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When should nonprofits spend more?

Here’s a quote about a program by Habitat for Humanity to try to get better results for people:

By betting big on property in a down market, and with the help of a donor network, the group is creating Habitat neighborhoods.
Habitat for Humanity Tries Big-Scale Approach to Housing in Oregon

That’s one point of endowments: counter-cyclical spending, like dollar-cost averaging over generations. There’s a rule of thumb in foundations (as with retirement spending) to spend 5% of the endowment per year. Most people believe that this is some magic rule, or that it’s been calculated to provide the optimal balance between short-term needs and long-term outcomes. Ain’t so.

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Stealing from the future

There are plenty of examples where companies and government units borrow from their future in different ways. There are very different issues for the two actors, so we’ll split this into two posts: this one on companies and another future post on government.

The traditional way that companies approach capital needs is to borrow money, raise equity, or get cash from operations. That’s pretty much all there is in terms of sources of capital. What good CFOs do is try to match up the timing of cash flows in and out between source of the capital and the use of the capital.

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Here’s an interesting reference to the story about the “tech surge” to fix healthcare.gov. The story is interesting from a tech perspective, of course. It highlights interesting themes in the tech world about a discernable power law in the performance of great, versus merely good, developers. 

But that’s not why I’m writing this. I’m hearkening back to a much earlier post about the 9 principles of war. One of those is Unity of Command. This quote says it all:

What Abbott could not find, however, was leadership. He says that to this day he cannot figure out who was supposed to have been in charge of the HealthCare.gov launch. Instead he saw multiple contractors bickering with one another and no one taking ownership for anything. Someone would have to be put in charge, he told Zients. Beyond that, Abbott recalls, “there was a total lack of urgency” despite the fact that the website was becoming a national joke and crippling the Obama presidency.

 Unity of Command: For every objective, ensure unity of effort under one responsible commander.

It’s more than just a “failure of leadership.” Leadership is a vague, fuzzy word that we use when we want to lay blame or don’t want to sort out what’s going on. 

But here, a specific failure can be identified. Unity of Command. This project had a pretty clear mission, an Objective. There were substantial resources available. Harry S had it right: the buck stops here.


My last point isn’t that it’s automatically the President’s “fault.” The government is, um, big. But someone should have been in charge of this project and those resources. If resources come from different groups with different bosses, a problem gets moved up the ladder and sorted out at that level. But some ONE has to be in charge. Or it just doesn’t work. That culture of assigning responsibility, or “seizing responsibility” if you’re a Wolfhound or a Ranger, isn’t automatic. It comes from the top, which is leadership by example.

I will be adding this to the book’s section on Unity of Command. It raises an interesting question of how this principle, Unity of Command, gets observed in crowdsourced efforts. Off the top of my head, I’d say first that many crowdsourcing contributions are tightly constrained so that not everyone is in charge — you add a rating on Yelp, sure, but Yelp decides what their information structure is, how to add pictures, and what you can and can’t contribute. Open source? Someone owns the project — Linus for the Linux kernel, and then him delegating down to committees and creating or approving rules that say how they’ll approve other changes. And the projects where anyone can contribute sort of anything, like Google Wave collaboratively written short stories, are art projects where the objective is to execute the process, not to build a bridge that won’t fall down or a website that hosts 50,000 concurrent users trying to buy health insurance.

We’re continually amazed by the plethora of articles in newspapers and financial magazines that trudge over old ground, or what we thought was old ground.

Short example, before we get to the article: why do otherwise wise-seeming publications continue to publish the historical results of mutual funds? Why do they ignore that whole efficient market thing? Why, if the SEC is so confident that past performance is no guarantee of future results that funds are *required* to disclose that, do these magazines feed the general public’s lack of understanding by talking about last quarter’s hot fund or booming stock? Apparently it’s time for us to revisit the issue with an economics professor friend. (Other times, non-financial papers carry articles that seem to be different, except that the message is a general “sometimes go with the old advice/sometimes don’t” — you’ll know afterwards which choice was right.)

