A Modern Marvel: The Funnel
Let me tell you why this $1.19 funnel that I purchased from AutoZone should astonish you. Behind it lies not only a secret about consumer product pricing but also an amazing but true fact about manufacturing.
First, the secret: a consumer product is typically priced at two to five times what it costs to make. Does that mean that most of every sale is profit? No, most of it goes to getting the product to where you’re going to buy it. Here are some real numbers from a project I’ve worked on:
The “Gross Margin” would be profit except that’s the money used to keep the central office running. Administrators were getting paid to keep everything running smoothly, and so was the landlord and also the power company keeping the lights on. Actual profit was far less than that 9%.
Now for the amazing part. Let’s apply the 37% that is “given to manufacturer” to the funnel. It works out to be $0.44. It costs forty-four cents to make this funnel. But it’s not only to make this funnel, it’s also to make the plastic. Imagine you were working at a funnel factory for $8/hr, minimum wage in Massachusetts. Forty-four cents represents 3 minutes of your time. But you’re not really in a funnel factory, so think about this: if I pulled out a stopwatch and I said “Go!” and gave you 3 minutes to make some plastic and press it into the shape of this funnel, could you do it? Three hours? Three days? Three weeks? Three months? Give me three years and I’d probably have a pretty good frankenfunnel, with the price tag printed up all nice, but it still wouldn’t be as good as this. And I’ll have spent a lot more than $0.44.
That’s the amazing but true reality of the world we live in, where you can go from “nothing!” to having a nice funnel in three minutes. And you just have to walk down the street to AutoZone to pick it up.
Landlords Pay No Taxes?
I’ve been writing a bit about technology startups lately. Let me flip back to the other end of the business spectrum — landlording — to share an interesting conversation I overheard recently:
Landlord One: How many landlords pay taxes on their rental income? It’s like no one. Everyone runs at a loss.
Landlord Two: Oh, no, my properties are very lucrative. I pay my taxes.
Landlord One: Then you’re doing it wrong. All of my properties are in separate trusts. My accountant shows me that each trust loses money every year, and if it were any other way, I’d get another accountant.
Let me explain what Landlord One means. Here’s what the income statement for one of his trusts probably looks like (I haven’t seen it; I have no connection to Landlord One):
The “depreciation” in the table above results from the following accounting practice: take the price you paid for the building, say, $250,000, divide that by 27.5 years, divide that by 12 months for our example, and the number you get, $757.58 per month, is how much you can deduct from your income for tax purposes. Repeat that for other “big purchases,” like a new driveway, a new roof, and new furnaces, and you can quickly get up to $1,200 per month in depreciation deductions.
Landlord One is thinking, “This is super. The IRS thinks I spent $1,200 per month, but I didn’t! Haha! That was cash going straight into my pocket!” Furthermore, the $200 per month loss can offset income from other sources, especially a salaried job, per the passive activity loss rule exception. (Sidebar: only the IRS would name a rule “passive activity”.)
The IRS can step in and say, “Your business has been losing money for too many years. We think it’s really a hobby. You can’t use your $200 per month loss to offset income from your job anymore.” As far as I know, this can happen for any business, but I’ve never heard of it happening for rental real estate.
Even if your business is never declared a hobby, there is still one big problem with Landlord One’s line of thinking:
Depreciation is a real expense.
It represents the ongoing capital you must invest in order for your business to remain in operation. Think about a house that hasn’t had any work done on its driveway, roof, or furnaces for 27.5 years. Would you want to rent an apartment there?
Think about it another way, as a function of purchase price. I wrote about this before, where I gave a similar example. If your depreciation is continually outstripping your income, it means you paid too much for your property.
Either way, your “fake” depreciation expense is going to come back around as a real reinvestment of capital. Either the roof will blow off and you’ll need to put a new one back on, making your entire year “cash flow negative,” or you’ll have to sell the degraded property at a steep discount to what the price would have been if it had been maintained.
So go ahead and claim those losses, Landlord One. They’re real.
An Entrepreneur Neither Loved nor Savvy
After leaving my corporate job last fall, I joined up with elance.com, a site designed to help freelancers find work. I submitted 29 bids and got selected once, the one time I offered to work for less than minimum wage. The economics are tough: elance is a global marketplace, so I was bidding with my high hourly rate against folks in parts of the world with much lower hourly rates. Many of those folks have similar skillsets to what I’m able to offer via elance’s framework.
