Imposter at the Conclave [as Applied to Business Owners]

Have you heard the story about the man who impersonated a Catholic cardinal at Vatican City?  We learn the man had gained access to a closed-door ecclesiastical meeting only to be exposed as an imposter and hastily ushered out of St. Peter’s Square.  The somewhat amusing imposter story reminds us of the not-so-amusing consequences that business owners face when failing to meet their obligations with government entities, which obligations may include federal (income and payroll tax), state (sales and franchise tax), and municipal (property tax and utilities). To the government, non-compliance to financial obligations merits ‘imposter’ status and a corresponding harsh response. We occasionally encounter small-to-medium-sized business owners (SMBs) who are struggling to meet their government obligations. We share a few observations of what can happen when the government as an important creditor is mismanaged.  We then encourage business owners to adopt a few proactive management techniques designed to increase the likelihood that government obligations can be met on a consistent basis.  We encourage your comments, which are always greatly appreciated!

Recently as over 100 cardinals of the Catholic Church assembled in preparation for electing their next Pope, a mysterious ‘cardinal’ was discovered in their midst.  He had arrived at St. Peter’s Square at Vatican City dressed splendidly wearing a dark clergy robe or cassock, a purple sash, a crucifix, and a well-fitted black fedora hat.  For a few moments, he fluttered around greeting other dignitaries and then gained access to a closed-door, pre-conclave meeting.  Security guards were less impressed. The man’s cassock was too short, his sash was really a scarf, the crucifix was of unusual design, and his fedora out of place – he should have been wearing a zucchetto, the traditional skullcap of bishops.  Upon further inquiry, the man was found lacking the right credentials and identified as an imposter.  Despite the man’s protests, a contingent of Swiss Guards forcibly escorted him away from St Peter’s Square.

Allow me for a moment to ask some silly questions.  Should the man have been allowed to stay?  What right did the Swiss Guard have to escort him away from such an important meeting?  Shouldn’t his vote have counted in electing the next Pope?  I hope we can all agree the man did not belong and as one who attempted to deceive others and who may not have had the organization’s best interests in mind, this man was labeled an ‘imposter’ and rightfully escorted out.

It is the right of organizations to use their power to defend themselves from those who do not follow the rules and who may try to do harm.

Some business owners occasionally forget this principle in interactions with their stakeholders.  By stakeholders, I mean those other entities that can help or harm a particular business.  The most obvious stakeholders are customers and suppliers – they influence the ability of the business to sell products and services and, ideally, to generate a profit.  In the fractional CFO business, we always encourage our clients to diversify their customer and supplier base so that no supply chain member has sufficient power to disrupt our client businesses – even if everyone seems to be playing nicely now.  Not all stakeholders fit this diversification strategy template.  One important outlier is government institutions.  We encourage business owners to respect and prioritize those relationships.  Government entities have no competition and are well equipped to protect themselves from perceived threats.  The IRS has little patience with businesses that habitually fail to pay their income and payroll taxes.  The State wants to see its sales taxes and franchise taxes paid regularly and on time.  The Municipalities like their property taxes and utility bills paid consistently.

So what happens when business owners fail to pay their obligations to these government entities?  A clear and certain process is followed which is by its very nature—punitive.  Though the process varies slightly by government entity, the end game is usually very expensive and disruptive to the business owner.  To protect itself, the IRS will begin a formal legal process that includes late-filing penalties and late-paying penalties and interest.  Fraud and accuracy errors are penalized heavily. The IRS can and will levy a company’s bank account, which may come at an inopportune time for the company and completely disrupt business operations.  Company payroll and vendor payments may be unexpectedly delayed, which is a major aggravation for all involved.  When collecting state taxes, the state operates in a similar manner as the IRS.  With regard to municipalities, it is common to have an immediate 20% penalty imposed for late payment of property taxes.  The liability is further compounded by interest until paid in full.  Utility companies typically charge a hefty fee for late payments and they stand ready and willing to shut off electric and gas power as necessary to encourage the company to catch up on paying its utility bills.  Taken as a whole, these government entities tend to be equally punitive or more punitive than other company stakeholders.