In this article by Jonathan Clements, he explains to people why a diversified portfolio of stocks and bonds might be a wiser choice than a portfolio of pure stocks, even though stocks generally return more than bonds. We have to admit that we thought diversification was a long-settled issue and that people learned how to construct portfolios that gave them the desired blend of variance and expected return.

In any event, the more interesting piece of information in the article is a comparison of historical P/E ratios between the early 1980s and today. Clements: “…if stocks reverted to the modest price-earnings multiples and rich dividend yields we saw in the early 1980s, the S&P 500 would tumble 60% or 70% from current levels.” We love this stuff because this type of analysis is one that lends itself to dissecting the omnipresent share price and figuring out what it actually represents. Now, there are those who have argued that P/E ratios reasonably should have increased over the years because earnings are higher quality now, as a result of improvements in reporting, fraud detection, and accounting principles such as revenue recognition. We agree: those issues would make net income more reliable than previously (or at least, strictly speaking, not as likely subject to the same confounding factors).

We think that the more relevant factor, rather than earnings quality, is cash flow multiples. While the problem still remains of matching data exactly, the numbers can be revealing.

More to come, of course.


I’ve been reading too much about some fundamentally misguided corporate governance notions from Cornell Law School professor Lynn Stout. 

Maybe it’s the author of the piece trying to make something out of nothing, but the article reads as if Prof. Stout simply knows what’s best for corporations, individual shareholders, and institutional investors. While it’s not uncommon to see academics pronounce superior judgment, Prof. Stout acknowledges the power of the board to control a corporation. A misstatement of law then intrudes, and this is where the article turns south in terms of quality: the board’s fiduciary duty to shareholders (a phrase not even mentioned in the article) to exercise their business judgment  is transformed, without support, into an obligation to create short-term increases in the stock price. Beyond being incorrect (that’s not what the law says at all except in the general scenario where the board has determined to sell the company and is then obligated to search for the highest price), there’s no real proof that that’s even what management and boards are doing in the first place. (That’s about four long posts’ worth of explanation foreshadowed right there.)

Instead, what this article really does is communicate Prof. Stout’s opinions about practices she doesn’t like.

  1. She says that tying executive compensation to share performance is bad; executives should get bonuses instead.

  2. She thinks that hedge funds (a convenient and irrelevant foil) engage in lots of “zero-sum” trading.

  3. She thinks that too many investors have a short-term perspective.

Separate from the notion that there are plenty of companies that take different approaches to these issues is the idea that Prof. Stout can certainly buy corporate control in the market and make long-term decisions instead. If that’s all it takes, she should make outsized returns. 

As with many academics, the solution is too quickly “you do as I say” rather than “let me do what I say and see what happens.” For each of these described problems, there are counter-examples and reasons for doing business a certain way. Google’s founders, in one well-known example, structured the company’s cap table to preserve their ability, consistent with their fiduciary duties under state law, to make long-term decisions that might have negative short-term consequences. Private equity funds take companies off the public market when investors disfavor short-term negative results as a price for long-term investments. 

If compensating executives differently is so easy and so obviously “right” that boards should be prevented from any other system (and there have been bonus structures in the past, obviously), then perhaps the way to actually prove this theory is by doing compensation consulting and basing the fee on results. I wonder whether Prof. Stout would reject stock-based compensation to share in any value increase to the company. Money plays no favorites; the market will respond to the results.


Nothing about the concept of shareholder value dictates any particular executive compensation scheme; nothing about fiduciary duties requires boards to focus on quarterly results. Whether some do, perhaps even unwisely, has little to say about the wisdom of requiring boards to act in any specific way.






(Conflicts of interest: Rick went to Cornell Law, Class of 1997. Mike went to Cornell’s Johnson Graduate School of Management, Class of 1999.)


Spreadsheet errors aren’t the biggest problem

Following the recent hullabaloo about some seemingly simplistic spreadsheet errors in a recent study, many articles have decried the pervasive nature of spreadsheet errors

What we’ve found though, is that just as typos are the not the biggest problem with written work, it is weak  or sloppy analysis that is the real problem in many more spreadsheets.