So I stopped bidding as an attempt to make money and I left my profile up as an invitation. I want to meet and work with aspiring new businesses and stay engaged with companies of various shapes and descriptions. Anyone on elance can invite me to bid their job along with all the many others around the world scanning the site regularly.
Here is an actual request (client’s name replaced with the word “Client”).
Now right away, having done one or two sets of startup financials, I can see that it isn’t going to happen for $50. I’ve found that when folks give a very narrow range like this, they know very well what they want to spend. I have two choices:
- Decline the bid with one of elance’s woefully inadequate, unchangeable stock messages, like, “The budget is too low”; or
- Bid something that will fit within budget.
I pick option two, because for me, on elance, it’s all about meeting great new businesses, not making money, not yet anyway. So here is what I bid:
That’s my bid. Pretty tidy and friendly, if you ask me. (Note: I use the word “we” because part of my advertising is, “If I can’t do the job myself, I can find the expert to do it for you.” Also, I’m doing this somewhat like a realtor does it, with a mix of personal trust and business officialdom: my personal image is featured prominently but I’m working under a separate company set up for this purpose. If they want to know more, they can view my profile on the site or reply to that message.)
Here is the first part of a short, increasingly unpleasant conversation that ensued before the client blocked me (yes, they blocked me):
For the record, when I submitted my bid, 19 other bids had been proposed at an average price of $90, a high price of $548, and a low price of $22. It would have been enough for this client to decline or ignore my bid and take one of the several that likely fell within her budget. Instead, she accused me of wasting her time. You’ll recall that she invited me to bid.
(As an aside, let me say that elance could do about ten times better than it does at screening and coaching clients.)
I wish I knew what business she was starting so we could track it, but here’s my prediction: it will fail. In business, you want to be both loved and savvy. If you can’t have both, you need at least one. People who are loved will attract others who will make up for their deficiencies. People who are very savvy make it work even if they’re loathed. So you need one or the other.
I’m going to go out on a limb here and say that maybe this isn’t the first time she’s flown off the handle. So who can she attract to work with her? And it’s not the savviest thing for her to give her financial worksheets – the most important part of her startup planning – over to the low bidder.
Why I Wouldn’t Bet the Farm
How many times have you heard an entrepreneurial success story where the founder took huge risks and won big? It usually goes like this: they took out a home equity loan, maxed out their credit cards, and pitched violently forward into the ditch of debt only to be saved at the last minute by a business miracle. It seems like that’s the way folks become successful.
I was at Boston ENET a while back and I heard a story just like this. The speaker talked about all that debt she had taken on, and all the cost-cutting she had done personally to squeak by. She offered as an aside the tidbit that she had taken a ZipCar to get to ENET that night because her own car had been repossessed.
I think I’ve heard about similar “all in” bets from Elon Musk for Tesla, and Marla Beck for bluemercury.
Some folks don’t quite subscribe to this approach, and I’m wondering whether that will forever consign them to the realm of the mediocre. The alternative looks like this: work a corporate job earning more than you need and save a big cash cushion. Buy one of the zillions of decent businesses out there with established models and relatively straightforward ways to make money from your cushion. Now you’re in some measure financially independent, forever, and you haven’t bet the farm. If you’re going to start a totally new business entity, you can continue this cautious approach and sprinkle in some professional services or other “easy & early” products to keep the lights on while you spool up.
That’s called bootstrapping, and I can’t say it makes for the sexiest story. But then, it’s not very sexy to close up shop, declare personal bankruptcy, and go back to your old job, either.
What the Market Thinks about North Korea
Is South Korea going to be attacked? Well, we can get a sense for market opinion by analogy with World War II.
Back in 2004, Financial History Review published an article correlating market events with World War II events. In particular, they looked at the prices of Nazi German bonds and Belgian bonds. Below is an example of Belgian bonds traded in Zurich. Before the invasion, starting in about 1936-37, the market slowly started demanding lower and lower prices (higher and higher yields) for taking the risk of buying bonds from Belgium. When Poland was invaded in 1939, Belgian bond prices dropped sharply. When Belgium itself was invaded, trading was briefly suspended (break in data), but then resumed at far lower prices (higher yields):
You can read the full article here.
So what’s going on with South Korea’s borrowing? Are investors demanding a high risk premium for buying South Korean debt? The answer is basically “no.” Here’s a graph of yield for South Korean bonds (you’ll have to mentally invert it to compare it to the graph above, which shows prices):
Over the last two years, buyers of South Korean bonds have been accepting lower and lower yields (higher and higher prices). There’s a slight uptick at the very end there, but overall, investors in aggregate seem to be saying that South Korea will be just fine.
