The Ultimate Sin in Business

...is to be unprofitable.

Sure, you'd say, that's your CFO "pedigree" talking, there must be larger sins than this.

So hear me out.

A bottom line (the profit) is easily dismissed as an accounting convention. Cash is king - they say. And it's true! But this accounting convention was not invented for the purpose of distracting cash-minded managers from what really matters. Profit is a long-term indication of a business's ability to turn out positive cash flow. Fail to deliver that and your cash-rich days will be over - sooner than you think.

So, beyond Finance 101, a red bottom line signals a dysfunctional business model. Persisting losses in a business lead to an accumulation of damages to the organization that become increasingly difficult to course-correct:

- the mindset of the organization moves from "who's building what" to "who's avoiding the next layoff round", which leads to high amount of unproductive political actions (lies, deceit, backstabbing) and to a very clear negative selection of personnel - only the weak ones (or whose only skill is organizational survival) are left, since the good ones are more likely to be hunted out of the organization;
- the increasing negative pressure for immediate results, coupled with a weakening control environment and a rationalization of what's acceptable to do in a chronically ill organization will lead to corruption, red tape and other forms of non-compliant behavior;
- beyond people, the asset base (tangible and intangible) will be eroded from lack of proper care and will continue to lose its capacity to accrue economic benefits to the business;
- there is an erosion of creditworthiness as well, which leads initially to higher costs from the supplier base (as everyone prices in the business's inability to pay on time), up to the breaking point of credit default and insolvency.

Some people may push some valid counter-examples, like start-ups - they are not yet profitable. But this may be not because of a dysfunctional business model:
1/ a start-up is a vehicle in search of a valid business model so they may not have found it yet;
2/ or its business model only gets validated at a certain scale

And of course, there's the unicorns, which are heavily-funded start-ups that are expected to prove their business model (and win big) at huge scales. But these are not yet businesses, they are just more sophisticated bets. Extremely few of them pay off big, some of them earn some money back, most of them nothing at all - isn't that the definition of a bet?

Throughout my career as a CFO, I have long been an enemy of waste - not surprisingly, my start-up actively works with visionary entrepreneurs and business leaders in fixing their most important waste baskets (inefficient and manual business processes, ossified enterprise landscapes). The results and the initial take off are amazing.

So isn't an unprofitable business model, just simply, the biggest form of waste? All the money thrown away, all the human talent drain, all the assets blown to pieces?

I believe so, but then how do we repent from this sinful behavior? :-)

There is no universal recipe, but the biggest building blocks are
1/ gain visibility over your waste baskets (how's your controlling, by the way?),
2/ fix the easiest/biggest waste baskets first (which may very well mean scaling back)

and then

3/ gradually heal your business model by putting in place the right people, processes and systems.

Sounds like standard economics textbook? You'd be surprised how few businesses go past step no 2/.

The secret to a sustainable, profitable business is execute 3/ every day so that you don't need to execute 1/ and 2/ every now and then.

Which could probably get translated as more righteous living leads to less repentance :-)

More to come...

Profit Driver #3: FUNCTIONS

“Capitalism has turned human beings into commodities. To the owner of a restaurant: the cook and a bag of potatoes are equally important.” 
~Mokokoma Mokhonoana


Well, of course a cook is much more profitable than the sum of the meals that could be cooked from all the potatoes in the bag (even if they may, sometimes, cost the same... :-) ). And this is because they fulfill radically different functions:
- a cook's function is to ensure quality meals, to manage a team of aides, to come up with new recipes, all in order to secure a repeatable positive customer experience etc.
- a potato's function is to be cooked and served in one single customer experience event.

That is the reason why a law firm will always earn more profits than a construction company with similar headcount - the market pays better for a perceived higher function that drives more value throughout the value chain.

Also, this is the reason why education is expensive - education amplifies a function so that it may earn more for its carrier.


Translating this to a lean start-up world, this gets very difficult to crack. A lean start-up has to make very tough choices not only about the risk priorities, about the assets to build, but also about the best functions to perform.

The original Business Model Canvas captures the function on the left-hand side: the Key Activities and the Key Resources.

The Lean Canvas instead replaces this with a different, more focused approach: the biggest areas on the left side of the canvas are called Problem and Solution. So a clear proposition emerges: split your start-up into a Problem Team and a Solution Team. 

Now, strictly in terms of business functions, Ash Maurya argues that a lean start-up should only employ the 3 most critical ones:
- Development (solution engineering)
- Marketing (customer understanding)
- Design (embeds design thinking into the functions above and makes them "sing" together in harmony)

Not coincidentally, the three quoted functions have the highest profit potential of all functions. Any other support function (finance, administration, legal etc), at the lean start-up stage, should be carried out by the founders.