Spreadsheets, like sentences and paragraphs, communicate ideas. In a financial model for a startup, the ideas include overt and hidden assumptions about major variables, such as length of a sales cycle and the salary requirements for a software engineer. But a model also communicates a vision of how the various assumptions fit together and becomes a representation of how the business functions just as clearly as any flowchart or business process diagram.

We’ve reviewed hundreds, maybe thousands of financial models. Many are constructed correctly, in that the cells match up and the formulas do what they say. But those same spreadsheets fail at the task of communicating the business model — how the company takes capital and employs it to bring in revenue, capture gross margins, and operates the business in such a way as to produce positive cash flow.


No, the real risk in your spreadsheets is that they correctly answer the wrong questions.


World Autism Awareness Day 2013

Today is World Autism Awareness day. My Facebook profile picture is my 8yo son Dylan, showing you, and me, what he thinks of autism. I imagine it’s something along the lines of “I just want to do what I want and have fun like every other boy. Sometimes it’s just hard.” Other times I imagine that’s it’s a hearty “fuck autism,” like when he’s scrambling up the rock climbing wall better than any 8yo in the place.

But he probably doesn’t think about it. He just moves through life, doing what he can and frustrated when his reach exceeds his grasp — just like the rest of us.

So, be aware, be supportive, and perhaps this year you’ll take some action, however small.

Awareness only gets you so far. I’d venture that Dylan is unaware that he has autism. He just acts.


When you should stick to your knitting

How do you know when you should change your business or keep doing things the same way? Applying two principles, Security and Economy of Force, will help you determine what type of problem you’re facing before you decide how to analyze it.

Here, we’re going to talk about making decisions that increase your business’s risk. A recent WSJ article describes the resurgence of lawyers trading legal fees for equity in pre-funding startup clients.

Equity stakes as a kicker are not a bad economic idea, but the handful of firms that really went full-bore down that road were generally unaware that they had traded some of the risks inherent to running a law firm for those inherent to running a VC fund. And, just as taking on lots of real estate risk is a field best left to real estate investors rather than law firms (see, e.g., Brobeck Palo Alto, San Diego, & Austin), VC risks are best left to VCs. It’s hard enough for them to make money regularly and that’s all they do.

Realistically, for long-tenured firms such as WSGR, the opportunity to make equity investments in clients is more about creating assets that are not tied to the pure fee-for-services model: in the firm investment fund model, the partners have funds and they’d like to diversify into a field where they can expect to be smarter than the average bear. Co-investment is a much better way to approach this strategy, and most investment funds see little threat from bringing related parties in. The amount of funds invested seldom approach the dollars of the primary equity investors, so there are seldom any of the typical issues when a deal is split among several funds (such as splitting control).

Trading fees for equity is a great specific example of risk expansion: assuming risks without necessarily subjecting the intent to do so to the same analysis you would if you were starting out with a new business. In other words, five prospective partners might sit down and create a new law firm that would take equity in lieu of fees, and they would likely spend more time analyzing the effects of that decision than a traditional five-partner firm who slides into that model bit by bit — another example of boiling the frog.

Assumed risk expands to absorb available economic surplus.

This false assumption that continuation of decisions is somehow different from a new decision is the result of a bundle of fallacies. Sunk cost fallacies and path dependency combine to cause many investors, for example, to hold investments that they would refuse to purchase at that day’s FMV. That’s nonsense of the highest order, particularly where transaction costs are low such as with widely held public securities in a liquid market. If you wouldn’t start your business today, that means you should be doing some serious thinking.


From a strategy perspective, this notion of sticking to your knitting is about acknowledging core competencies, playing to your strengths, and eliminating ancillary risks. Ancillary risks are those that your business model fundamentally rejects in favor of others you’d like to take on. The main reason for rejecting risks is that you’re not particularly well-equipped to handle them better than someone else. Managing business risk is very conveniently described in insurance terms, even when the other party is another company just like yours. Security is the principle of business that most reflects this notion of protecting yourself against risks you don’t want to assume. The difference between Security and Economy of Force is that Security is protection against additional risks — increased number of assumed risks — whereas Economy of Force is protection against additional revenue streams — increased number of businesses.