But it’s hard to say, especially with menacing North Korean displays like this.
Sam Walton on How to Treat Employees
I’d like to share a surprising quote from the book Made in America, a sort of conversational biography of the founder and manager of Wal-Mart, Sam Walton, who said:
The larger truth that I failed to see turned out to be another of those paradoxes — like the discounter’s principle of the less you charge, the more you’ll earn. And here it is: the more you share profits with your associates — whether it’s in salaries or incentives or bonuses or stock discounts — the more profit will accrue to the company. Why? Because the way management treats the associates is exactly how the associates will then treat the customers. And if the associates treat the customers well, the customers will return again and again, and that is where the real profit in this business lies, not in trying to drag strangers into your stores for one-time purchases based on splashy sales or expensive advertising. Satisfied, loyal, repeat customers are at the heart of Wal-Mart’s spectacular profit margins, and those customers are loyal to us because our associates treat them better than salespeople in other stores do. So, in the whole Wal-Mart scheme of things, the most important contact ever made is between the associate in the store and the customer.
Those words were spoken in 1992 or before. Now 21+ years later, when you think of Wal-Mart, do you think of a role model for collaboration between corporations and employees? I don’t. Take, for example, this New York Times article from earlier this year, which makes a recent addition to a years-long story of Wal-Mart and wage disputes.
Walton goes on to say (back in 1992):
Theoretically, I understand the argument that unions try to make, that the associates need someone to represent them and so on. But historically, as unions have developed in this country, they have mostly just been divisive. They have put management on one side of the fence, employees on the other, and themselves in the middle as almost a separate business, one that depends on division between the other two camps. And divisiveness, by breaking down direct communication, makes it harder to take care of customers, to be competitive, and to gain market share. … Anytime we have ever had real trouble, or the serious possibility of a union coming into the company, it has been because management has failed, because we have not listened to our associates, or because we have mistreated them.
It’s been about a generation since Walton spoke those words, but they seem just as applicable today.
Anyway, if you’re keeping a reading list, Made in America is an easy read that I highly recommend.
For further reading:
Check out my previous post on one way how not to treat employees.
How to Tackle Someone in an Elevator
I’ve been going to meetings for the Boston Entrepreneur’s Network for a while now. I like the group a lot and have found the meetings to be very well moderated and timed. (This is a big deal for me; it means I know the guest speakers have had a chance to say what they wanted to say. Hearing them is the primary reason I attend.)
Last night they had three real VIP’s: two partners at venture capital funds and one director of an angel fund.
I laughed at Art Fox’s presentation. He gave a formal introduction about the kinds of things he looks for at a startup (passion and enthusiasm, intelligence and expertise, honesty and integrity, people skills and likeability). He summarized this introduction by saying startups were about three things:
- Management
- Management
- Management
Later on he plugged Toastmasters. He said they had helped him get over a stutter. His slide said, “Practice, practice, practice.” To which he added, “I still like saying things three times.”
After the meeting, the speakers were swarmed, as always happens. There was no chance I was going to fight my way in, and I think it’s rude, anyway, especially when they just gave two hours of their evening to the audience. So I talked with a few folks I had known from previous meetings, then headed for the elevator.
One of the speakers had escaped the throng and was hurrying — smiling, professional that he is, talking to everyone who assailed him — in a harried way towards the elevator. He got in, dragging the crowd with him. I got in after the speaker and plugged the entrance, which closed on the crowd, the speaker, and me in the elevator. I handed him my card, on which I had scrawled “business plan/exec summary,” and offered that if he wanted to give me feedback on the one-pager, I’d greatly appreciate it. He asked what I did and I gave him — wait for it! — the 10 second elevator pitch.
Smiling and waving, he sprinted out the doors and into the night.
Usually this “write on the card, let them escape” tactic works decently, because you haven’t been too pushy. I’ll let you know how it goes.
A Month in the Life of a Landlord
In Massachusetts, residential rentals are highly regulated. To do it by the book, you need to have a non-discriminatory tenant finding procedure, an apartment that meets requirements for the sanitary code, no lead-based hazards, and a rental agreement that could stop bullets. You also need to have a nice place, an attractive ad, a responsive person on your end of the phone, and someone to show the place to prospectives. So how much does it all cost?
