Guest Post by Dan Murphy
How Direct Selling Companies Can Conduct a Straightforward Financial Tune-up

Anyone who is a veteran of the direct selling industry generally loves the industry. This is one of the few business models where you can do good while you do well. Executives have the honor of offering an opportunity that has the potential to change people’s lives for the better. It is also a responsibility to make sure that the opportunity remains viable over a very long period of time.

For this reason, I find it necessary to conduct periodic financial reviews for direct selling corporations, to safeguard a company’s position and to ensure its long-term success and viability. I’ve conducted dozens of these reviews over the years, and I’ve never once had a review not results in a significant positive results to the bottom line.

I’m also always surprised at how many direct selling companies do NOT go through this exercise of what I call a financial tune up. So that’s why I want to introduce the concept to you in this article.

So what is a financial tune up? It is a detailed review of the Key Performance Indicators (KPIs) of a company, as well as a review of the various financial cycles. KPIs include the metrics that result in revenue and growth within a direct sales company. Financial cycles include Revenue, Inventory, Margin, Freight and Distribution, Information Technology and General Overhead.

A complete review requires a session of key stakeholders with the organization over a period of typically about two days, provided the proper historical and current data has been assembled in advance. The goal is to examine KPIs and each cycle to determine if industry standard benchmarks are being achieved or exceeded, where there is a gap, and determine steps to achieve or exceed industry benchmarks.

This is a very disciplined approach, but it pays off in the end. You’ll find that over time certain assumptions have been made which are actually excuses for suboptimal performance. Some of these assumptions could be:

• Our customers will simply not pay freight rates equal to our costs so we subsidize lower freight rates in order to grow the business.
• Once we achieve scale we will be able to purchase products at lower costs allowing us to achieve profitability. Until then, we will lose money.
• The current overhead is a long-term investment that will help us grow rapidly once we hit break even.
• The KPIs will improve if we could only find a good field development leader to run our sales efforts.
• Yes ,we have a competitive compensation plan which we copied from (insert current rising star company here), but the margin in our products less the payout of the plan doesn’t produce adequate dollars to support even minimal overhead. How does Company X do it and we can’t?
• You don’t understand, we are not like any other direct selling company. We are unique and the industry standards just don’t fit us.

 
These are simply a handful of the statements over the years that I have heard executives make in support of the current status quo. If you believe and hold tightly to any of the above statements, as well as any other number of excuses, performing a financial tune-up will be a waste of time. If you are ready to examine honestly every component of your business that you will find great benefit in going through this type of exercise.

So let’s get started: Step one is the review of all KPIs. First, do you have KPIs? Many companies I work with know what KPIs are, but they don’t actually have them in place and track as a way to manage their business. Examples of KPIs include the sponsoring rate, the retention rate, activity rate, orders per active, average order size, paid as leadership statistics, reorder rate, auto-ship average life, fast start achievement rate, performance of each months new consultant class, event attendance, % of attendees that actually order. If you don’t have KPIs, the first step in a financial tune-up is to agree what KPIs are important for your business and a commitment to start tracking them.

Once you have your KPIs identified, track how have they been trending over time and what are the root cause of changes, whether positively or negatively. Set concrete goals that are tied to actual financial outcomes. Determine what the life time value of a new consultant joining your business is. This will drive decisions regarding support for sponsoring initiatives, as just one example.

The revenue cycle review should include a line review. A line review looks at each and every product in an objective manner, which calls for a judgement as to what it’s reason for being is. In order to conduct a proper line review, SKU and style history is needed. In most company’s 20 to 30% of the merchandise drives 70 to 80% of the revenue. What is often discovered is that the product line is bloated, and poor performing items remain in the line due to high inventory levels, or because it is a top leader’s favorite product.

Poor performing items need to be identified, and a specific plan put in place to eliminate the items over time. This is a tough process, but you must challenge yourself to establish concrete measures for success. In addition, new items or planned new items should be reviewed to determine if the margin in the items meets the overall objective. Lastly, a pricing review should be conducted again with margin objectives in mind. The outcome of this review should be implemented at the earliest possible opportunity, usually at the start of a new season.

Inventory control and management are crucial elements for success and should also be reviewed, generally this review coincides with the revenue review. For this section, an inventory aging report should be prepared.  Old and discontinued inventory does not appreciate with age. Tying up capital in bad inventory can be a serious drag on a company’ success. This cash is better to be freed up to invest in other parts of the business—everything from technology to human capital.

