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It is better
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the web than
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not know why

John Sumser

is more
it seems.
John Gall


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Making Money III
(January 17, 2003) - 
For a public company, the value of the firm is determined by multiplying the number of shares available by the current stock price. This value, as we noted yesterday, is a function of the operation's ability to reliably convert revenue into margin. In 'sensible markets' (whatever that means), there is a sort of inverse relationship between a company's value and the prevailing interest rate. The lower the rate, the higher the value and vice versa.

For most real entrepreneurs, the fact that the proceduralization of their efforts is, in itself, valuable is one of the most pleasant and unnerving experiences of their lifetime. With the exception of business school graduates, most business starters do so for the margin, not the underlying value. The fact that entrepreneurialism creates wealth and leverage is a surprising and somewhat mysterious aspect of running a business. From the entrepreneurs perspective, a feat of magic is performed as he/she goes to work each day.  The very repetition of the company's processes creates a value over and above the profit made on sales.

Quite often, this is the entrepreneur's introduction to the world of capital. That is, the value of the company, like equity in a house, is something that is easy to leverage but hard to spend. One of the major features of capital is that it varies in form and relative liquidity. Liquidity is a banker's way of describing the ease with which wealth can be spent. Cash is very liquid, stock in a small private company is hardly liquid at all, equity in a home is somewhat liquid (it can be borrowed against).

Most of the time, when people talk about making money, they are referring to the creation and accumulation of capital. Cash is only one of the many forms of capital available. Cash, equity and debt, the three major types of capital, all obey one supreme principle: compound interest. Just as you'd imagine, this is as simple as a basic bank account. Compound interest is the thing that drives most owners of capital to explore a variety of investments. The riskier the investment, the higher the potential of return (and as we have seen recently, the greater the risk of loss.)

Although many entrepreneurs successfully start companies without capital (and we have a general sense that they are more likely to be successful), a small range of companies use capital to get the ball rolling. This startup (or seed) capital can be generated from friends and family or institutional investors (who range from banks to formal venture capital companies to local 'angel investors'). Acquiring startup capital means that the entrepreneur sells off a significant piece of the future of the company in order to have cash at the beginning. 

Money at the beginning can be very useful. Products and services have to be created. Software needs developing. People need training. There is no shortage of ways to 'burn' money in the early days before a sale. In spite of the fact that mistakes are highest at the start, quite often the value of a company is described as a 'multiple' of the early investment.

Capital is also often used to fix structural cash flow problems. If a business is somewhat cyclical but its employees need to be permanent, operating capital can be used to iron out the bumps in cash flow. New products, research, growth and other ventures are also places in which capital is used. Each time a business uses capital it incurs an obligation to repay at some compound interest rate. A business will acquire capital in order to execute a strategy if the strategy seems likely to pay off at higher than the going rate.

We thought this tutorial would be useful before we get into the 'real subject": How does HR take a more strategic role? In general, companies were formed to make money, not to save it (though identifiable waste is well worth reducing). Typically, HCM functions do not obviously help the company accomplish this fundamental task. Next week, we are going to explore some of the ways in which Recruiting and HCM in general could be structured to generate capital.

- John Sumser  

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