ThinkFlood Blog

Today I spent a couple of hours compiling and cleaning up financial statements in preparation for talks with investors. Whenever I do this, all I can think about is how glad I am that I did not pursue a career as a financial analyst or an accountant.

So, it’s probably pretty obvious that I have some bias against jobs in finance. It’s not that I distrust people in finance, or that I think finance and accounting are useless. On the contrary, there is certainly a place for them as management tools in business. However, I think the problem is that finance is so abstract that we tend to separate it from the fundamentals of business.

In some ways, finance and academics are similar. Both are necessary for an informed picture of the world — they help us develop the critical thinking and language we need to understand and to communicate important concepts. However, if pursued without a regular and solid grounding in real world experience, they can create false pictures and lead us into some sticky traps.

I think this separation from reality is what has happened in the current financial meltdown. For example, one of the basic goals in finance is to reduce risk. We have many vehicles to do so — we share risk through insurance, we minimize the impact of risk through hedges, we evaluate risk by marking assets to market, and so forth. However, one dimensional risk management does not make a good financial instrument. There are other factors, such as transparency. It seems to me that credit default swaps and collateralized debt obligations played up the risk management idea, but completely ignored the importance of transparency. As a result, we no longer know who owns what, whether terms are negotiable, or what the “real” value of the assets are. Throwing money at the problem reduces leverage — and therefore mitigates certain kinds of risk — but it does not provide any greater transparency, and so other types of risk linger.

I don’t say these things to point blame or to criticize well-meaning actions already taken. Rather, I point out the difficulty in constructing things like financial models and forecasts. Yes, we can analyze this or that historical trend and come up with some estimates. But in the end we don’t really know. At best, finance is a guide that helps us determine what to look out for — we cannot afford to depend on it as a primary means of creating wealth, because so much of it is speculative.

This attitude has dictated many of my practices in business. First, I prefer to work in a company that provides an actual product. Sure, there is a room for services, but ultimately I feel that products have a more sure foundation — they are real creations, not just virtual reshuffling. Second, I do not see much point in playing games with payables and lines of credit. These things have their place, but if used too extensively they create race conditions which can make a business insolvent. They also create internal conflict between debtors and creditors — I much prefer equity ownership, which aligns investor and company interests. Finally, I like to get out into an operation to see what is going on. Numbers are useful, and I enjoy looking at things in different ways. But unless I can tie those numerical conclusions back to real-world observations, I refuse to accept those conclusions as fact.

In some ways, we have a credit problem – though it’s not the same one that the larger economy faces.

While we haven’t gone public with what we are working on, it is no secret that ThinkFlood is a small startup. Right now, there are three of us on the team (an early founder jumped ship when we changed products back in April). We are gearing up for our first product launch this coming April — a hardware accessory for the iPhone and iPod touch — so we currently have no revenues. In addition, we have worked with a handful of service providers over the past few months, but our expenses have been relatively low and so we do not have a lot of payment history. Finally, early last year we made the decision to stay away from VC funding, so we don’t have gobs of cash in the bank (although we do have enough to get going).

With all this in mind, it’s not surprising that we have a credit problem. It’s not so much that our credit is problematic — we pay all of our bills quickly and reliably — more that we just don’t have much of a history. So, last summer when we were lining up contract manufacturers, we were not surprised that most of these potential partners wanted us on secured terms — or at least a very short leash (e.g., Net 15 days).

No problem. When we walked in the door, we expected a bit of pushback (being young and small and everything), and we were ready to work with them. Cash up front? Sure, for the first few months. Our only expectation was that once we established regular sales that we might be able to get standard industry terms (e.g., Net 30 days). But no rush — we have some cash, and an existing line of credit at the bank can finance our inventory purchases well enough. What mattered more to us was the level of service and flexibility that we could get from these partners.

We distributed our initial bid package in mid-August, and then we waited. Our first order of business was to find a place to build our prototype devices, so when the one month mark rolled around and we hadn’t received any responses, we started calling to ask for at least a quote on the prototype work. A couple of weeks later we finally received some bids.

The price spread on the prototype bids we received was nothing less than astounding. While fixed costs (setup, stencils, etc.) were fairly comparable ($1,000 to $2,000), the per piece costs were all over the map. Our high bidder came in at just under $400 per device, while the low bidder was $65. We had a cluster around $300, and a few others scattered across the range. This despite the fact that we were providing all the prototype material on a consignment basis — leaving only the cost of labor in the final total. When the production bids started coming in we saw a similar spread: the high bidder was more than twice as expensive as the low bidder, and even the low bidder was offering to do the work at a 100% markup over the bill of materials cost (we had expected a markup in the 30-35% range).

Of course it was obvious to us that the high bids were essentially a rejection of our business. These companies were happy to take our money if we were foolish enough to give it to them, and their high prices were a vote of no confidence in our future. But why? It couldn’t be a concern over our finances, because we were willing to pay up front (in fact, the low bidder was one of the companies that gave us a line of credit). Could business be so good that they don’t need the work? On the contrary, these were all local New England contract manufacturers — an industry largely down on its luck since the bursting of the telecom bubble a decade ago. When we were touring their facilities, most looked uncomfortably quiet — here and there a medical device build, but honestly nothing too impressive.

Now our goal all along had been to keep production local as long as possible. While it is nice to be able to print “Made in USA” on a label, there are other reasons — the ability to drop in to monitor production, a closer working relationship with plant management, reduced shipping costs, etc. In fact, while labor costs are an issue, electronics manufacturing today is highly automated, so the real pricing differences between domestic manufacturing and production in a low cost region are small. Moreover, because our product is aimed at the consumer market, we designed it to snap together quickly to minimize these costs.

Frustrated, we decided to broaden our net. The response was incredible. Within a couple of weeks of releasing our bid package to contract manufacturers in Asia (Taiwan, mainland China, Thailand, etc), we received responses. And the price? 25-30% markup over our bill of materials cost — or just about what we had expected. In fact, one of the manufacturers even offered us Net 45 terms. And all this despite the fact that we had relatively weak connections to these companies before we contacted them — whereas most of the manufacturers we contacted in New England had done work for one or more of us when we were with prior employers.

We had a similar experience trying to find a plastics manufacturer for our device enclosure. Local US firms took 6-8 weeks to respond to our requests, and then were 2-4 times as expensive as their Asian competitors, who typically responded within 1-2 weeks. For example, we ended up paying $19,000 for two, dual-cavity injection molding tools to a company in China (which incidentally also has electronic assembly capability and is FDA-certified to make medical devices for Procter and Gamble), while a local US manufacturer wanted to charge us $67,000 for single-cavity tools. The quality of these tools coming out of China is just as good as what we would get here, and the service we are getting is fantastic — in spite of time zone, cultural, and language differences.

Here is what I don’t understand: where is the sense of hunger in US manufacturing today? I would think that given the state of the economy — not just now, but over the last decade or more — these companies would be itching for new work, and happy to find new companies to supply them with jobs in the future. Sure, some startups will fail, but they can manage the risk and still be successful. We would have been happy to pay in advance for a few months. But we can’t afford to pay 100% markup (much less 300% markup) over our component costs and have a viable business. No wonder so many startups fail — if they cannot get the support they need from established manufacturing partners.

Now, in the end everything is working out for us. We can get what we need at prices that make our business viable. But we aren’t going to be doing much production here in the US, and it’s not for lack of trying on our part. Why does an Asian company on the other side of the globe show more interest and confidence in us than the guy down the street? As a rule, the Asian companies have bigger manufacturing facilities, newer equipment, and cheaper labor costs, so we expected to go there eventually. But I was surprised how quickly the US manufacturers pushed us there with their own disinterest. Is it surprising that our manufacturing output is declining at an alarming rate, or that US businesses are losing to competition overseas? To me, the reasons don’t seem to have anything to do with NAFTA or any of the other demons that Lou Dobbs tries to summon in his tirades. Outside of a few entrepreneurs, it seems to me that US business just isn’t as hungry as it needs to be. The fact that so many companies are looking for a piece of the government bailout pie is just evidence to support my theory.