughts of a management team, particularly when that planning is likely happening simultaneous with a diligence process. Teams that are willing/able to go into a strategic planning session with a prospective investor are saying, through their behavior… “I have nothing to hide. I’m comfortable expressing the good, bad and ugly about my business and you are going to want to invest despite having heard it all.” An investor that goes through that process with a management team and follows-through with the investment is saying… “I know about all of your imperfections; I acknowledge them and I love you despite them.”

Pre-investment strategic planning isn’t the only way to build alignment and trust between an investor and an entrepreneurial management team, but its a pretty darn good starting point. Investors and entrepreneurs need to lay the groundwork for alignment and trust before the closing of a new investment. Everything becomes easier with alignment and trust in place… If the right alignment and trust aren’t there, don’t proceed with the investment; that goes for both entrepreneurs and investors.

Thanks to Holland & Hart for hosting the event and to Matt and Flint for being great co-panelists. I had fun participating.

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