PowerOfLeverage
IRR/Power of Leverage/Goal Setting
More Please, Sir
We are going to talk here about models used in Entrepreneurialist
Culture to:
1. Determine your own personal
discount rate and measure the internal rate of
return (IRR) on a new startup, project or division of a larger enterprise;
2. Establish sales goals (using a reverse IRR Model) that you need to
reach each month in order to achieve not only breakeven but your profit goals
as well;
3. Demonstrate the power of debt to increase your
returns (i.e., by using more leverage).
1. Determining
the Internal Rate of Return
Probably the truest measure of a project’s rate of
return is its Internal Rate of Return. The IRR is that interest rate that exactly balances the discounted value of
future net cashflow with the investment required to develop the project or
enterprise. The higher the interest rate needs to be in order to offset future
net cashflow and upfront investment, the higher the IRR is and the better the
project is, at least in terms of return on investment.
The IRR can be found by solving the following
equation by trial and error (computers do it using an iterative process).
In the simplest model, if a student loans a
Professor $1,000 and the Professor pays it back in three years with interest
of, say, $150 per year, we have:
Year Investment/Cashflow
(from the Student’s POV)
0
-$1,000
1
$150
2
$150
3
$1,150
The IRR can be found by solving the following
equation by trial and error (not much trial or error here):
$1,000 - $150/(1+irr)^1 - $150/(1+irr)^2 - $1,150/(1+irr)^3
= 0
or IRR = 15% p.a.
Now, I have done survey after survey (not
scientifically, I may add) of my students over the years and I haven’t yet
found any students yet willing to lend their Professor $1,000 in return for
$150 per year of interest. They usually don’t get interested until the money
gets to be around $200 a year and most of them are looking for even more, $300
or $400 in interest per year. This implies that their Internal Rates of Return
are in the 20 to 40% p.a. range.
Some work I did earlier on rates of return
for students getting an architecture degree suggested that their IRRs are
in the range of just 14%. There could be a number of factors at work here including
the possibility that architects (unlike more hard headed engineers like me or
business students) are somewhat ‘other directed’ (a nice way of saying they are
taking their architecture degrees for reason other than the big bucks).
In any event, it is well known that personal
discount rates tend to fall as people get older because: a. they have usually
have more money as they get older and a greater supply of money implies that
its price will fall, and b. their willingness to take risks drops so that they
would rather have it in T-bills than startups by the time most people are in
their 60s, 70s and 80s.
Just as IRRs tend to decrease with age, they tend to
drop as companies get larger. Mega corporations tend to have minimum
expectations for their IRRs (for their equity) of around 22% p.a. Entrepreneurs
and startups usually have to be much higher than this because so many things
can and do go wrong that you have to aim high just so you don’t go oob (out of business).
When the Disney Company acquired an expansion
franchise in the NHL in the early 1990s, there was some concern that Disney
could afford to ‘buy’ players and push up salaries even faster than they were
already going up. Executives from that Company reassured Expansion Committee
members that every Disney investment including sports teams had to meet certain
minimum investment criteria and this shouldn’t be a concern. The Mighty Ducks
of Anaheim began play within a couple of years thereafter.
If you look at the spreadsheet
for the Rental Home Builder attached here, you will see that if a builder/developer
puts down 25% equity on each unit, he or she will see a 22% IRR. If they put
down just 5%, their IRR on their equity jumps to 56% p.a. In both cases, the IRR
of the project hasn’t changed—it remains 10.8%. What this tells you is that the
IRR for a project (or enterprise) is made up of a series of IRRs on equity and
debt. In this case, the capital structure is simple—there is the
builder/developer’s equity and bank or mortgage debt.
So the IRR for the Project (at 10.8%) is kind of
like the ‘weighted’ average of the IRR on Equity (22%, or 56% in the case using
greater leverage) and the IRR on Debt (in this case, this equals the interest
rate on the mortgage, which is 6%). For more complex projects, you can have
many components in the capital structure—equity, structured equity, debenture
debt, secured debt, sub debt, capital lease, unsecured debt and so forth. Each
tranche will have its own cashflow profile and IRR.
You might ask how can Banks afford to lend money at
6% when the above graph suggests that mega corps want minimum IRRs of 22% p.a.?
Well, just ask yourself how much interest you are getting on your savings
account. If the answer is less than 1% (in fact, after you calculate all the
fees you pay your Bank, it is probably negative), then you can figure it out
for yourself. Bottom line, the Banks use OPM mixed in with a little of their
own so that their IRRs on their equity are among the best on the planet. Don’t
worry about your Bank’s rate of return, worry about your own.