So, don't start up by stocking up on your cafeteria supplies, by renting out the nicest office space or by buying that ever-present ping-pong table :)

Profit Driver #2: ASSETS

If I collected all the diamonds in the world, I'd have no 'income' but I'd have a lot of 'assets'. Would my company be worth nothing because I have no income? A lot of Net companies are collecting assets. They have to be measured with a new set of metrics.
~Vinod Khosla

Such is the case with a start-up. More specifically, a lean start-up collects a lot of diamonds: these are the nuggets of insights, knowledge and wisdom that are the main outcome of the experiments conducted on their business model.

Everything, in a lean start-up, is targeted at maximizing learning:
- formulation of falsifiable hypotheses
- splitting into problem team / solution team (same thing for the interviews)

The lean stack promoted by Ash Maurya is a very useful tool by which the knowledge gathering process is managed.

Knowledge may be the most important asset in this stage, but there are others too:
- the recruiting process is not merely important, but fundamentally vital - it can literally make or break the start-up;
- the ability to pivot the business model, to continuously weed out potential waste.


One more thing
You may have noticed that I have not included in here the "classic" assets: IT infrastructure, patents, products already designed / built etc.

That is because I believe that, at a start-up stage, such "hard" assets are actually liabilities - they hinder innovation, they are a trap of past thinking and habits, they entice you to reuse sunk (and maybe failed) efforts, they force your solution into an already existing mold.

This is the innovator's dilemma applied to start-ups: you may become captive not to your existing market (because you don't have one yet), but to your existing asset base.

You have to keep pivoting your asset base and you best do this when your asset base is intangible. Your "hard" asset base should, for the time being, stay on your P&L (as a rental cost), not on your Balance Sheet.

Next week, on Profit Driver #3: Functions!

Profit Driver #1: RISK

“To get profit without risk, experience without danger, and reward without work, is as impossible as it is to live without being born.”
― A.P. Gouthe


This first profit driver is a no-brainer for everybody and common wisdom is full of references about risk as an important way of accruing future gains in business.

In particular, start-ups are, by their nature, extremely risky undertakings. If you ever doubt this, try getting a bank loan based on a start-up business plan. Ok, I'm glad we've cleared that up :)

In a start-up, uncertainty is the only well-known attribute: you don't know exactly who is your customer, you don't know what is the actual need of that customer, you don't know how will you satisfy that need, you don't know if your product will ever work, you don't know if your team will hold during the runway phase, you don't know how long your runway really is.

Let's take the possible risk responses according to the T-A-R-A framework:
- Transfer - can you really transfer the start-up risk? Not really. I'm not aware of any insurance policy for this, other than the normal practice of ringfencing the start-up from other profitable endeavours you might have (if possible, protect your personal assets in the same way).
- Avoid - sure, you can simply cop out and forget we ever talked.
- Reduce - you can share the risk by going through seed rounds and accept contributions (cash and advice) from other VC's or investors. Since you know this will dilute your equity, you know then that reducing risk means also reducing possible future benefits.
- Accept - and that's the only interesting scenario that I want to bring up in this blog entry.

Once you've chosen to accept the risk of entrepreneurship, you might as well just manage it!

Strictly from that point of view, the lean start-up methodology is just that: a very smart risk management methodology for start-ups.

Let's just look at the main chapters of Ash Maurya's excellent book, Running Lean:
1. Document your plan A
2. Identify the riskiest parts of your business model
3. Systematically test your business model

If you want to build a low-burn start-up (and who wouldn't?), you have to read Ash's book. This is one book that compels you to take notes as you read it :)

The lean start-up methodology is grounded in the scientific method: you formulate falsifiable hypotheses (i.e. formulate them in a way they can be explicitly negated as a result of experiments), continuously test them (if possible, in caeteris paribus conditions), learn about customer responses from those experiments and seamlessly incorporate them in your next product iteration.

The more you can rinse and repeat this learning cycle, the less risk and waste will be incorporated in your start-ups early life. The lean start-up methodology teaches you to systematically navigate through the start-up's unknowns, discover them and translate them into your unique advantages in the newly discovered marketplace. Your assets.

On Assets (as Profit Driver #2), next week.

A Lean Start-up Perspective On Profit Drivers

Profitability is what makes a company real.
~Elon Musk



When I was still a relatively junior Finance Manager, I have learned from my dearest mentor that, for a business to be profitable, it must have a combination of three key drivers:

RISK
Any business needs to venture in the unknown. There is no money left where the markets have already priced in all the information, opportunities and events. Conceptually, the more risk you take, the greater the return you should expect.

ASSETS
By definition, an asset is something of a long-term value that is held by a business with an implied expectation that the asset will accrue future benefits to the business. Again, theoretically, the more assets you can leverage (and think of assets in the broadest way possible), the more profits you should expect as an entrepreneur.

FUNCTIONS
It also matters what type of activities the business undertakes. The more sophisticated the activities, the greater the likely return. For example - engaging in basic web design will earn you far less than creating a web platform with an embedded network effect.

I will tackle, in the next few posts, some opinions on how to maximize the combination of the three drivers to reach profit as a lean start-up.

By the way, the 3-driver concept is now a major methodology used in international tax planning.