Actions have consequences—mostly unintended.

One of my clients in Texas acquires houses out of foreclosure, rehabs and rents the properties, then sells the properties to investors.

Yep, they “flip” houses—one of the emerging business models in this new economy. The secret sauce in this business is in acquisition and resale, not in the rehab.

This company acquires houses through county foreclosure auctions, which are an amazing example of the unintended consequences of government regulation.

At every step in the foreclosure and auction process, the government regulations are clearly designed to protect an abstract concept of fairness. As a result, the process inflicts the maximum financial damage possible on the unfortunate homeowner, who is already losing a house.

Foreclosure processes are controlled at the state and county level, so we’ll use Texas as the example, although many other states are even more peculiar.

Big problems often start small, then grow.

To give some perspective, each month Harris County (Houston), Texas has around 4,500 bank foreclosures and 500 county tax foreclosures. This is about ten times more than 18 months ago. That’s growth on the scale of the internet—or health care.

After a hundred years, things may change…

Texas foreclosure laws, mostly written in the past 50-100 years, require that all foreclosure auctions must be conducted on the first Tuesday of every month, on the county courthouse steps, in an “open outcry” auction. Rain, shine, or holidays, eager bidders convene on the courthouse steps every first Tuesday to search for bargains.

But this is not just one auction. Harris County has eight precincts, each with several constables, and each constable conducts his own tax auction. To add to the confusion, trustees, who hold the property title for the foreclosing banks, also must conduct their auctions, at the same time, and on the same courthouse steps.

So, on the first Tuesday a property investor will find ten to fifteen constables and thirty to fifty trustees all auctioning off foreclosed property in open outcry, at the same time. It’s more like a flea market than an auction.

Texas law specifies the method of notification. Foreclosure notices must be posted on the courthouse wall by the 18th of the month preceeding the auction. An investor has only two weeks to review 5,000 properties, estimated a market price, and make a personal inspection.

Texas law also specifies the method of payment – cash or cashier’s check – and the bidder qualifications. A bidder can bid only for himself. Stand-ins are not allowed. So an investor may find 10-20 properties of interest, only to discover that they are being auctioned by different people, in different places around the courthouse, at the same time.

Constables and trustees do not identify the property by its street address, but use a tax ID number – a string of 14 digits, with no alpha characters or other breaks, so there’s yet another challenge for the potential investor in identifying his selected property, attempting to listen to a soft-spoken constable amidst many other auctions.

Government regulations tilt the playing fields.

Finally, Texas law specifies the remedies for a buyer at the auction who may make a mistake. There are none. Once the bidding is done, the county cashes the cashier’s checks and the investor owns the property.

No possibility to recover from any mistake. It’s a huge opportunity for investors with lots of cash, lots of time to do the homework, and with nerves of steel. As a result, bid prices are very, very low.

It looks almost as if the state of Texas designed a process to minimize the bids on foreclosed properties at auction. While each of these regulations made some sense at the time, they look very dated now and one significant unintended consequence is to destroy any homeowner equity remaining in the foreclosed property. Another major unintended consequence is to shift the advantage heavily to full-time investors with lots of cash—the “fat cats” who have the time and knowledge to game the system.

It’s easy to poke fun at the process; but that’s not to the point. If we investigated government-run insurance, government-run construction projects, or any other government operation, we would find exactly the same situation.

Regulations create exceptions and processes that experts can exploit.

More regulations create more exceptions, more experts, and more gains.

Is there any solution for the unintended, unfair consequences of government regulation?

Next week we will explore goals, judgment, and transparency. Can these play a role in reducing unintended consequences? What are their unintended consequences?

I’m traveling today, so I’d like you to welcome Miles Mochizuki.

Miles is a certified public accountant and principal at M. Mochizuki & Co. He is a CPA and MBA with more than 25 years of experience as a finance executive, auditor and consultant.  He is the former CFO of several technology companies in Silicon Valley and a financing specialist who has arranged financing ranging from venture capital, bank and lease financing to multi-million dollar debt and equity offerings on Wall Street.  His consulting clients include pre-IPO start-ups and established public companies. You can reach Miles at (925) 413-9198 and miles@mmochizuki.com

Summary

The recession and credit crunch have made cash a strategic asset.  While debt and equity financing is still available, these sources of cash have become unreliable and difficult to tap, increasing the importance of operating cash flow.

Optimizing cash flow requires the close scrutiny of incoming and outgoing cash transactions and the implementation of credit, purchasing and strategic decisions that impact cash.