One of the most critical and common issues I see at both small and established companies is what I call “betting on the future”. Entrepreneurs start their business but quickly learn that the key to a successful business is to have an adequate “X cost multiple”. In a typical successful business, this multiple is anywhere from 6 to 10 times the cost of the products. Let me repeat: That’s 6 to 10 times the cost of the products! This level of margin is necessary to fund a competitive compensation plan.

If the compensation plan doesn’t provide adequate rewards, it will prove impossible to attract and retain a sales force. The error that I mentioned previously is that a start up often doesn’t have the purchasing power with its suppliers to get the cost required to power the model. Many founders make the decision to start with a cost multiple of 4 or 5 with the idea that as they get to scale they will be able to get better pricing from vendors. This is a fine concept, but then the initial losses from operation will need to be funded from seed capital. Any company that is following this philosophy while at the same time boot strapping their launch will inevitably fail.

We now come to the cost side of the equation: I refer to any direct selling company actually operating multiple profit and loss centers. What I mean by this is obviously there is a P&L for the sales of actual products to end consumers. In support of that, there are other profit loss areas: Freight charges and cost of delivery is a separate business that needs to stand on its own; printed matter sold to consultants and the cost to produce that printed matter; fees charged for information technology and the cost to deliver that technology. In the case of a party plan company, there is the hostess program which includes all the benefits provided to someone acting as a host or hostess. All of the items that I just previously mentioned have to run at a profit. It is the responsibility of management to measure and take action to bring each of these areas into a profit position.

I am going to go deep on one of these areas mentioned above: Charges for freight. This is often a sore subject—we all here about e-commerce companies that offer free freight. A successful direct selling company will charge enough to cover their actual cost of freight as well variable warehousing and the direct cost to process an order. Management needs to know their costs as well as their package profile. One way to ensure that you are getting a good deal from your carriers is to work with a respected auditing and negotiating partner as a third party (let me know if you would like recommendations). I have seen in case after case where, at no cost to the Company, this third-party expert finds opportunities in freight costs. I personally know of one company which has saved over one million dollars over the last four years in lower freight cost directly due to negotiations that were quarterbacked by one of these companies.

There are a number of ways to make adjustments to this cost structure without causing a revolt from your field leaders. In one case, I worked with a company that shipped very heavy products. As a result, the freight charged to the end consumer was significant because they made sure that they more than covered their costs. However, the “freight issues” were a concern for the field. After careful review and consultation with leaders, they came upon a unique solution. They brought down and simplified freight charges while at the same time boosted morale and increased the rate of sales by a factor of 40%. They added two dollars to the price of each item, which was non-commissionable. The commissions to the field remained exactly the same as they were prior to the change, but the cost of freight to the end consumer was reduced by as much as 67%. The field was over the moon excited with the change, and sales went from plus 10% to plus 16% immediately following the implementation of the change.

Once again, the same posture as presented in terms of freight cost and charges needs to be established with printed matter, information technology and the hostess program in the case of a party plan company.

Finally, let’s talk about general overhead, or SG&A. These are all the other costs that have not been previously covered. Typically the largest element in this category is people to man a home office and executives to run the company. There are, of course, secondary buckets of cost such as credit card discounts in order to have a merchant account, printing costs, fixed warehousing costs, all utilities including telephone, heat, light, internet connectivity, etc. This is an area that needs to be watched carefully and managed skillfully. My advice is to run as lean as humanely possible at all times. I am not suggesting to be penny wise but pound foolish. But I’ve seen too many companies increase their costs too quickly, only have to make drastic cuts later when it could have been avoided.

In summary, there is a tried and true model to success in this industry:

• Set and manage to KPI objectives.
• Sell products that are 6 to 10 times their cost.
• Offer a lucrative compensation plan that supports sponsoring.
• To the extent possible, keep your costs variable by using outsourced resources.
• Tightly manage the overhead.

 
The outcome will be a profitable company from the outset. I am a firm believer that a direct sales company can be profitable at almost any level of sales if you’re diligent in managing your finances.

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Guest Post by Dan Murphy
The 5 Steps a Venture Capitalist Takes to Value Your Business

In the world of direct selling, one of the most difficult issues includes capital formation and how to make your particular company attractive to a venture capitalist in order to raise the necessary capital to take your company to the next level of growth. In this article, we’ll discuss how VCs (Venture Capitalists) think about valuing business, and how you should think about it as you prepare.