Understanding alternative fees (ahead of our time)

A recent Forbes article describes the alternative fee problem, how to reasonably price legal fees using something other than an hourly basis, as a potential application of big data analysis.

Conveniently, we said this over three years ago in describing the data needed to create alternative fee structures.

Some corporate clients have enough legal liability of their own that they can do the analysis internally: an auto manufacturer’s finance arm can address auto loan defaults, for example, as can almost any company with a large volume of litigation, such as an insurance company. There’s likely to be enough data that reasonable connections could be drawn between various attributes of each case (amount at stake, jurisdiction, age of account, and similar items, many of which are related to the underwriting process in the first instance) and the ultimate legal fees and result (productivity: comparing input and output).

But for many corporate clients, they are only infrequent participants in litigation, and thus they turn to outside law firms on the cost question for the same reason they turn to those firms on the legal specialty question: volume of work for an outside lawyer is almost always higher than for a comparable in-house lawyer. I worked on more IPOs in two years as a corporate associate than most GCs would work on in a lifetime at a company (most companies only go public once!).

So law firms have the possibility of interpreting their data to find the answers, but there are a few major hurdles.

First, their incentives are not clearly aligned with doing the work to overcome the other hurdles. When all firms have the same problems, no one sees a pressing need to move first and invest in figuring out what they know.

Second, lawyers don’t like to be pinned down — it’s inherent in the hourly fee model: the risk of there being more work falls on the client. Since it’s the client’s lawsuit, lawyers see that as fair, and it pretty much is when the amount of work can be dictated by someone else, such as the other litigant!

Third, virtually all firms don’t collect the sort of data that might be useful to divine the cost drivers of litigation. (Insurance claims adjuster files might, but those companies can already do their own analyses.) With the need for either an upfront investment in collecting the absent data or in adopting a new process going forward, firms find it easier to use the excuse of “no data” to stick with the “I’ll give you an estimate that is really just a guess based on my own anecdotal approach.” Anecdotal evidence isn’t — and firms recognize that because they’re unwilling to adopt their own estimates created this way.

Fourth, law firms aren’t really sure yet about the risk transfer inherent in an alternative fee structure. The connection, in terms of ultimate outcome, between facts, law (which while knowable is seldom exactly known early in any given case), and lawyer skill, is fuzzy. Law firms have historically benefited from that fuzziness because excuses abound from the underlying facts (“you were always going to lose on these facts”) to the law (“there are just too many unfavorable cases”) to the process (“with this judge and this jury, it turned out to be a loss; with a different judge and jury, …”) to the client (“by trying to be cost-effective, we didn’t have enough resources available”). The rationale of “the other lawyers were smarter than us” is non-existent. But that’s what performance fees are about: betting on yourself and trying to manage the other cost factors.

We’re always looking for legal services opportunities, for corporations and law firms, to apply our approach to this alternative fee problem.


NACD – Years late, Millions of $$$ short

The industry group for public company directors, the NACD, recently announced that they’re producing a guide to compensation structures to help connect pay to performance. The purpose is apparently to guide corporate directors, in part because 

directors on compensation committees are under unprecedented pressure to define the strategy and rationale for their executive compensation decisions.

That’s funny because we’ve been reading articles, from the popular press (the WSJ told us “How to Fix Executive Compensation” just four months ago!) to financial journals, for over a decade talking about pay and performance. The topic reached a crescendo during the dot com boom as the value of stock options grew to unforeseen heights for many companies. But that, too, was just an echo of an earlier rise during the heyday of the MBO, when putting management’s “skin in the game” was part of a strategy to improve performance. More recent restricted stock grants have similar goals.

Why the NACD thought that last week was finally the time to create this guide escapes me. Consider, for starters, that all of these directors are ALREADY subject to fiduciary duties to perform their duties competently. What is the NACD saying? That companies really don’t know what they’re doing? Or that there’s a right way and everyone has been mucking it up all along? 

I’ll stick with the cynical explanation that the compensation consultant and law firm sponsors/advisors to the guide finally coughed up enough money to make it worthwhile to the NACD to pretend to solve a problem that has already been the subject of scads of actual academic research and that has already been “solved” annually by every board on which its members sit.