New Venture Lab: Equipping Christian Entrepreneurs

Things are going to get much worse due to the bungled bailout attempts, the principle of the J Curve and the principle of the Ripple Effect.

1. First, the bailout will only delay any recovery.  Click here for a previous post for more on that.

2. Second, there is the principle of the “J” Curve.  The J Curve is one of those concepts that, much like the Pareto Principle (80/20 rule), seems to apply to much of life.  While the Pareto Principle (also known as the Law of the Vital Few) states that, for many events, roughly 80% of the effects come from 20% of the causes, as in 80% of a company’s sales revenue comes from 20% of the company’s customers, the J Curve rule of thumb states that no matter where you are, things will always get worse before they get better since any effort applied to improvement always carries a cost.

So, no matter where we are at with the economy, as we try to improve the economy, the cost and pain of doing so will mean that we need to take some bitter medicine first and therefore from the point that we are currently at, we need to travel down the downward curve of the “J” on our journey to improvement prior to eventually hitting bottom and then beginning the long, slow trip up the stem of the “J”.  Much like how God sanctifies a Christian with difficulty in order to draw him closer to God, pain almost always precedes growth and investment (cost) almost always precedes improvement.

(For example, the J Curve principle is relevant in global trade as talked about by policymakers regarding what happens when a country’s currency depreciates:  the country's trade deficit will often worsen initially because the higher prices on imported products will in aggregate amount to more than the reduced volume of imported products (going down the initial downward swoop of the “J”), but eventually, the depreciation of the currency will lead to an increase in exported products and a reduction in imported products, which will reverse the fortunes of the country in question as its trade deficits are reduced and the balance of trade/payments is improved (and it begins to travel up the stem of the “J”.)

The J Curve principle also applies to each startup in general (and entire venture capital portfolios) in that when you initially start a company, you have no revenue and no expenses and therefore no losses, but as you apply effort to grow the business and experience startup costs, the path of the startup’s profitability will follow a J Curve as it begins to burn cash and mount losses prior to experiencing enough revenue and earnings to climb out of the other side of the “J” and back to profitability.)

3. Third, there is the fact that nearly every company in every sector in America is currently restructuring and we haven’t seen the full impact yet because we are still in the early stages of the Ripple Effect.  Much like when you drop a pebble into a pond and you see the ripples continue to widen, the initial ripples of our economic woes were the mortgage and housing industries and then the automotive industry.  What I predict is affected next is nearly every other sector as the ripples continue to widen until every aspect of our economy has been affected.  And, much like the fact that the outermost ripples in the pond are more subdued than the initial ripples, other industry sectors will not be hit as hard, but the total impact of all of this restructuring will, in aggregate, mean that we have a lot more trouble coming our way prior to any meaningful recovery.

To best explain this, I need to relate a scene that I saw play out over this past weekend.  I am helping a friend of mine restructure one of his venture capital investments and the situation is indicative of what I think is happening right now all around our country.

The thumbnail sketch is as follows: Two years ago my investor friend and a couple of other co-investors (including the entrepreneur) invested $1m in a well-known quick-serve food franchise and backed the entrepreneur who had a good track record of operational success.  With the strength of the $1m in equity investment, they were also able to secure a $3m business loan from a major lender.  The entrepreneur, already saddled with a large house mortgage, had invested most of his life savings in the equity and he willingly signed a personal guarantee for the $3m loan.   The total capitalization of the company was therefore $4m with the debt-to-equity ratio of 3:1 ($3m in debt to $1m in equity).  (This kind of debt-to-equity ratio was typical for the kind of capital structures of just two years ago and partly the blame for the trouble we are in with our debt-induced growth that led us to a sense of false prosperity.)  The money went to pay for the franchise fees, building the initial stores, hiring and training staff and local market advertising to get the ball rolling.

Fast forward to our meeting over the weekend.  This was my initial meeting to assist in the situation and therefore I was able to look at it with fresh eyes from a dispassionate point of view.  What I saw was bleak.  Sales were 50% below plan as consumer demand for his discretionary food and beverages flagged and the fledgling company was hemorrhaging cash which had dwindled to nearly zero.  Teetering on bankruptcy, the entrepreneur had just completed the following initiatives in the past month:

• Laid off nearly half of his employees
• Implemented a 25% pay cut for the remaining employees
• Negotiated a 20% lower rent payment on all six stores with the various landlords
• Completely stopped paying any franchise fees to the franchisor, whether they liked it or not
• Completely stopped making any principal and interest payments to the lender, again, whether they liked it or not

The entrepreneur was also attempting vainly to get a second mortgage on his home in order to continue to prop up the sagging company , which not only is not a good idea, but I’m sure no one will lend him additional funds.  Not only was he desperately seeking solutions, he was a shell of a man worried sick about losing his company, losing his life savings and facing personal bankruptcy due to the $3m personal guarantee.  He also mentioned that he was having a hard time cutting back his own salary because he needed $180k to maintain his lifestyle, indicating to me that he was way over-levered himself with personal fixed expenses that were way too high (think huge mortgage-laden home, two-new cars with car payments, children in expensive private schools and the other trappings of an upper-middle class lifestyle in suburban America.)

At this stage and given my vantage point, I would give the company only a 25% probability of being able to pull out of its current nosedive.  What struck me was the impact that this one small company was having in terms of the layoffs, the pay cuts, the reduced revenue to the landlords, the reduced revenue to the franchisor and the impaired loan to the debt lender, etc. 

It also struck me that those same landlords had probably had to lower the rents of their other tenants, hoping they will survive rather than facing the possibility of an empty building and standing in a creditor line with little hope of collecting anything.  And that same franchisor was probably dealing with the same issue with most of its other franchisees across the country.

This was a typical, very American food store that had just hit a brick wall.  Now multiply that by thousands upon thousands of other small companies just like it that are facing the same issue all across the country.  This is not the mortgage, housing or auto industries that we have been hearing about in the news – this will be new news that will hit in the coming months as tightening credit and shrinking demand continues to put a cash squeeze on most operating companies in most industry sectors leading to more unemployment, an even more dispirited consumer outlook, and even lower consumer demand as we enter a doom loop.

That’s why I came away thinking that the economy is going to get a lot worse before it gets better.  I don’t think the bottom of the J Curve is even in sight yet.  After all, it took us nearly 30 years of debt-fueled growth – both on the corporate side and the government side – to get here, so it will take us a long time to work through that and get back to real growth.  And adding more debt and looser credit standards via a bailout will only make it worse.  Look for more announcements about more industries failing and look for unemployment numbers to rise.

Hopefully the people’s reaction will be to cut expenses and increase savings, which is what we need to rebuild our economy.  After all, a national economy can only grow via three methods:

• Increased savings, which provides growth capital (we’ve had too little of this in our economy)
• Increased debt (we’ve had an imbalance of too much of this)
• Foreign direct investment, which is when foreigners invest capital in US-based companies (this is not a very attractive time to expect an increase in this area)

These are tough times, but like the sons of Issachar, we need to understand the times and react appropriately.  My advice to entrepreneurs is to tighten your belt now rather than be surprised later when this hits your sector -- if it hasn’t already.  Take decisive action to restructure as necessary to the lower demand and leave the rest to the providence of God.