Everyone thinks venture valuations are black magic and arbitrary. But there’s actually some science behind it. The methodology below is a grounded way that VCs arrive at valuations.

Venture Capitalist Principals for Direct Selling Valuations

The process a VC takes to produce a term sheet valuation is quite simple:

1. Estimate exit valuation range. Venture money always wants a way out. This is an important consideration to ensure that in your business you understand that this is the end objective of venture money. Don’t start down this road if you want to build and own your business over the very long term.

2. Build target ROI with safety margin. The Return on Investment (ROI) needs to be grounded in key performance indicators for your business: sponsoring, retention, activity, average order size and leadership development.

3. Divide exit valuation by ROI to get current acceptable valuation.

4. Sense-check (strongly) against the rule of thumb values.

5. Check if this is too much/too little money for the business plan.

Let’s dig into the details of each of these principles.

1. Estimate exit valuation range.

VCs start with the end in mind. They’ll triangulate your business model, your addressable market, and your buyer universe to identify a range of likely exit values for your business.

Note that likely is the key word here – VCs know that the typical exit is in the low $100s of millions so it takes a pretty strong case to convince them a unicorn valuation is in the exit range.

2. Build target ROI with safety margin

VCs work backward by an expected ROI. The average multiple for a “home run” VC exit (which drives a portfolio) is 16x. This is driven by the Pareto principle in venture investing – because of the high failure rate of startups, the successes need to be home runs to drive portfolio returns.

But of course, VCs will actually need more than the 16x at the outset. This is for two reasons:

* First, the math here doesn’t account for dilution from future rounds. So earlier investors will demand a higher “expected ROI” than growth stage investors – probably at least double the ROI.

* Second, VCs are wrong often and they know it, so they’ll build in a safety margin into their ROI to compensate for mistakes. They don’t know how many of their portfolio companies will be home runs, so they’ll actually shoot for a little higher than 16x to compensate for this.

So the big question is what ROI do VCs look for? There’s a lot of chest-thumping around “we need 100x!” but we feel it’s not actually that high. We think a good estimate is anywhere from 20x-40x (that’s exit cash divided by invested cash). This is actually a great question to talk about with your VCs, so you can tune this even more specifically with each potential investor. Some VCs might consider this controversial, but if you can’t have this discussion openly, you probably don’t want them as your investors.

3. Divide Exit Valuation by target ROI

If we take our exit ranges of $100M or more, and divide by target ROIs of 20-40x, we end up with a rough startup valuation range of $2.5M to $50M.

That’s a pretty common range of valuations you see for venture stage startups. The range feels large, but bear in mind this is for startups from Seed to Series B. For brevity, we won’t do the math for each individual series here, but the calculations for Seed, Series A, etc., individually all fall within their more specific ranges.

4. Sense-check strongly against rule-of-thumb values

After all of this precise, results-driven math, the dirty secret of venture capital is that everyone still triangulates against market values.

The good news is those ranges are wide – ballpark US direct selling businesses at $2-6M for Seed, $10-40M for Series A, and $30-$200M for Series B in 2017. So all of the work we’ve done so far isn’t a write-off, but the market will definitely encourage a VC to nudge the valuation in either direction.  One example to determine that nudge is revenues – a Seed/A/B startup should be in the $500K/$2M/$10M revenue range, respectively. And if you fall above/below that for your stage, expect to be on the high/low side of your above range, respectively.

5. Check if this is too much/too little money for the business plan

VCs generally look for about 20% per round, so divide your valuation by four to figure out how much is the ticket size (glossary: ticket size = how much their investment amount is).

This again gets a nudge and is a big driver of what pushes valuations around within their market ranges. The key here is that (honestly, for reasons unknown) the 20% is fairly constant. So if there’s a strong case for you to raise a larger round, then you’ll get both more cash AND a high valuation. Great!

For example: if you’re a Series A company, the valuation ranges start to widen – from $10-$40M. What’s the difference between $10M and $40M valuation? The $40M business here would have strong proof that they’re ready to productively scale up their sales force. This will drive a larger ticket size (roughly $10M). So they would ideally show that they can invest $10M in scaling the business NOW and achieve solid ROI.

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