In this series I want to talk about the new role of the CFO in the modern enterprise. And we will do so by talking about start-ups. Because start-ups tend to have more freedom in doing things the right way. We start with the topic of capital allocation.
So before entering into a deeper discussion on capital allocation, let’s start with the very old basics that every CFO must be able to handle.
- He must be able to budget. And he must be able to control the budget. Simple.
- He must be able to account. And must be in charge of accounting practices.
- He must be able to make payments. And handle all that working capital stuff.
That is a basic framework everyone will agree upon. But let’s redefine these objectives.
- He must be able to budget for the best outcome to the company. And must be able to identify if the targeted outcome is actually achieved via controlling.
- He must be able to account for the proper operating model of the company. And change the systems of reporting and accounting in such a way as to best reflect the operating model.
- He must be able to control the freedoms within the organization as such that he is capable to optimize working capital, balance sheet, cash flow and other items in a way that it steers the company in the right direction.
All this also pretty much is simple and agreeable. It goes without saying, that this view requires the highest form of integrity and we are assuming away all the mechanics and hacks that a CFO uses to pump certain stakeholder opinions from achieving tax cuts, to blinding investors and so forth. That is a different game that the CFO also must be willing and able to pull off, but let’s ignore it for now.
The big impact from (a) the responsbility of outcome, (b) the proper collection and analysis of data as to understand the operating model and drivers of the business. The 3. part is not as important right now. So let’s go deeper into (a) and (b).
The two core new objectives
The objective (a) is that of being responsible for outcomes. It no longer is sufficient to simply look at available cash and historic records and create a budget and ensure it is met. The new CFO needs to :
1. Be a risk taker in such a way that he must put the company at risk if that is what is required to drive the growth of the organization. He must be more radical and insight-driven when defining a budget – not every cost center is a flatline forward – and must create budged sizes that might be unhealthy for the company while still keeping spending in total in check, and he must be willing and able to throw the budget under the bus if change requires changes.
2. He must take the view of the investor in a company. He must be willing and able to cut down the budget for everything that does not work out and does not provide sufficient evidence that this issue is being solved. He also must put more money into the areas where it is really needed. That still sounds like standard budgeting. But the new CFO must do so not upon request, but under plausible belief and reasonable evidence that the multiplier on every dollar invested into a particular area must be sufficiently optimal.
In other words:
– He does not put money somewhere because it always was done this way.
– He does not put money somewhere because someone told him that is where to put it.
– He does not put money somewhere just to fully allocate his available funds, but where
he has full conviction that the impact is there.
So the mind set of owing anyone any budget and money is dead. The time where the CFO is not able to tell exactly what the return on the investment is on every dollar into a particular branch must make him nervous. It is his “risk taker” part that might go for it, but every such allocation is the result of not having set up the data environment necessary to base his allocation of capital to – let’s say marketing – measured past results. And last, but least, he really does not need to allocate money to something that is not working. He can as easily retain earnings and force the unit to come up with more reliable data at lower rates.
To give an example of a company. The CFO has to determine the marketing spending for teh entire year. He is understanding that metrics to support the decision are not there. He is also understanding that allocating budget to this area is highly relevant to the business. So far so good. But he must, at the same time, pull the plug on every marketing budget if his core belief and data he is provided suggest that the impact of the marketing spending will be low due to the leads generated via the marketing effort not going anywhere, either because the sales or marketing organization are not able to drive the incoming leads through the funnel. Or because the product is not ready to sell to the new market.
This new responsibility for outcome of allocated capital requires the new CFO to master two things: (1) efficient systems that enhance the data-drive in a particular business function to a level that he can have a sound picture and view on whether to allocate money or not. And (2) a thorough understanding of the business and all activities and statuses within the system that warrant the successful lock-in on the desired ROI to a function X if the company ROI is depending on an event or process chain that spands from P to Z. So he must know the organization qualitatively, understand it qualitatively, and must build the metrics that help him decide on where to allocate capital and where to not do so.
Controlling has become a B.I. and analytics part. And budgeting a process that requires a thorough and deep analytical and qualitative assessment of the the progress of the organization. He no longer can hide in numbers. He must be head-to-head with the CEO and COO and other functional managers of the business.
The objective (b) is that of being responsible for the operating model. The operating model is the most reliable and trustworthy accounting-based representation of the company success on its mission to gain shareholder value.
The operating model has a few very relevant, but also very simple aspects. This is described in more detail in the series on business models in the Entrepreneurship > Series > Business model area.
In principle, the CFO has to :
1. differentiate between the going concern spending of the business and the non-recurring business more radically than in general accounting,
2. Move everything related to sales, retention, growth and COGS under the revenues and above the net revenue item of his P&L, and do this exercise for every product-segment combination (read the segment definition in crossing the chasm).
3. Ensure that all product-segment combinations are net contributors to net revenue and the best mix of product-segment combinations are chosen given resource constraints,
4. and make sure that net revenue is paying off the recurring items below net revenue which may contain SG&A, R&D and CAPEX/D&A and more.
Forming the operating model like this makes the goal of the CFO very easy.
1. He has to evaluate every non-going-concern / non-recurring spending based on its impact on the recurring items. Capability increasing or enabler spending is okay, the rest should not be done. (This is taking out non recurring items from the business model)
2. He has to ensure that the net revenue reducing spending [aka NRRS] (includes COGS – Cost of Goods Sold, COS – Cost of Sales, COR – Cost of Retention, and COG – Cost of Growth) divided by the customer lifetime value is smaller than one for every product-segment combination. (this is the infamous CAC-TLV ratio or “product-market-fit” validation question when you look at it a bit more honest than merely looking at vaguely defined CAC).
4. He has to ensure that the recurring parts or going concern parts of OPEX are covered in foreseeable time – after a spike in cost of growth and investment into the other income reducing spending items – by the sum over all net income coming from all product-segment combinations. (That is the classic business model validation question)
And 3. He has to make sure that given resource constraints and competitive forces, the company is focusing on the most attractive product-segment combinations the company can attack given its resources.
This goal is pretty much universal and structures the P&L in a meaningful way. The hard part is setting up the measurement and controlling instruments to assess the per-dollar elasticity of OPEX on the NRRS positions and the per-dollar elasticity of the NRRS positions on revenue and understanding the investment cases of non-recurring initiative spending on driving these elasticities.
The scope of action
Now the above still sounds like a standard enterprise CFO kind of work case. But we said we look at start-ups. And we also said the difference is the freedom of scope. What is freedom of scope?
The freedom of scope can be found for example in hiring. Are you hiring your top A.I. guys from the top A.I. centers in the world or somewhere else? What are the ROIs and the relevant elasticities in the short run – per FTE output for instance and time to maximum productivity per FTE – and mid-run – cost of communication overhead and mythical manmonth issues when trying to scale an R&D organizations. But it is not only a cost game, it is a raise to the moon or execution velocity question. Your first 19 months of R&D in this sector might make or break the going concern or market penetration of your organization. And if this is the case, and the cost of a prime R&D hub is 10 times that of a tier 3 hub, then it is exactly the CFOs responsibility to understand the risk-reward issues in this decision and ensuring that the proper vision is formulated and – talking start-up – the appropriate amounts of funds are being raised.
That freedom can also entail the decision of direct or indirect distribution on the sales channel. A solid business case may warrant under time-pressure and market forces conditions that instead of doing a soft landing in a remote industry or geography using indirect / partner sales, the organization must scale up internal resources to maintain velocity. It goes without saying that this also has a substantial impact on the velocity and penetration rate and cost of acquisition of a geography or industry. In this case, it is again the CFOs role to not only sell the different scenarios in an advisory role to the management board of the company, but to outlay the risk and reward mechanics to potentially risk-averse investors. That role stops, of course, at the boundary that the execution capability the management team and organization has. The CFO hence not only must understand optimal allocation in a very wide area of options, but must be able to assess the current capability of the organization.
At the same time, the CFO makes a material mistake in his function if he understands the capability of the organization as exogenous. If the strategic positioning and long-term survival of the organization is materially affected by such decisions, the CFO, alongside other executives in the company, must clearly understand the value at risk of any option compared to another and must identify viable options of remedy, if a capability gap is an issue. Talking value at risk, this clearly sits in the realm of the CFO to measure and quantify the financial impact of chosing the wrong direction due to capital restraints. And it it goes without saying that the CFO fails, if he can not convince investors and his other executive staff in pushing into the right direction.
The scope of action for a start-up CFO is so much wider, because there is no legacy and lock-in effect holding the organization back. Which brings us to the understanding that the CFO must understand the global arena of resources available to the company very well and must be able to influence the key stakeholders to understand and properly account for the options and choices available.
So what is capital allocation
It might stem from the fact that I myself enjoy investing since I am quite young and I enjoy allocating my capital for outlandish return opportunities and high risk high reward investments, but for myself investing private money into foreign entities or trading opportunities is not much different from allocating capital to different areas of a businss in the role of a CFO. It is only natural to understand the CFO role as that of an investor.
But it was likely more the recent reading of William Thorndike’s Outsiders that left me with the absolute conviction that value investing in the Graham way us not in any sense different than operating and financially allocating capital within an organization.
Thorndike’s book writes succinftly about those cases where CEOs that were in essence investors into their own company and took that financial view of capital allocation to the extreme created unparalleled returns for the companies they ran. Plus this goes hand in hand with my understanding of why private equity funds exist to this day.
If one re-thinks the roles within a modern organizations and one understands the very clear goals and responsibilities of the CEO and the important role of the CFO as a primary financial markets and value focused companion, it is only natural to assume that the role of the New CFO – among other things – is that of being a strategic allocator of capital. Alongside the CEO, advising the CEO and taking over the responsibility of the CEO.