Occasionally, I encounter the triple-whammy effect, in which a company is delinquent in paying at least three government obligations, which may include payroll taxes, property taxes, and utility bills.  When I find companies with these problems, I have a simplistic solution that may not work in every situation, but it gets the conversation started with the management team.

  • If you cannot afford to pay your payroll taxes, then your company payroll is too high!  Recommended course of action is to lower the payroll.
  • If you cannot find the cash to pay your property taxes, then you have too much real estate and / or personal property.  Work to eliminate or consolidate your holdings.
  • If you cannot pay your utility bills, then shave energy costs.  I would rather shut the power off myself than have the utility company shut my company’s power off at an inopportune time.

I have probably oversimplified a complex situation, but I felt a need to get these pent-up recommendations off my chest.  Just some thoughts from one who has worked with many business owners in many different situations with the objective of facilitating their financial success.

On Gridiron Greed, Employee Embezzlement, & Management Misappropriation

Are you keeping up with the news story about the prominent college athlete who was either cruelly duped by a perpetrator pretending to be his girlfriend or who conspired with the perpetrator to generate publicity for his gridiron career?  Assuming the football player’s version of events is the correct one, at what point should he have suspected his virtual girlfriend to be imaginary?  Perhaps we will never know what happened here and I don’t pretend to know what happened; however, I do believe that distinguishing between ‘what is real’ and ‘what is not real’ can be extremely difficult for entrepreneurs who tend to be very optimistic people.  Being an optimist is a great strength! Optimists move forward with their ideas and business ventures despite encountering a myriad of naysayers along the way.  Being an optimist can also be a humbling weakness.  Optimists can be easily duped by others if the appropriate safeguards are not in place.  The football story reminds us of the vulnerability that business owners and investors face when entrusting others with their cash.

The cost of business fraud is enormous.  According to one study, “Fraud eats up 5 to 6 percent of a company’s revenue each year and hits small businesses the hardest.”[i]  Another study determined: “Small firms can suffer more than their giant counterparts. A 2012 study by the American Association of Certified Fraud Examiners (AACFE) found that businesses with fewer than 100 employees that were affected by fraud suffered a median loss of $147,000, compared with $100,000 for companies with 1,000 to 9,999 employees.”[ii]  As a CFO who typically works with privately held, family-owned businesses, I have seen my share of business greed.  These cases often involve embezzlement and misappropriation.  What hurts most is the perpetrators are usually caught too late and they are rarely punished.  The victim, sometimes a business owner and sometimes an investor, is left holding the bag – an empty money bag I might add!  It can take a long time to financially catch up from a bad situation.  Here are two recent, personal experiences of business fraud:

An interior design company was positioned to grow its customer base.  The ownership team hired a confident bookkeeper to manage the financial records.  He was well compensated and highly trusted.  After several years of his involvement, I was asked to provide strategic oversight to the company.  To gain a clear understanding of the financial condition, I convened the team regularly to discuss finance structure and performance.  During the meetings, the bookkeeper agreed to action items, but would not complete those items afterwards.  He defended his inactivity with excuses.  Eventually, the ownership team became very frustrated and investigated the bookkeeper’s workspace.  They discovered the bookkeeper had been embezzling company funds by creating expense reimbursements to fictitious vendors.  It was also learned he spent a good portion of his workday surfing inappropriate websites.  A difficult situation could have been averted if only the proper controls had been in place.  The bookkeeper was fired, but the damage had already been done.  The President suffered financial losses and, for a long time thereafter, suffered from an inability to trust anyone else with her books.

A specialty electronics retailer was anxious to grow its number of nationwide locations.  To open each new store, the management team, which consisted of the majority owners, sought investment dollars from investors whose individual store investment was rewarded based on that store’s performance.  The management team aggressively committed to a growth plan that relied on new stores being routinely added and every store being profitable; the only problem was only half of the stores were profitable.  The company was bleeding cash.  Investment dollars were routinely misappropriated to cover store losses, fund project overruns, and pay excessive management salaries.   This comingling of funds made it difficult for the management team to keep agreements with the investors who had invested in profitable stores.  Dividends were owed, but cash was insufficient to pay the dividends.  A growing chorus of impatient investors wanted to understand why their dividend checks were not forthcoming.  Once the facts were on the table, the investors, some of whom were attorneys, threatened to file criminal charges against the management team; ultimately, the investors took control of the business.

