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Smart Metrics and Dumb Metrics

Posted on November 16, 2014 by John F. Dini

“We doubled our profit over this month last year!” When I visit a coaching client, that’s a pretty exciting opener. Of course I want to know how and why. Too often the answer is “Well, last year this month had three payrolls,” or “We had two more working days than last year.”

If you have to explain the circumstances of a measurement, it’s a dumb metric. “Manage what you measure” is a pointless axiom when the thing being measured isn’t consistent. If your results vary because of circumstances beyond your control, how can you manage them?

In my most recent book Hunting in a Farmer’s World, I discuss the problems created when we stick to a farming calendar created centuries ago. Few industries (other than agriculture) actually function according to a twelve month cycle, but most continue to measure their results that way.

In the hospitality industry, a thirteen month year makes far more sense. Business volume is higher on weekends, and having a consistent number of weekends (four) in each cycle simplifies comparisons. Other companies in manufacturing and distribution pay attention only to quarterly results, because 13 week periods are far more consistent than 19 to 22 day months, which vary depending only on when the first day falls.

In a cyclical industry, such as those related to capital goods, an even longer cycle makes sense. Comparing numbers over a rolling three or even five-year period permits better analysis of trends and market share.

The whole concept of Key Performance Indicators (KPIs) requires that you compare between like things. The availability of big data allows it to be easily confused with actionable information. If 12% of my customers purchase a side order of Brussels Sprouts, and 23% order a Tiramisu, what does that tell me? Nothing. If 12% order the sprouts and 40% want the French fries, I may have information on which to base my menu design.

Useful business ratios don’t begin with the numerator (how many, how much), but with the denominator (of what?). Profit dollars, number of orders and labor costs are pretty useless data by themselves for comparative purposes . Margin percentage, closings per lead, sales per day and output per hour are critical management information.

If you are still reviewing your monthly P&L by mentally adjusting each month’s variables, you are wasting precious time. A twelve month cycle is required by the IRS, but that doesn’t mean you need to run your business by it. Choose ratios and periods that allow real comparison. Only those are smart metrics.

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One Response to Smart Metrics and Dumb Metrics

Steven Bankler says:

November 16, 2014 at 9:57 am

>>A twelve month cycle is required by the IRS, but that doesn’t mean you need to run your business by it.<<

While technically correct, IRS does allow 52/53 week years, which includes 13 – 4 week months!

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The Luxury of No Resources

Posted on November 9, 2014 by John F. Dini

Among the Baby Boomer business owners who are beginning to plan their retirement, there are millions who founded the companies they plan to sell. Many of these were technicians when they started. They began as employees, and then used their skills to start a small business.

When you are bootstrapping a new business, there really isn’t much opportunity to make big mistakes. You can’t afford it. The “luxury” of no resources can be described in two ways. You don’t dare take the risk of betting everything on one course of action (because a wrong decision kills the business) and you simply lack the wherewithal to try anything, no matter how enticing, in a really big way.

For most startups, that means the owner undergoes a process of trial and error through low-risk experiments. Advertising is limited. Hiring is cautious. The first option for any new skill required by the company is usually the owner. He or she learns how to do everything in the business, because it’s too expensive to pay someone else to do it.

Of course, most small businesses fail in their first few years. The business school explanation is that they are “undercapitalized.” The practical translation is “They have no money.” They lack the resources to hire highly skilled employees, or for aggressive marketing. For many that shut down, “undercapitalization” means simply that the business failed to generate enough money to provide the founder with a living wage.

Owners with sufficient creativity, tenacity and vision make it and grow an enterprise. Their experience in low-cost, trial and error experimentation becomes part of their skill set. “Good decisions come from experience; experience comes from bad decisions.”

Thus, many technicians grow gradually into the role of business owner. A few bad hires at low wages prepare them for better decisions when taking on more skilled, higher wage employees. They can oversee all aspects of the operation, because personal experience with sales, marketing, and accounting gives them a broader knowledge base than just the operational skills they started with.

For any subsequent owner, this “Trial by (small) fire” approach to learning the business isn’t feasible. A successful business has too many moving parts to permit a gradual, start-from-scratch approach to building an ownership skill set.

Whether a retirement strategy involves transition to employees, family, or a third party, the first step is documenting the owner’s knowledge base. Expecting new ownership to simply “know” what to do isn’t reasonable.

My 48 page eBook, Beating the Boomer Bust, How Baby Boomers Changed the Face of Small Business in America, and Why it isn’t Over Yet, is available as a free download here. The password is “Woodstock.”