Simply put, maximize cash by spending wisely.

Reduce and Control Expenses

Headcount is a main driver of operating expenses.  In good times as well as bad, organizational rightsizing is essential to effective cash management and controlling the company’s “expense burn.”  Operating expenses are also strongly influenced by the company’s business model and strategic focus.

Here, the aim should be to reduce complexity by eliminating unprofitable products, markets and customers.

Reducing complexity will also simplify the purchasing process and reduce the required investment in inventory.  Operating expenses such as travel and supplies should be examined and nonessential expenses eliminated.  The feasibility of a negotiated rent reduction and other contract restructurings should also be considered.

The company should adhere to a regularly scheduled check run, typically once a week as a means of instilling discipline in the disbursements process.  During this process, cash disbursements should be prioritized in order of importance to ongoing operations.

This usually means that payroll and essential vendor payments will have a high priority and will take precedence over other disbursements in the event that expected cash inflows do not materialize.

To the extent possible, disbursements should be timed to coincide with cash inflows so as to not unnecessarily deplete the company’s cash reserves.

Overall, the goal of managing cash inflows and outflows is to preserve and, optimally, increase the company’s cash balances so as to provide a financial buffer for operations.  This conservative fiscal management will also result in presenting the company in its financial best light for the purposes of bank credit lines and other outside financing.

Weekly Monitoring of Cash Flow

Another component of effective cash management is the preparation and review of a weekly cash flow statement.  This report should show in sufficient detail the items comprising cash receipts (cash sales, A/R collections, etc.) and cash disbursements (payroll, benefits, inventory purchases, etc.) for the current week and projected for the next 4 – 8 weeks.

This report should be prepared by accounting with input from sales and purchasing.  It should be reviewed by the CFO or Controller, along with the current week’s A/R and A/P agings and check run.  Follow-up items from this review should be discussed, as appropriate, with sales, operations and management.

Cash as a Strategic Asset

There is no question that in these uncertain times, cash and ready access to cash are strategically important and may make the difference between winning and losing.  A company that manages its cash well will be in a strong position to weather the downturn and take advantage of the opportunities to strengthen its market share.

Conversely, in this economic environment poor cash management can quickly lead to insolvency and bankruptcy.

Image credit: svilen001 on sxc.hu

Among the annual flood of business and economics books, two recent ones caught my attention.

Shaking the Globe: Courageous Decision-Making in a Changing World by Blythe McGarvie (230 pages, John Wiley & Sons, 2009) addresses the fragmented, multi-polar world of global business.

In this book, targeted to execs at mid-to-large businesses, Ms. McGarvie surveys the plethora of challenges and opportunities that companies face in the new century. She details the diversity in three major areas: cultures, nations, and generations.

Simply put, companies no longer have the luxury of ignoring any of these diverse constituencies. Even if a company is not competing internationally, then it is defending its domestic market against a multi-national competitor.

Likewise for multi-generational workforces and multi-generational customer bases. For the first time ever, many companies have up to four generations in their workforces, and possibly four or even five generations in their customer bases. Illustrating this trend, a recent survey identified the fastest growing age-group of employees in the US as people in their seventies.

The book amply documents the simultaneous interconnection and fragmentation of businesses, people and markets across the globe.  It identifies various segments and constituencies in each major area, providing a good overview for readers wanting an introduction to the topic. The book concludes with three key messages:

“First, we need to understand how the world is interconnected and that all people in it are interdependent… We need to transcend our nationality.

Second, we must face the financial realities that created this need for going global.

Third, we should become aware of the six forces shaping personal courage if we are to go global. Namely, we experience different cultural norms as evident through beliefs, family, and time horizons; communicate with youth in new ways; tap into the talents of women; understand shareholder interests; capture the entrepreneurial drive for innovation; and respect individuals’ value systems.”

Most interesting are the personal vignettes which Ms. McGarvie uses to illustrate particular topics.

As a reader, I look forward to another book by the author, possibly in a case study format, in which she explores specific situations in much more depth, based on her personal experience.

Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Tom Woods (194 pages, 2009, Regnery Publishing, Inc.) is a timely analysis of the underlying causes of the current recession. Although the style is light, the analysis is thorough and detailed. Mr. Woods explores and debunks a number of myths about the current recession.

“In both cases [the Great Depression and the current recession] an inflationary credit boom brought about by the Fed’s lowering of interest rates led to massive resource misallocation and a distorted capital structure. The Fed tried in vain to inflate each of these booms back into existence, and grew frustrated with banks that refused to lend out the new money it was pumping into the banking system. In both cases the federal government sought to prop up prices… rather than allowing them to fall to a level that made sense [in the market].”