The examples of business fraud are plentiful.  What can business owners and investors do to minimize the likelihood and severity of financial fraud?  They should create an environment that includes a mix of fraud controls in the areas of employee due diligence, bottom-up accountability, top-down oversight, and risk mitigation:

  • Employee Due Diligence—runs a background check on new hires.  Interviews past employers.  Look for inconsistencies on resume.  Avoids hiring the cheapest resources on the market.  Enforces company policies on drug screening, internet usage, etc.
  • Bottom-Up Accountability—creates and enforces finance department procedures that focus on maintaining transparency, separating work duties (invoice entry, check writing, vendor/account reconciliation), and building employee competency.  Outsources transactional and reconciliation work.
  • Top-Down Oversight—ensures clear cash oversight comes from the top.  What checks did I write? To whom? Was there anything unusual to investigate? Uses 3rd parties to review the books and look for fraud.
  • Risk Mitigation—considers purchasing employee theft insurance.

As an entrepreneur, or as one who works with entrepreneurs, you have every right to be optimistic about the future!  Just remember to temper that optimism with pragmatism because when money comes along, greed may soon follow.   We would like to hear your experiences with business fraud as well as any safeguards that you have put into place.


SMB Trends – Bimbos, Twinkies, & Rising Labor Costs

Food manufacturer Hostess ($3 billion sales; 18,500 employees) recently announced plans to liquidate its assets after years of struggling with rising labor costs in an increasingly competitive market space.   Mexican food giant Grupo Bimbo ($11 billion sales; 127,000 employees) is hungry for some of the most valuable Hostess assets including Twinkie.

How did an iconic U.S. brand become prey to a flagship Mexican brand?  Perhaps the answer lies with the labor pool.   Although Grupo Bimbo is not entirely a Mexican company—having some bakeries in the United States and other countries, the overall labor cost structure of the two companies is different.  Unlike Grupo Bimbo, the Hostess compensation structure includes funding expensive pensions, generous medical benefits, and operationally inefficient work rules.  The lesson here is that rising labor costs in a global market are sure to make companies less competitive.

How do the struggles of a large company like Hostess apply to small-to-medium-sized businesses (SMBs)?   Like large companies, labor costs in SMBs are projected to rise for at least two reasons related to the Affordable [Health] Care Act.  First, the cost of employer paid health insurance is projected to rise substantially to pay for a nationwide increased population of insured (some 30 million newly insured).  Second, many employers will be required to cover more employees than they had covered before or face a free rider surcharge of up to $3,000 per employee.

Let’s assume we are owners of a $10 million revenue company with a 10 percent net profit margin.  We have just learned our health care costs are increasing by $50 thousand per annum thereby decreasing our net profit from $1 million to $950 thousand.  Our response will be based on at least four options:

Accept Less Profit – we could choose to accept less profit.  Investments are all about risk and return.  It will be difficult for many business owners to accept less reward for the same amount of toil and sacrifice.  They will seek ways to preserve their profit.  Inflationary cost pressures will not be the only pressure on business owners.  The threat of rising personal income taxes will discourage business owners from accepting less profit inherent with an increased cost structure.

Increase Sales – to overcome a $50 thousand increase in labor costs, the company would need to increase its sales by 5 percent or $500 thousand.  Many SMBs experienced sales downturns several years ago with slight upticks in sales since, but no real recovery.  Revenue growth in many SMBs is currently stagnant.  We expect industry supply chains to raise prices, but those price increases will be passed down the supply chain and have a negligible effect on company cost structures.  Business owners who expect sales increases to pay for rising employee costs are utilizing a risky strategy.

Decrease Employee Wages & Benefits—like Hostess, there will be pressures to lower employee wages and benefits, but these efforts will have mixed results.  The best employees will go elsewhere for better compensation; the worst employees will stay.  After several years of a recessionary environment with frozen pay in the private sector and an increased consumer price index, we think lowering employee compensation will be a difficult, last option.