Posted in Exit Planning, Thoughts and Opinions | Tagged Baby Boomers, Boomer Bust, business ownership, business planning, business strategy, entrepreneurship, exit planning, exit strategies, hiring, management, selling a business, small business advice | Leave a comment

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Key Man Policies May Not Cover a Buy/Sell Agreement

Posted on November 2, 2014 by John F. Dini

Over the last few weeks, I’ve had a number of conversations with clients about key man insurance. Let me say at the outset that I don’t sell insurance, and have no financial stake in whether any client has coverage or not. The use of such policies, however, may not always fit their intended purpose, especially in smaller companies.

The most common intended purpose of a key man policy is to fund a buy/sell agreement. The benefit payment goes to the company, which in turn uses the proceeds to purchase ownership from the family or estate of the deceased. If it works that way, it’s an excellent planning tool for your family’s security, but there are a number of things that can get in the way.

To begin, the company probably needs the money. If they are scrambling to replace you in the business, partners may be reluctant to part with a cash windfall that can keep them going. In most cases, the insurance company’s responsibility ends when payment is made. The buy/sell is a separate agreement, and enforcing it may require legal action by the bereaved family. In the meantime, the cash is being used elsewhere.

Surprisingly, some policies are in place to buy out a sole owner. A company can’t own all of it’s own stock. Someone else has to have at least minimum ownership, since treasury stock (repurchased by the company) has no voting power. If the buy/sell was put in place for former partners, you may want to revisit both the shareholder agreement and the policy.

Finally, there is the small matter of company debt. The absence of the principle credit guarantor (which applies to most majority owners) will trigger repayment clauses. Lenders are in the business of mitigating loan risk, and credit agreements likely give them first call on any available funds. Unless the company remains on a strong footing, with another guarantor who can step into the primary role, the insurance payout might not be available to either the heirs or the business.

There’s one additional area where the objectives of a key man policy and a buy/sell agreement may not meet. That is in long-term disability. Because most buy/sells lump repurchase terms for death and disability together, many owners forget that the insurance only pays in the first event, and has nothing to do with the second.

There are many approaches to obtaining coverage to secure your family’s financial well-being and/or the sustainability of your business. Although I’m an exit planner, that world of split premiums, whole and universal life, insurance trusts and other, far more arcane structures makes my head spin. All I can advise is if your current broker advertises “auto/home/life” he is not likely the kind of specialist you need. Find someone who is experienced in reviewing shareholder or partnership agreements, and who can tailor a product for your requirements.

Thanks to all the readers who responsed to last week’s survey on energy costs. Just under 69% said either “Falling energy prices are good for my business” or “rising energy prices are bad for my business.” Of course, 14% said the opposite, which just proves my point.

Posted in Entrepreneurship, Exit Options, Exit Planning | Tagged Baby Boomers, banks, Boomer Bust, business ownership, business planning, business strategy, entrepreneurship, financial, selling a business, small business advice | 7 Comments

7 Responses to Key Man Policies May Not Cover a Buy/Sell Agreement

Frank Benzoni P.E. Retired says:

November 2, 2014 at 8:56 am

John

Another “Wide Awake Article” – To be advised is to be prepares, and you continually do that.

Always look forward to the next !!!

Thank you

Frank

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Brad Elmhorst says:

November 3, 2014 at 8:39 am

John,

Agreement that key-man insurance policies should be separate from buy/sell – ownership agreements. Having lived through the unexpected loss of two employees, I would encourage small businesses to look beyond ownership when considering key man insurance as part of their disaster planning process.

Brad

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Mike says:

November 3, 2014 at 10:49 am

Another type insurance to consider is whole life purchased using Section 79 Insurance.
Allows the company to pay for the insurance ( deduction to the company) owner pays tax on only part of cost, however beneficiary is the stock holders estate ( or wife) .
Company pays for policy , stockholder owns and benefits from it directly.
Can tied funding this to some part of stock valve in the future.

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RICH FREELAND CBC says:

November 3, 2014 at 8:17 pm

John- My 43 years in the life business has taken me into many areas of practice. The usual KEY MAN POLICY is usually designed for one purpose only.It is to cover the loss of a “Key Man” such as a top salesman that brings in more than 50% of the companies business or an engineer or project manager that a company could not operate or complete a job if they should die. Buy and Sell agreements are usually to cover owners , partnerships or corporations for death or long term disabilities to owners or stock share holders to keep the business from imploding or having to deal with non producing spouses or minor corporate owners.All these plans should be drawn up by a law firm that is experienced in Business Law! not Legal zoom! The last thing is making sure that the agreements are funded with the proper products to meet the contracts specifications in the B&S agreement. I would shy away from Sec 79 plans in funding these agreements and look at the latest IRS rulings on SEC 79 use in business insurance? Comments Welcome! RICH FREELAND CBC

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- John F. Dini says:
  
  November 4, 2014 at 5:25 am
  
  Thanks Richard. I agree that key man policies should be used for critical employees as well. I know dozens of companies, however, where key man covers the owner, who does not function in a sales or client management role, and the owners’ belief is that the benefit will be used to purchase stock from their families. As to the applicable IRS codes, you illustrate my point that such instruments must be carefully constructed by a professional such as you.
  
