Back of the Envelope

I was educated as an electrical engineer. That meant a lot of calculation. And doing all those calculations made me get used to back-of-the-envelope calculations of everything relevant all the time. This includes order of magnitude (when you use a slide rule you need to figure out the zeros yourself) and a sense of scale.

Keeping secrets - not!

For many years, I went into consulting clients and asked basic questions. They would tell me that they couldn't tell me things because these things were proprietary. I might want to know cost information to make risk management decisions about reasonable and prudent project costs. When I asked for revenue, they said departmental breakdown was confidential, but they showed me where they worked. Once I looked at the rooms they worked in, calculated the number of seats (rows times cubicles per row), and determined the level of the workers (look at titles and/or ask what they do), I would state as fact, things like "so you have 25 testers, 15 document folks, ..." and so forth. They would say yes, and using my general knowledge, I would then say something like "so the employee budget is about $X and with overhead of about $Y, the total is about $Z/year". At this point they admitted the 5% difference between my off the cuff estimate and their official number, and I was able to help them make a better decision by ruling out things that were too expensive.

Eating my own dog food

Of course I also ran my consulting businesses, and for job estimation and similar things, I had to do the same calculations. It's just obvious and should be reflex in considering any business decision to get a quick rough estimate of the costs, potential revenues, cash flow issues, and related financial issues, and use this to immediately throw out ideas that won't work.

It's a tell

In considering investments, and in making business decisions, anyone responsible should understand enough about what's going on to be able to answer such questions immediately, including taking into account changes and ranges of conditions. It's a tell when someone asks what happens if X or how you are going to do Y, and you don't know the answer or have the ability to calculate it right away. It shows you didn't really think it through, or worse yet, you don't really know your own business.

As an example

As an angel investor, I see plenty of opportunities for potential portfolio companies. Last month, one showed a growth in sales by a factor of 6 for each of two years. The CEO made 11 sales last year (one a month), would have to make 66 this year (more than one a week), and would have to make more than one a day the following year to make the numbers. When I brought it up and asked how they were going to do it, the answer was "channel partners", but the details of those partners, which I had experience with, told me right away that they would not make those numbers that way.

What to do about it

Whether you're an investor or a company seeking funding, you need to know enough about what gives to make quick estimates, you need to understand what to calculate, and you need to be able to come up with a close estimate in no time at all. For investors running in packs, it's good enough to have a group that has the right set of knowledge, but for the potential portfolio company, the key people on your team had better be there during your pitch, or you will be caught in the tell.

It's not a case of "gotcha"

As an investor, I am not trying to trick a presenting company into a mistake. I'm trying to find out whether they have thought through the things I find to be strange of hard to buy into. If you have a growth plan, you will need all the things required to grow at that rate. If you don't know what they are or haven't thought them through, your calculations for my return on investment could be way off. It's easy to be off by a factor of ten in costs and time to get from here to there, and that means a factor of 100 reduction in the value of my investment. And if you haven't thought it through in the days, weeks, months, or years you took to get from where you started to asking me for money, at least to the point where there are no obvious fatal flaws that I see when you present a slide full of numbers to me for 30 seconds, that shakes my confidence very quickly.

Do your homework

When I ask people for money or to trust me to work with them, I expect that they are going to check me and my proposal out. If it looks expensive, there had better be a good reason that justifies the costs. If I say I can do something and they ask me a simple question about how I plan to do it that I cannot answer, I expect that the business will not happen, that they won't want to ask me again, that they will tell the folks they know, and it's my own fault.

Trial and error

But having said that, not all business ideas are good ones, and I cannot tell the good ones from the bad ones all the time any more than you can. I often work with other people by identifying ideas that I want to discuss with them, and in the process of testing out the idea through that interaction, I come to the conclusion that it won't work. When that happens, I tell them so, detail why, and hope that they will tell me something I don't know that solves the problem and allows a variation on the theme to go ahead.

The nature of getting to a successful business idea, in my experience, is that it takes a lot of different ideas, each one gets viewed through a series of increasingly detailed and harsher lenses, being adapted until it's clear there is not path forward, until one makes it through and still seems like a good one. But to test more and more of them faster and faster, means making lots of quick estimates and back-of-the envelope calculations.

Summary

Get good, and fast, at back-of-the-envelope calculations. Or get a partner who is good and fast at it. I know that spreadsheets are very helpful once you get past the first few steps, but I would say less than one in 10 "good ideas" gets past the back-of-the envelope and makes it to the spreadsheet. When I see pitches that don't get past the back of my envelope, I ask questions, and the answers had better be good, or I won't get near the deal.

Copyright(c) Fred Cohen, 2016 - All Rights Reserved