2. Establishing
Sales Goals Using a Reverse IRR Model
The Reverse
IRR Model helps you establish monthly goals for your new enterprise that,
if (when) achieved, will also allow you to pay your bills and make a profit
too. You want to make a profit not so you can take a trip to Vegas but so you
can reinvest in your business and in new technologies, new products, new
services, more staff, more staff training, etc.
Set Your Goals, Visualize Them and Achieve Them- One
Step at a Time
People are really good at reaching goals once they
set them. If you are involved in a timed race, you always want to go second or
at the end when you know everyone else’s times. Then you have a goal, you can
break it down into intervals and WIN.
Same thing for business. It does you no good to say,
I want $150k in sales my first year. What you need to say is, I need $12,500 a
month in sales or $625 a day, every day for the 20 working days in each month.
Visualization is key. Put up a sign “N = ?” in your office and every day focus
on it and drive N up. (N can be sales, number of customers, number of products
shipped, whatever. It is the basic metric for your business.) Don’t think that,
oh well, I didn’t make $625 in sales today, I’ll make it up at month end. It
doesn’t work that way. If you miss today’s target, it means you have to sell
$1,300 tomorrow or $1,925 the day after and pretty soon, you and your business are
toast.
The Reverse IRR Model is based on the assumption
that going in, you are likely to know your costs more accurately that what your
revenues are going to be. The latter we have seen, whether based on marketing
surveys or percentage of the total market that you think you will get, can be
highly unreliable. So using goal setting (i.e., establishing a profitability
target) as a mechanism to establish your revenue streams is probably as good a
way to do this as any.
3. The
Power of Leverage/Using Other People’s Money
Note also the power of using OPM (Other People's
Money) or leverage (aka debt). It increases the IRR on your equity and it
allows you to use a limited amount of capital to do more of whatever it is you
are planning on doing.
Leverage is usually interpreted (especially by
Banks) as increasing risk too but as you will see in the rental home example we
are using here, it may be that if you develop five rental units instead of one,
your risks (and your Bank’s exposure to you as well) may go down not up despite
higher gearing.
Archimedes Clearly Understood the Power of Leverage
If you use your equity to build five units instead
of one (i.e., you are putting 5% down on each unit instead of 25% and financing
the rest), and if one tenant leaves, you will have a 20% vacancy rate instead
of 100%. The free cashflow you are earning from the other four (still occupied)
units can assist you in paying the mortgage for the vacant fifth unit.
If the average vacancy rate for each unit over a ten
year period is, say, 10%, then the probability that all five units would be
vacant at the same time is pretty low (0.1 to the power of five or just .001%).
So, as entrepreneurs, we can argue (with our Bank) for more leverage not less.
Obviously, the Bank will say:
1. If you put down more equity, they will be looking
at a better debt to equity ratio and that means if asset values tumble, their
loans are protected by your equity since in a Bankruptcy or Power of Sale
proceeding, the secured creditor gets paid first.
2. If you only have one unit and it becomes vacant,
your income from other sources (the cashflow coverage for your loan (in this
case, your mortgage payment)) is relatively higher than if you had to cope with
all five units suddenly becoming vacant.
This is what I like to call the ‘nuclear bomb
scenario’ or what other people call the Banks’ ‘belt and suspenders’ approach
to lending. Banks generally only like to lend money to entrepreneurs who don’t
need it (i.e., that have enough of their own cash to start a new venture).
From your POV, your cash on cash returns are much
higher if you build five units. The spreadsheet shows if you leverage your
$37,500 in equity into five rental properties (with 5% down on each unit), you
have a cash return of $254,052.85 over
five years as compared to $89,291.00 if
you can only build one unit (with a down payment of 25%).
Bottom line, you need a sophisticated, motivated
lender before you can do highly leveraged deals.
_________________________________________________________________
So summing up so far, in Entrepreneurialist
Culture, we have learned to Get
the Business Model Right, add some ‘Pixie Dust’
to it, test or score
our Business Model, construct a Balance
Sheet and Income Statement, measure our Rates of Return, Use Leverage and
establish Sales Goals. Still ahead is using guerrilla
marketing, bootstrap
capital, negotiating
and selling, market
by media release and more!
Copyright. Dr. Bruce M. Firestone,
http://www.dramatispersonae.org/EntrepreneurialistCultureFrontPage.htm