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by Alnoor Bhimani, Founding Director of LSE Entrepreneurship and Professor of Management
Accounting at the London School of Economics.
In this new book, published at the beginning of this month, Professor Bhimani makes the case that technology companies are different from traditional manufacturing or services companies, and should approach financial management in a different way.
In this context, ‘technology’ means IT (information technology), or even more specifically software, although there are examples in the book from other sectors – one is a manufacturer of iPhone plugs. Throughout the book the author gives detailed worked examples from well known companies, mainly well established US companies such as Microsoft, Facebook, and Apple, but including others such as (nearer home) Iomart, and companies in Denmark and Australia.
Observing that technology is enabling new business models, the book begins with an analysis of why technology companies are different. Traditional industries tend to have a linear progression, turning materials into products sold to customers. Customers for technology companies are often not the same as consumers. There are many business models where the consumer pays little or nothing, and the paying customer is the organisation which needs to reach these consumers – Google is one example. This leads to networks and what the author calls “channels of exchange” being at the root of value creation for these companies. This ultimately leads to markets where “winner takes all”, and this theme is developed throughout the book, for example when discussing with calculated examples how two competitors in a software market can have extremely different revenue growth despite similar fixed and variable costs at the outset.
This means that it is vital for technology companies to decide on an appropriate business model, which enables the business to ”differ across costs, volume, and value creation dimensions”, and there is a helpful chapter setting out the issues involved with plenty of real world instances. The necessity of learning from the market and being prepared to pivot the business model is emphasised here and elsewhere in the book.
In chapters discussing the ‘financial control loop’ for technology companies, the book covers the usual accounting and reporting concepts. The first of these chapters, on ‘contribution analysis’, describes fixed and variable costs, and achieving breakeven. The second, ‘financial analysis’, covers the usual financial statements (balance sheet, P&L, cash flow), and the third, ‘progress analysis’, sets out the metrics which companies use to measure progress, including ratio analysis.
Against this background, the book goes on to discuss many aspects of financial management, including pricing in a market where there may be high development costs (often sunk fixed costs) but low variable costs, and what strategic options this might open up. It also focuses on the importance of cash control, quoting CB Insights research which states that shortage of funds is the second most important reason for company failure in the technology sector.
Although many of the worked examples, eg of ratio analysis, are based on established companies, the author is well aware that start-ups have their own issues, in particular when they are pre-revenue. A series of chapters proceeds from setting out a cash budget, to discussing the various ways of securing funding. After discussing options such as boot-strapping, grants, business awards, and debt finance (and their pros and cons), a major section of the book covers equity investment.
This section describes the different types of equity investor, why they invest and the vehicles they use, and gives advice on interpreting term sheets (including a complete example). It also addresses the question of deep interest to company founders – how much equity should be released to investors, for what valuation? The section (and the book) close with a consideration of returns from the business, and exit strategies.
The book covers a wide range of situations in great detail, but some ‘local difficulties’ in the UK are not covered. For example, there is an excellent description of how business angels use convertible debt to finance early stage companies, with the conversion triggered when a VC or other institutional investor completes a series A investment round; this is less usual in the UK, where angel investors typically use ordinary shares in order to qualify for EIS relief. Also, although the book rightly points out the traditional trap of overtrading, where a business looks profitable but is unable to manage the cash to sustain growth, companies which can achieve early payment on long term contracts (which is true for many technology companies) have the opposite problem – they are cash rich, but because the profits from the contract must be spread over the period of delivery, they can have trouble explaining their profitability to investors unfamiliar with the accounting requirements.
That said, the book gives a thorough insight into the financial management practices which technology company founders need to know about, and gives examples which will be encouragingly familiar to those with little previous financial experience.
- Jonathan Harris
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