  Reply
Todd Marquardt says:

October 7, 2017 at 8:21 am

A key man insurance policy is different from a buy sell insurance policy. You hit the nail on the head. The purposes are different.

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Thomas says:

August 14, 2018 at 8:00 am

The trick is to get the business owner to planning table. In my 34 years of selling life insurance and disability insurance there is a significant resistance by small business owners to approach the topic. The vast majority of small business owners do not have these plans in place. It is even more critical for family businesses. I completed a large plan for a family business in 2004, the business was started in 1946. Good luck to all the life insurance purveyors out there. It’s a mine field.

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“Tis an Ill Wind…

Posted on October 26, 2014 by John F. Dini

…that blows nobody good.” That old sailor’s proverb, first recorded in 1543 and further popularized by Shakespeare in “Henry VI” in 1623, is as plain today in its meaning as it was almost 500 years ago. Anything that is bad for someone is probably good for someone else.

It’s especially true in business. The failure of a company is a terrible event for its owners, employees, vendors and customers, but clearly offers opportunity to its competitors. A hurricane is rightfully characterized as a disaster, but it may not be such for contractors or lumberyards. Droughts are bad for farmers and ranchers, but generally benefit beach resorts. The effects of Moore’s Law place ever-increasing margin pressure on vendors of computer equipment, but the rest of the business world benefits from enhanced productivity.

Energy costs are one of the most far reaching examples of this dichotomy. Oil prices (at 85% of their foreign exchange) have propped up the Russian economy, despite sanctions over Ukraine. If they fall too far, it may destabilize the situation in Eastern Europe much further. Despite that, thousands of businesses would celebrate the savings from decreased transportation and chemical costs.

Natural gas prices have recovered from their lows of early 2012, but remain far below the averages of the middle 2000’s. Producers frequently flare off the gas from oil wells, rather than try to take it to market. The gas producers want to convert LNG importation facilities for export, since prices are far higher in Europe. The chemical producers, enjoying cheap feedstock for plastics and fertilizer, want the plants left alone. Local governments on the Gulf Coast stand back, afraid of offending either large-employer base.

What effect do swings in energy prices have on your business? Please answer my one-question survey here. No respondent information is collected, and you can see the current results instantly.

Posted in Thoughts and Opinions | Tagged business strategy, economy, politics, small business advice | Leave a comment

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When Employee Incentives Don’t Work

Posted on October 19, 2014 by John F. Dini

My definition of an incentive is variable compensation designed to encourage specific behavior. The challenge is to make sure that behavior is really something you want to encourage.

A home building company bonuses purchasing managers based on their ability to reduce the cost of construction. Not surprisingly, those managers negotiate aggressively to lower bids from subcontractors. The lowest bidder frequently wins the work with a price that is a few hundred dollars per home less than his competitor.

Unfortunately, in one case the lowest bidder is a firm that is notorious for falling behind schedule. They frequently delay the closing by two weeks or more, at a carrying cost to the homebuilder of about $150 a day for the delay. Despite the cost, the purchasing manager continues to award the subcontractor new work. Why? Because the manager’s bonus doesn’t consider the complete scope of building costs, but only direct construction pricing.

A Wholesale Distributor compensates salespeople on total sales. He also instructs them to never lose a deal to a competitor because of price. The salespeople regularly sell products at a margin that doesn’t completely cover costs.

A provider of home security services scales compensation based on each salesman’s ranking at the end of the month. The company also promises installation within ten working days of purchase. Every month there is an influx of sales as month-end approaches. The first two weeks of the next month require substantial overtime among the installation crews to meet the guarantees, although those same crews are frequently idle during the last half of the month.

As you read this, it is natural to say “That’s easily solved, Just change this, or stop doing that.” In fact, that kind of objective viewpoint is one of the primary benefits of the peer groups we run in The Alternative Board®, and is frequently the first level of value I deliver in my consulting and coaching practice. “Why are you doing that?” is sometimes surprisingly difficult for an owner to answer.

Usually the response is “Because it works.” The definition of “success” in these cases is that the employee is engaging in the behaviors expected. He or she is selling more product or cutting costs. The owner is afraid of what will happen if the incentive is changed. Will expenses spiral out of control? Will revenues plummet?

Adding conditions to existing plans (“You can now meet price only as long as it isn’t below a certain margin.” or “You can hire a low bidder only if his job performance record is satisfactory.”) is inevitably perceived by the employee as restricting his or her ability to maximize the incentive, and often leads to gaming the system.

Incentives are an ongoing balancing act between what is best for the individual and what is best for the organization. When the results don’t serve both parties, they have to be restructured. The short-term impact of a disgruntled employee is more than offset by the improvement to organizational health.