Leverage Outsourcing Solutions—companies will scour their financial statements for cost savings opportunities.  Eventually, the focus will turn to headcount justification.  Each position will be evaluated for its ability to add value to the business according to three criteria: [1] Are important relationships being nurtured?  [2] Is company-specific intellectual property and / or know-how being developed and preserved?  [3] Are problem-solving skills required to resolve ever-arising, unique problems?  Positions that do not meet these three criteria and instead include highly proceduralized work that includes work papers that can be readily digitized will become candidates for either outsourcing or automation.  These labor categories include human resources, information technology, finance and accounting, legal services, purchasing, and reception.  SMBs that implement these types of outsourcing options may very well realize savings that overcome the costs associated with rising labor costs.

In summary, business owners must proactively respond to the increasing labor cost environment.  As they consider the practicalities associated with increasing sales and decreasing costs, many can and should consider the wide range of outsourcing solutions available on the market.

SMB Structuring – The CPA Myth

The contrasts between large and small businesses are striking. By large, I refer to the range of companies from Fortune 500 down to middle market; by small, I mean small-to-medium-sized companies (SMBs) that typically have less than $20 million annual sales and less than 100 employees. On the surface, large and small seem readily comparable—both include basic business functions such as sales & marketing, operations, human resources, and finance.  However, the ability to staff each area with high-quality talent often varies considerably.  Large companies recognize a need for a variety of talent and they use their much larger budgets to pay for that talent. In contrast, SMB business owners with more limited budgets don’t always recognize the need to staff themselves adequately from a finance perspective.  They are too busy running their businesses.  Customers must be acquired and their needs met.  Products or services are manufactured and delivered.  Bills are paid. In most SMBs, the budget for senior management is usually spent in sales & marketing and operations functions and NOT on a highly compensated finance resource.

Under these premises, many SMBs begin making fundamental mistakes with respect to how they structure their finance departments. Mistake number one is to hire underwhelming talent. Mistake number two is to ignore one or more finance disciplines in the hiring process.  The four basic finance disciplines include strategic finance, compliance services, controllership / bookkeeping, and business process design.  Each takes years of training to master. The typical SMB retains a CPA firm to perform compliance tasks and some level of bookkeeping talent is employed to manage company records.  The strategic finance and business process design disciplines are often overlooked.

Often these finance staffs carry glorified titles like Controller or VP of Finance, but the titles don’t really reflect the nature of work being performed. The books are kept from a transactional level—customer invoices are being generated, deposits made, AP invoices received, and payments made-but no one is really thinking about what to do with that information on a strategic level. By strategic, we mean the level of information that contributes to financial decision making for the purposes of optimizing cash flow and improving profit. It is difficult to attract the right kind of finance talent into SMBs. Think about it. If you were graduating from college with an accounting degree, wouldn’t you rather choose to work for a large accounting firm with an ample training budget and promotion opportunities instead of working for a small company with a limited budget and advancement opportunities? So the status quo for SMBs is to attract underwhelming finance talent, oversee that talent with a management team that does not understand what to expect from their finance department, and plod along hoping everything will be okay.

Here is where the CPA myth comes into play. Business owners often mistakenly assume their CPA (who is fully qualified to handle compliance items) is also watching out for them from a performance perspective. The thought process goes something like this: “I don’t have time to look at my financial statements – that’s what my CPA is doing. If something ever goes wrong, he / she will tell me about it and help me resolve it.” However, that conversation rarely—if ever—happens. Most CPA firms in the SMB world are not in the business of selling consulting services outside of tax compliance and assurance (compilation / review / audit).

As a result of hiring underwhelming talent, overlooking critical competencies, and unrealistically relying on a CPA firm to stand guard, the business owner is left with a business that accumulates problems and has no effective means to address those problems.  In later blogs, we will address methods that SMBs can use to staff themselves with adequate talent while protecting their budgets.

Have you found businesses that are poorly staffed from a finance perspective? How do SMBs with limited budgets attract high-quality finance talent?  We would love to hear your ideas.