Comparing this recession to the Great Depression and many other recessions in the 1800’s, the book identifies the common culprit in the boom/bust business cycles – government manipulation of the currency. Although this conclusion is no great surprise, the compelling analysis makes for good reading. He defends free markets, pointing out that the money supply is not a free market, but a government-controlled monopoly.

Mr. Woods makes a damning case against the Federal Reserve, condemning it for hidden dealings, a bias toward inflation, and backroom collusion with banks. His analysis demonstrates that government action not only causes the booms and busts, but that same government action significantly delays and cripples the eventual recovery.

As if on cue, in December the Fed strong-armed Bank of America to complete its acquisition of Merrill Lynch even when that purchase significantly weakened the bank and increased the risk to the economy. Of course these machinations occurred in secret, with no disclosure and no transparency for investors, customers, and employees of either company.

In his conclusion, Mr. Woods calls for the abolition of the Fed, proving that he is an incurable optimist. Failing that, Mr. Woods predicts significant inflation ahead, due to government debasement of the currency. Government tampering with money is not just a recent phenomenon, as the author illustrates with examples as early as the tenth century, of governments (then kings) cheating their subjects by debasing the currency.

Even in the age of the internet and electronic commerce, some things have not changed.

Image credit: Amazon

Economic pundits, eagerly searching for signs of the recovery, are grasping at almost anything. “The rate of decline has slowed.” “Unemployment has stabilized.” “The cardboard box index has bottomed out.” And the shape of the recession and recovery has been predicted to be a V,  W,  L, or even a double-bounce W.

I think they’re all wrong.

The old economy will never come back.

This economic meltdown is much like a forest fire. After the fire burns itself out, the storm may be over, but the burn area is fundamentally changed. It does not “bounce back.” It starts at a different place.  Sometime in 2010, the economy will stabilize, but it will not “come back.” We will go forward from a fundamentally different position. This new starting point will reflect the impact of deep, long-term, global trends in the nature of work, the value of the dollar, and our relationship to our government. The current recession is a convenient marker to recognize these trends.

Work Is Changing

The nature of employment will continue to change. The United States will continue to shift to a “just-in-time,” service-based workforce. The manufacturing sector will continue its decline, from 29% of GDP in 1950 to 15% in 2000 (see analysis by Dr. Mankiw). It will drop below 10% by 2010. You can construct your own labor trend at indeed.com. ( This website is a fascinating example of the business of data, which we discussed in the last three posts.)

Many new service-sector workers will be involuntary. Growing unemployment and under-employment in the United States (which will exceed 15% this year) is driving many people into self-employment as service workers. An analysis of Japan’s Lost Decade by Tom Coyner, long-time resident of Japan and Korea, provides one instructive example of this phenomenon, and some associated risks.

These new service sector workers will be driven to a “do-it-yourself” model for almost everything. They will have to provide their own health care plan, retirement plan, office arrangement, and business planning. Many of these workers will be home-based, with little differentiation. The most common product/pricing model will be piecework, with unit pricing based on the alternative of being completely idle. Ironically, one result will be the re-integration of work and home life.

Entrepreneurship is Changing

Investment capital will no longer be available for any but the most solid businesses; and the vast majority of these newly-independent service workers do not have plans to build large businesses. As a result, the successful ones will exhibit four common, positive characteristics:

Local—In a global world, being present still counts. A local service provider who can show up in person has a distinct advantage. In addition, some services simply cannot be outsourced. When your car is broken or your roof leaks, you need a local service person. For locally-based services we may see an increase in a local, personal relationship with service providers.

Immediate—Without investment capital to fund long-term research and development, independent service-providers and small businesses must focus on services that provide immediate value. The “cash-to-cash” cycle must be less than one pay period. Fortunately, credit/debit cards and other immediate payment methods support this trend.

Information-based—Information will provide significant improvements in service quality and competitive differentiation. For instance, simply finding a customer is difficult and expensive. Irritating prospects with unnecessary and unwanted sales promotions is also costly. Successful service providers will use information to target customers on a “just-as-needed” basis.

Green—Setting aside the discussion of whether the earth is warming or whether green is good, government policies will reward green activities preferentially. Independent service providers will offer green services or enhance green aspects of their existing services.

Start-Ups Will Explode in Unlikely Niches

The availability of many talented people and the flexibility of independent service providers will fuel new start-ups. While these may not completely replace the loss of investment capital, they will certainly provide an alternative path of low-cost labor for new businesses. The change may be refreshing, for us individually, and for our economy.

This is perhaps the greatest unknown—how much will individual creativity and inspiration replace financial engineering.

I am hoping for a few delightful surprises ahead.

The great thing about this this blog is that I have the luxury and pleasure of taking a longer view in one of the most turbulent economic times since World War II over fifty years ago, as I’ll be doing over the next few weeks.

Globally, we are seeing seismic shifts in trade flows, financial relationships, business fundamentals, and the balances between people, governments, and business. In many ways we are corks bobbing about in these economic tidal waves.

However, we are corks with intelligence and capability. While we cannot change the tidal waves, we can and should understand them in order to improve our own lives and the lives or our co-workers and friends.

A long view can provide understanding and perhaps some enjoyment in the understanding. But  it is also valuable to connect that long view back to the here and now, to address the question “What do I do about it?”

In this article I address the fundamental shifts occurring in employment models in the United States, tracing the roots of the “lifetime” employment model that emerged in the aftermath of World War II. That model has crumbled and the new models are only now appearing.

Tying this long-term trend back to today, we look at two companies pioneering new employment models.

The Old Model—Lifetime Guarantees

Since World War II large US companies offered an amazing, lifetime employment agreement to their workers. This lifetime agreement had three planks:

• Lifetime employment at the same company
• Lifetime health care
• Lifetime retirement

Following World War II, the United States represented only about 5% of the world’s population, but controlled over 95% of the world’s economic activity. The economic infrastructures of Europe, Russia, and Japan had been destroyed. These countries had also lost almost an entire generation of young men, further crippling their economic activity and recovery.

American companies competed only with each other, and completely dominated the global economic landscape. Several factors—tax structures, unions, and a very limited government—led companies to take over the responsibility for health care and worker retirement planning. Since American companies competed primarily with each other only, they could offer the “lifetime employment” agreement mentioned above.

Today the world has changed. The United States still represents about 5% of the world’s population, but controls only about 25% of the global GDP. American companies compete with the

• EU, where governments have taken over the responsibility for health care and retirement, and
• emerging countries, where no one takes responsibility for the workers’ health care and retirement.

American companies can simply no longer afford to offer the three benefits of lifetime employment – job, health care. Some new models are emerging, but they themselves will change as the global economy continues to shift.

The New Model—Just-in-Time Workers, Do-it-Yourself Benefits

The new employment model is just-in-time, do-it-yourself. Companies now acquire workers just-in-time, shifting their employment burden to independent contractors and outsource service providers. Workers, even the direct employees,  are responsible for their own healthcare and retirement planning. Indirect payroll costs for direct employees will climb significantly in the next ten years, so companies will continue to reduce their direct employee base and increase their use of contractors and outsource providers.

Example—Building Contractor Restructures for Cash Flow

A Texas building contractor I’ll call TexHomes provides a good example of a “new model” small business. In this post we will focus on his employment model, saving the business model for later discussion.

TexHomes sharpened the company’s focus on restoring foreclosed houses—traditional single family residences, typically restoring about 50 homes each month.

With the sharpened focus, TexHomes needed fewer subcontractors, primarily painters, carpet layers, and maintenance people. With the steady volume and a smaller number of subcontractors he experimented with direct employees, planning for improved control.

But the costs and paperwork escalated rapidly, and the company lost considerable freedom in other areas (retirement contributions, health plans, vacations, etc.). So the company switched back to a subcontractor model for almost all of its workers, even though it provides them with full-time work. Currently the company has a very tight work team:

• Employees – 3 people. CEO/owner, Business Manager/co-owner, Accountant (CEO’s wife)
• Independent Subcontractors – 12 people. All the trade workers are independent subcontractors.
• Outsourced Services – every other function. The company uses an independent accounting service, an independent HR service, and independent maintenance service for all company equipment.

With only three direct employees, this company qualifies as a small business, thus reducing its regulatory compliance burden. In addition, the company operates from a home office, further reducing its operational expenses. Since the three direct employees are also owners, the company can coordinate employee benefits to maximize total cash flow to the owner/employees.

The company generates over $20 million in annual revenue with a pre-tax profit margin exceeding 35%. While it may be a small business, it generates considerable cash for its owners and workers.

Unlike the construction industry, many businesses do not have a long tradition of independent subcontractors. However, you may want to consider how you can apply some of these lessons to your business.