I recently tried to answer this question by tracking my time as I went through the whole process myself, from explaining the move-out procedure to the current tenants to welcoming the new tenants and opening their security deposit account. The goal was to rent a three bedroom apartment. The rent was at or below market. The advertising started off-season in February. Here’s what it looked like (these are scanned excerpts from the paper log that I kept):
The total time from February 2 through when I opened the new security deposit account on February 26 was 47.3 person-hrs. Basically, add up the times in red, and if I had to have someone helping me (like on February 6) count that time twice.
Some highlights:
- February 2:
- First of all, note that regular landlording stuff is not separated out, like when I dealt with a 3am emergency call about a neighborhood disturbance. That almost never happens, but I left it in for color.
- Craigslist is great. It saves your ad from the last time you posted, so it took me about 18 minutes to check it over, tweak it, and get it listed again.
- Nothing interrupts your day like calls about an apartment. The average call lasts just a few minutes while I collect pre-screening info. You can see that on the day I posted my attractive ad, I started getting calls immediately, from 9:30 to 10:12, and so on, and again on the 4th, the 5th, and so on. The true cost is more than just the phone time because it interrupts what you were otherwise doing.
- February 4:
- It took me about two and a half hours to get my lease agreement up-to-date. The changes I made were things I had queued up from my reading and my learning best practices from my property owners association, and also from some changes in the law.
- Starting this day, it took me about five hours spread out over several days to repair some wall damage to the otherwise pristine apartment. Don’t let tenants put stickers on the walls.
- February 6: The final deleading inspection for this unit and one other (the work for which was completed before tracking began) took two people nearly four hours. All totaled the deleading cost me well over the $1,500 tax credit for this unit.
- February 12: Starting here, I spent about three hours reviewing tenant applications. (I also experimented with a wireless doorbell that I ended up returning.)
- February 16: Here’s when I made the decision to rent to one set of prospectives. Note that I also had to buy a change of locks and make a repair to the rear exterior door jamb.
- February 20: Having made the decision to rent, I went on landlord vacation. I dealt with about 18 minutes of calls while “off duty.”
- February 25: I spent almost three hours split between the previous tenants (itemizing their security deposit deductions) and the new tenants (explaining the rental agreement).
- February 26: My bank was terrible that day. It took me almost two hours to see someone and then set up a new security deposit account.
- February 27 and 28: I guess I didn’t write down what I did here. Just another 1.6 hours somewhere…
Fortunately, any given apartment isn’t likely to be vacant in a month, but when it is, you can expect to pay quite a lot to do it “by the book.” If I paid an employee to do all this at $22/hr, that’s $1,040, or by orders of magnitude, a month’s rent. So that’s where a property manager’s fee goes. Plus I had the added non-recurring expense of a deleading, plus the lost income.
So when you do get a tenant, be good to them and hope they stay a while.
The Surprising Math Behind Startup Dilution
This recently blew my mind, so I thought I’d share some simple math with you.
Imagine an investor wants to invest in your startup. He says it’s worth $1 million and he wants to invest $500,000. He’s going to take half your company, right? Wrong. He’s going to take one third. At least, that’s the usual math.
In publicly traded stocks, it works the way I’d expect. If I buy $500,000 worth of stock in a company with a capitalization of $1 million, I’ll own half the company. That’s because my stock came from other stockholders. My money went to pay out existing owners.
In the startup world, that’s very unusual. All the old money has to stay to keep the business alive. There’s no “capitalization” yet, not in the sense of capital sitting there doing its job. So when someone invests in your startup, they don’t buy shares from existing owners. They add to its value.
So in the example above,
Don’t believe me? Think about it in terms of share price. Say you have 1 million shares. A $1 million valuation divided by 1 million shares = $1/share. The new investor buys 500,000 shares in your company at $1/share, equaling his $500,000 investment. You create those shares by issuing new shares, rather than by selling him existing shares. Now there are 1.5 million shares out there, and he owns 500,000. So what does the investor own? One third.
Banned from the USA
So this young businessman named Nick remixes a Disney movie with their permission, and US Border Protection decides that the US wants none of that. So they deport him, and they put his name into the computer so that he won’t be able to get back in for ten years. I’ll let you hear the deportee tell it his way:
The truth is, if I could vote on which would-be immigrants to let into the US, I wouldn’t be voting against remixers. Nor would I vote against scientists, entrepreneurs, or any other ambitious person. Just think if Andrew Carnegie’s father had been deported! That’s why bills like the Startup Visa are important steps for the US.
To end on a positive note, check out one of this deportee’s “crimes”:
