Why raw data alone is insufficient for making decisions The WSj recently published an article regarding the prospects of asking/demanding that political candidates or prospective CEOs release DNA sequence information.

For us, even though data-driven analysis is the first phase in our business leadership process (Data-Driven Analytics (DDA), Informed Decision-Making (IDM), and Intentions-Based Guidance (IBG)), it is important to understand that data alone is meaningless. While the connections between sales data and pricing strategies or marketing campaigns is at least intuitively in the ballpark for most managers, the connections between DNA sequences, genetic predispositions, health risks, and actual health problems are far more attenuated. Geneticists and doctors (since the intersection is the important issue) know that only certain DNA sequences lead to definite health problems, and that only some health problems are tied primarily to purely genetic factors. For example, Huntington's Chorea, a genetic disorder, is caused precisely by a specific gene and regularly occurs when the mutation is present. Alternatively, even if I don't have a genetic predisposition to lung cancer, if I smoke a pack a day, I'm very likely to end up in trouble.

From a business perspective, it is clear to all (well, most, since we've found some of the exceptions) that if your sales price doesn't cover your costs, you're either in for a serious economic catastrophe or an antitrust investigation. But that single accounting snapshot is not a good description of how business happens. Businesses are continually making sale after sale, at varying prices, to different customers of different products and services. Tracking the change, rate of change, and source of change across those variables can point you in the right direction. Financial snapshots are like DNA; it's possible for them to point to problems all by themselves, but most of the time, you have to analyze the system dynamically because it's a dynamic system. In science, it's called experimentation; in medicine, it's called treatment; in business, it's called management.

Labels: DDA, execution, leadership

Saturday, November 01, 2008 :: posted by Rick Colosimo @ 1:32 PM

Legal Spending per share is wrong metric A recent PLI newsletter article referenced an idea of measuring legal department spending in terms of $0.xx/share. The editor notes, correctly in our opinion, that the per-share measure is likely to be unsuitable over the long-term because share numbers change for reasons wholly unrelated to legal department spending.

What we often tell clients to consider, instead, is an easier-to-compute number of X as a percentage of revenue. Indeed, at a recent PLI live event in New York, Mark Chandler, the general counsel of Cisco, remarked that his budget guidance is driven not by absolute numbers but rather by his actual expense as a percentage of revenue. That makes sense to us because, for example, if Cisco files 20% more patents because of new products being produced, that is probably a good reason for legal expenses to increase. If there are 20% more contracts to negotiate because there are 20% more sales, that is a good thing. An easy way to get a quick handle on whether the GC is doing the job well is to see how the cost of legal services to produce a dollar of revenue is growing in comparison to revenue. This approach treats legal expenses like many other costs, such as the cost of raw materials or manufacturing, and measures them in similar ways. The artificial delineation of above the line/below the line costs (COGS vs. SG&A) because of "direct" (and any CPA is welcome to point us to the specific US GAAP or international standard) allocation to revenue has unfortunately made it easier, even acceptable, to ignore other costs in terms of their relationship to revenue and specific items of revenue.

We will explore this bottoms-up, functional analysis approach in greater detail in upcoming posts, seminars, training, and even a book. We are working on software to make these analyses easier for boards, executives, and managers to implement at any level of the organization. It is the application of these ideas to the nonprofit world that will find a home in the activities of the Wolfhound Fund.

Friday, October 24, 2008 :: posted by Rick Colosimo @ 11:21 AM

How Bailout courses of action should affect your business model This article from the 2001 Nobel laureate in economics is a concise and cogent description of the courses of action re: the bailout.

We're pleased to see that someone is talking about the need for quality due diligence and the potential risks of shoddy or slight investigations into value. We have pushed this message with our M&A acquiror and PE investor clients. They understand pretty readily once the costs are discussed.

Where we still find the most disbelief or unwillingness to accept the facts that diligence leads to estimates of value that support transactions that actually get executed is on the target/portfolio company side of things. Founders and CEOs find it difficult to explain how they will actually achieve the numbers in their projections; we often find that the fundamental business model is unexamined. By business model, we mean not the spreadsheet itself but the concept of the business, in terms of how efficiently a company uses its invested capital to produce revenue, how well it controls product costs as it converts revenue to gross income, how it controls operating expenses as it achieves EBITDA numbers, how it organizes its capital structure as reflected in EBT, and how it manages tax issues as reflected by Net Income, and finally how it balances reinvestment in the business and invested capital as we turn to a pure free cash flow (FCF) number.

We are building new tools and offerings to help companies at the board and senior management level think about their business model in the level of detail required to understand the implications of investor expectations. We focus on simplifying complexity to help direct management attention to the right links in the FCF value chain.

As we start presenting our ideas to the market, we'll announce more here.

Labels: due diligence, expectations, governance, performance

Monday, October 06, 2008 :: posted by Rick Colosimo @ 10:54 AM

Software Bounty: $250 for blackberry email tweak Wanted: a work-for-hire (so it can be released under a CC license for non-commercial use, exact license TBD) software "widget" that, at a minimum, works on a GSM Blackberry Pearl (AT&T) using Hosted BES from Intermedia.

Feature: allows for an option-type (i.e., one time) setting to auto-BCC a single address on every email sent from the device.

Reference: When using the blackberry in a non-corporate environment, using the Blackberry Internet Service, it is possible to set an option that allows the user to BCC an address on every email. However, when we shifted to a hosted Blackberry Enterprise Server platform, that option disappeared. We want to be able to BCC ourselves automatically rather than type in the address each time. The solution could take many forms, as long as the feature is delivered without other errors. Constraints caused by the solution may be acceptable.

Reward: $250 for first working version. Submissions to rick@thoughtstorm.com. I will test the applet myself and then have a colleague confirm the solution is acceptable. All submissions will be recognized here.

Labels: nonprofit, software bounty, tips

Thursday, October 02, 2008 :: posted by Rick Colosimo @ 4:31 PM

Bailout: cause & effect Larry Ribstein, who's a law professor and pretty focused on corporate governance generally, just described the bailout in some pretty straightforward terms.

WARNING: we are not typically focused on macroeconomics except in scenario planning. However, we see strong tendrils of the situation that are really about investor expectations, the efficiency of the market, and the quality of public disclosures.

Here is our brief description of the background of at least the current portion of the crisis (not the subprime problem itself, which is very different):

1. Banks have capital requirements so they won't be as likely to fail.

2. Part of bank capital is loans and portfolios of loans as well as fuzzier items, such as swaps and other derivatives.

3. The value of the fuzzier items concerned regulators, in part after seeing big drops in startup stock after the dotcom bust.

4. Regulators then required banks to carry those items at market value (just as they would for regularly traded securities) rather than book value. The purpose of this was to get some idea, as fuzzy as it may be, about the value of the assets that the banks wanted to use to fulfill their capital requirements.

5. Market values of CDOs (collateralized debt obligations) dropped as the estimates of subprime defaults differed from original estimates on which the price of the CDOs were set.

6. Banks reduced the value of the CDOs and other assets on their books according to the rules set by FASB for making those estimates when there isn't a regular market for assets (i.e., anything different than traditional stocks & bonds).

7. When the fuzzy assets were counted this way, the banks didn't meet the capital requirements. That led to banks raising a lot of capital at lower stock prices (Citi raised $10b(?), mostly from overseas), which obviously led their share prices lower.

8. Lower share prices & lower market values for the fuzzy assets & mark-to-market led to more capital raising, and so on.

The idea we've read in various places that mark-to-market by itself is somehow responsible for the underlying change in value of the assets is silly and violates causality. The assets in question are now so fuzzy that the market transactions I've read have imposed huge discounts, of 20-40%, on the assets. The real issue for the equity holders is being grumpy about the fact that they need new capital, which is coming in a discount, meaning dilution.

Ending mark-to-market would give everyone less information -- yeah, that's a *good* idea. Everyone, including the market, understands that it's hard to put values on fuzzy assets, and that risk is priced in accordingly. Now, if the regulators want to shift the capital requirements that are directly causing the need for sales of distressed assets and equity, that might make sense, but we recently just read a different item in the NYT on how similar reductions in capital requirements preceded the S&L bailout. Maybe that idea doesn't make sense after all. [NB: added text] Other alternatives proposed also focus on the capital requirements, but from the investment angle rather than the regulatory angle. No matter how you slice it, the capital requirement is the issue, not the valuation method of the capital per se.

What will happen, what indeed must happen in the end, is that these illiquid assets will end up in the hands of people who can afford to own illiquid assets. Illiquidity is kryptonite for banks, who had it bad enough back when they were taking in demand savings & checking deposits and making 5-year car loans and 30-year mortgages. Newer instruments seemed to improve things, and probably did, but changes in value seem to have been exponential rather than linear, at least over the small changes I've seen quoted, such as doubling the default rate on subprimes from 1.5% to 3%. While that could eliminate profits on thin margins, that shouldn't destroy more than 3% of the portfolio value if you owned all the mortgages and recovered ZERO from any default.

So that, to us, is one view of the situation.

Labels: disclosure, equity analysis, expectations

Wednesday, October 01, 2008 :: posted by Rick Colosimo @ 1:19 PM

How to allocate risk you find in due diligence We generally subscribe to the theory that commercial contracts are about allocation of risk in a transaction. Dealbook today writes about a clause in the Merrill Lynch / Bank of America merger agreement.

Here's the clause: "(c) No investigation by a party hereto or its representatives shall affect the representations and warranties of the other party set forth in this Agreement." It's found in Section 6.2(c) of the merger agreement.

The purpose of the clause is questioned. In our experience, buyers typically use language like that found in this specific clause to hold targets to the terms of the reps and warranties. The idea is that even though you perform due diligence on an issue, such as reviewing a stack of material contracts, your own diligence investigation does not excuse the target's failure to make adequate disclosures.

The situation could play out like this: material contracts are provided to the buyer that include the terms of a real estate lease that show that it must be cancelled six months before the expiration of the five-year lease or it will auto-renew. The six-month deadline has passed and so the lease will auto-renew. The target reps that there are no leases that are not cancelable on thirty days' notice, a deadline that has not passed. When this situation starts to resolve itself, targets often say "we gave you the documents, and you reviewed them." They may note that an item was specifically noted to be in contradiction with the rep as a reason for excusing the breach. With the quoted language in place, the due diligence investigation by the buyer is not a defense to the breach of the rep.

To outsiders, this sounds like the sort of weasel legalese that the public now expects from lawyers. A few other examples showcase the benefits: first, imagine a dispute about the legal effect of a notice (the target sent a notice that it believes is legally valid to cancel the lease, and the buyer disagrees. Under the rationale we've described, the deal can go forward and allocate the risk of the notice being ineffective to the target. Second, imagine further that there's a lawsuit pending (but not served) regarding the termination of the lease. The buyer will certainly want to know about it but may not want to underwrite the litigation. Using a "no threatened litigation" representation, the buyer can shift the risk of loss from the issue to the target.

Why should targets do this? Why would they take these risks? The proper allocation of risk is much like an insurance analysis -- the risk should generally lie with the party best able to manage and minimize the risk and control the outcome actual underlying event/issue. In almost every case, the target is far better equipped to at least know about the nature of the risk and appropriately price it rather than requiring the buyer to price the risk as part of what's included in the purchase price. Usually, a knowing omission from the disclosure schedule, which is how this shift of risk is typically accomplished, is only appropriate for material risks that are hard to manage and difficult for a buyer to investigate. For example, we have used this explicitly in a situation where the founder of a technology company was being challenged by a former employer about whether the employer's trade secrets were being used in the new company's products.

Labels: contracts, deals, due diligence, law

Sunday, September 21, 2008 :: posted by Rick Colosimo @ 2:03 PM

Kennedy on action "There are risks and costs to a program of action. But they are far less than the long-range risks and costs of comfortable inaction."

This expands on one of Mike's favorite sayings to use with clients: "the unaimed arrow never misses." We use it to help clients understand another Army maxim of failing to plan is planning to fail. Of course, President Kennedy said it much more eloquently.

As junior officers, we were trained to be decisive, to take action even though analysis wasn't completely complete -- to learn when enough information was gained so that a decision was about as good as it was going to be, when the tradeoff between more investigation and delay tips in favor of DOING something.


Readers will see a reinvigorated blog over the next few weeks as we re-engage ourselves in this process of communicating with the markets. Thanks for your patience

Labels: leadership, quotes

Sunday, August 24, 2008 :: posted by Rick Colosimo @ 9:21 AM