Learnings from Stanford GSB: Wk3

This week we focussed on 2 main topics: Working in Teams and Finance

Teams

Efficiently completing tasks as a team comes down to three main points. The planning phase, minimising process loss and team dynamic. Each of these can further be broken down to critical sub-components.

The planning phase

Agree upon the goal

There is a difference between ‘Task’ and ‘Goal’. While you may be tasked to build a new product, the goal of your team may be to have fun or to learn. It is important to understand that everyone in the team may have different goals. This is often a source of conflict within teams and it can be overcome by having a conversation on the beginning about the overarching goal of the team.

Create a common language

Everyone comes into a team with different assumptions and ways of communicating. It is important to spend the time to make sure that everyone is on the same page so that communication can be clear and efficient. An example of this could be as simple as defining orientation. E.g “When we say the left side, we are referring to our left not the users left”. This will help to minimise simple communication errors

Divide the labor

In order to complete a task, it is important to divide the labour amongst the team. Each person on the team should have a very specific and clearly defined goal so that they can focus and execute their portion of the task without confusion. It is important to spend time evaluating the best method to divide tasks based on the objective. Efficient division utilises all team members and minimises the amount of coordination required.

Find individual expertise and determine roles

This is often a challenging this to do because people who say they are experts probably aren't and those who deeply understand the field/topic underestimate their abilities. It is important to adapt roles as you progress to ensure that you are getting the best out of everyone.

Create a coordination mechanism

I really liked this point. You can have great sub-teams who produce perfect individual parts, but if there is no management of coordination or how the parts will fit together, the whole product will be ruined. It is important to have oversight over coordination or make sure there is enough cross-team communication to facilitate solid coordination between sub-systems

Identify the unknowns

There is a big difference between know and unknown unknowns. However, it is important to plan for both events. We as humans often have a far too optimistic outlook on the world and so we neglect to consider unknown unknowns during the planning process. If you have a critical team member, have a contingency plan for if they were to fall ill or quit. This will ensure that you are ready to act when things inevitably go wrong. It is also much better to under promise and over deliver than the other way around, so having contingency will help meet your obligations.

Expect conflict and disagreement at each of the stages

It is likely at any or all of these stages there will be some level of disagreement with the team. It is important to go back and review the goal that everyone agreed upon. Each decision should be made in a way that gets you closer to this goal.

Process Loss

Often when working in teams, the sum of the whole can be less than the sum of the parts. Why is this? There are a few forms of process loss that cause individuals to perform below their best when working in a team.

Coordination loss

This goes back to the previous points of division of work and coordination. When you bring a lot of star players into a team, the team often does worse than a team of average players who are very cohesive. Why is this? Coordination beats talent and things always break at the joints. By inefficiently joining high performing teams, the quality of their work often decreases. It is critical to have cross-team collaboration and oversight to ensure that there is a successful wholistic outcome.

Motivation Loss

This might seem counter intuitive, but the more people you add to a team, the less motivated the individuals in that team become. Why does this happen? Often it is due to a loss in visibility into individual performance. Why should I work extra hard, just for my team to take credit for it? It can also be attributed to a loss of role clarity. The more people you add, the less clarity around each persons responsibilities. Motivation within the team is also highly correlated with trust. If a high-performing team member sees a teammate leaving early, they may be less inclined to work hard, even if the teammate is putting in long hours from home. Thus by building a good team culture and a high level of trust, it is possible to get all team members to trust that each other are striving for the team’s common mission.

Ability Loss

The difference between being a professional and being an amateur is autonomy. Professionals have automated the process and so they can execute without excessive cognitive capacity. When we are around others, we become stimulated and so we fall back on our dominant response which tends to be something we have automated. Thus, it is beneficial to give your team the time and practice to acclimate and automate their roles. One thing cannot be automated and that is creativity. Being around others when you need to be creative, will diminish your ability and skill, since you will be highly distracted.

Below are some potential ways to overcome the above losses

Team Dynamic — 4 Player Model

This method outlines the key characteristics of successful and efficient team members.

1. Move

   1. This act sets the team in motion by providing action, direction or a suggestion
      

2. Support

   1. This act creates momentum and cohesion by supporting, following or building upon the ‘Move’
      

3. Oppose

   1. This corrects or provides alternative view points by disagreeing (constructively) or providing arguments against
      

4. Reflect

   1. This initiates deeper thinking by reflecting, inquiring and uncovering the groups assumptions
      

In order for a team to be efficient, it requires an equal portion of all these behaviours, but more importantly, it requires each individual to provide equal portions of these behaviours. It is a fine balance. Too much of each characteristic can cause poorly thought out plans, excessive conformity, negativity and confusion/inaction. However, too little of each can cause no actions, insufficient collaboration, conformity or blind action.

A final point on communication & leadership

When we are communicating, we do so with an intent. Whether this is supporting or disagreeing with the other person. Therefore, it is the obligation of the communicator to ensure that the other person understood the intent you were trying to convey. Different people perceive things differently, so a comment that is intended to be support could be perceived as opposition.

As individuals, leadership looks different to each of us. We all have our own ‘model of leadership’. It is important that we inspect and think deeply about what our own ‘model’ is and whether it is what we want it to be. Sometimes the best leader is the person who can fill the position that is lacking in the 4 player model above, to ensure the team’s output is maximised.

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Finance

As our professor told us at the end of this class, we essentially covered a semesters worth of finance in a few hours. There was so much info, so I tried my best to summarise.

Accounting is a backward looking process, whereby the financial statements all reflect the past value of assets and liabilities. i.e. A property that a company purchases is represented on the balance sheet as initial purchase price minus depreciation. This is not an accurate representation of what the asset is worth today, or into the future. That is essentially the goal in finance. To assess forward looking value of assets.

P/B — Price to Book Ratio

This forward looking value is reflected in the price to book ratio of a business. It is the ratio of the company’s stock price (what investors are willing to pay) and the value of the company on its balance sheet (Total shareholders equity). This ratio is rarely ever 1, which means that investors value the company either higher or lower than its value on paper. This reflects the difference between accounting value and projected future value.

P/E — Price to Earnings Ratio

The price to earnings ratio is another important factor which values how much investors are willing to pay per $1 that the company returns. This ratio often captures the forward looking of investors. When the P/E is high, it can mean that investors are predicting the company to grow.

NPV — Net Present Value

When making good business decisions, it is vital to consider the costs and benefits, in the short and long term. ultimately, the value of the benefits must be greater than the value of the costs. We measure this using the NPV:

NPV = Value (Benefits) — Value (Costs)

Hence, good business decisions have positive NPV, meaning the benefits outweigh the costs.

FCF — Free Cash Flow

Free cash flow is the cash left over after a company pays for its operating and capital expenses. It can be calculated using the following:

FCF = EBIT — Taxes + Depreciation — Increase in NWC — CapEx

NWC — Net Working Capital

The NWC is the capital required to run the business. It’s dictated by the following:

NWC = Inventory + Cash Requirements + Receivables — Payables

Discounting cash flows

$1 today is not the same as $1 tomorrow. The same can be said for cashflows of a company. This is due to two factors: The time value of money and the risk. Thus, if we are assessing a decision today, we need to account for the fact that I could invest my money today and make a safe/risk-free return, and then compare that to the value generated by the business decision.

We call the fraction on the left the ‘Dicscount factor’.

Cost of capital

As an investor, you want the highest return possible. However, not all investments are the same. Treasury bonds may have lower interest, but they are also extremely low risk. Small stock companies have the potential to 1000x but also are extremely high risk. This means there is a balance point. If my expected return on an inherently risky stock is lower than the return of an ultra safe treasury bond, I would just invest my money in the bonds. When interest rates are low, there is more incentive to invest in businesses since their returns will seem much more appealing. This is the core part of monetary policy. Changing interest rates to stimulate or slow investment and ultimately effect the economy.

The yield curve

The yield curve is a graph of interest rates for different maturity treasury bonds. This is an extremely useful tool as it is a prediction of what investors are expecting the market to do. Normally, you expect higher interest rates for longer maturity, as there is greater risk of future increases in inflation.

Example of a yield curve — Copehagen Post

However, the shape of the yield curve can be varied, which is indicative of the expectations of which direction interest rates will move and when. The yellow curve is an example of an inversion in the yield curve, which suggests that rates will be high in the short term and drop over the long term. Yield curve inversion has been a successful predictor of the past 8 recessions so is a very valuable metric to track.

Diversifiable risk vs Market Risk

Let’s take two different examples. Home theft insurance and earthquake insurance. Both have different risks associated with them, but let’s say they both have 1% chance of the event occurring. If we are the insurance company and we sell these policies to 100,000 customers, what happens if the event occurs? In the case of the theft, 1% of 100,000 customers will make a claim which means we will have to pay out on 1000 claims, so we have to keep at least 1000 claims worth of money in reserve. In the 1% event of an earthquake, what happens? An earthquake doesn’t just effect a few houses, when it happens it effects all the homes. That means on the 1% chance that the event occurs, we have to pay out on all 100,000 claims. This means we need to keep the whole fund in reserve ready to pay out.

This highlights the difference between diversifiable risk and market risk. The difference between theft and an earthquake is correlation. Theft has low correlation. If I get robbed, it is unlikely that someone in my street also gets robbed. But if there is an earthquake and my house is ruined, it is highly likely that same person’s house is also ruined. By pooling together theft premiums together, we diversify the risk and reduce the payout. This makes it diversifiable. Market risk is risk that cannot be diversified (i.e. earthquake cover)

Risk premium

When investors take on risk, especially market risk, they expect to be compensated (just like insurance premiums). The way risk premiums are calculated are based on a companies Beta. Beta is a measure of a companies sensitivity compared to the overall market. By plotting market returns against the returns of the company for a 2–5 year period, a scatter will emerge and a line of best fit can be drawn. The slope of this line is the Beta.

Beta analysis plot for TSLA — Slope of line of best fit (1.92) is representative of Beta

The risk premium can then be calculated by multiplying Beta by the risk premium of investing in an index fund (Beta = 1). This tends to be around 4–5%. Therefore, the higher a stock’s return variance, the higher the premium an investor will require.

Financial Model Sensitivities

There is incredible value in building out a financial model as it allows you to test how different factors can impact your NPV and FCF. Keeping key factors as variables in the model also allows for a quick sensitivity analysis to be conducted. By varying these assumptions, you can quickly see how greatly they effect the outcome. This can help to prioritise resources and clarify confidence in certain assumptions. For example, if varying the product cost in your financial model leads to significant swings in NPV, it may be valuable to talk further with the engineering or procurement team to ensure you can that they can deliver the product within a tighter confidence interval.

It can also be helpful to build models that simulate different cases. I.e. your R&D fails or your product becomes obsolete earlier than expected. These models will allow you to calculate an NPV for each case and given the likelihood of each case occurring, a weighted NPV for the entire decision can be created.

Staged Investment

Many decisions in business, especially when innovating, have a high probability of failure. This doesn’t mean we shouldn’t try, but we need to account for failure probability to make more informed decisions. Rather than just investing a lump sum upfront, set key milestones with aligned funding targets. This way, you stage your risk and allow your money to be spread across a lot of simultaneous attempts/endeavours.

By starting at the end and working our way backwards, we can see that despite the low probability of success, making the first investment still produces $360k of value. By staggering these investments, we are able to maximise our probability of success, assuming that we know when to pull the plug. This is very similar to the method used by VCs. By investing in an early seed round and then seeing if the startup hits the next milestone, they are able to invest in subsequent rounds and effectively stagger their investments.

VC Valuation

We have discussed valuation based on the DCF method, by when VCs are investing in startups, they often have negative cashflow. This compromises the valuation of potentially brilliant companies. In this case, industry comparisons are usually used and the VCs must consider failure rates, the impact of dilution and exit value. One way to do this is using exit multiples.

Exit Multiple

The exit multiple is a simple method to value a company. It is a shortened DCF method which uses the following formula:

Where g is the expected long term growth rate. If we divide this by expected revenue, we get the following equation:

This equation allows you to quickly plug in expected r

VC Terminology

When fundraising, a lot of terms get thrown around, so I wanted to summarise a few:

1. Pre-money valuation

   1. This is the value that new investors assign to the existing firm and is dictated by the pre-transaction share count multiplied by the post transaction share price.
      

2. Post-money valuation

   1. This is the value of the firm at the close of the additional investment and is dictated by post-transaction share count multiplied by the post transaction share price.

   2. It is important to highlight that Pre-money valuation + Investment = Post money valuation
      

3. Dilution

   1. Any time you raise additional funds, you add additional shares. This dilutes the percentage ownership of the previous parties. Dilution occurs primarily for three reasons: Closing out a funding round, Issuance of new employee options or taking the company public.
      

4. Down round

   1. A down round occurs when an investment round’s share price is lower than the previous rounds share price. Essentially the valuation is lower than it was prior to the previous round of financing.
      

5. Anti-Dilution provisions

   1. This is a mechanism to prevent investors from losing value in a down round. If a down round occurs, they receive additional shares to compensate. This further dilutes the founders and employees.
      

6. Liquidation preference

   1. This mechanism gives priority over the company’s assets to a certain party in the event that it is liquidated. This usually involves investors receiving a multiple (1x — 3x) of their investment before any proceeds are paid to common stock holders. This can leave the founders with nothing if the exit value is low.
      

7. Participation rights

   1. This is essentially a double dip, whereby participating preferred shareholders get liquidation preference, but then also get their pro-rata share of the remaining proceeds. They get their initial investment back + their portion of whatever is left over.
      

Hurdle Rates

Hurdle rates are the minimum rates of return that an investor expects to proceed with their investment. Hurdle rates combine discounting and failure rate to produce a failure adjusted required rate of return. VCs tend to have very high hurdle rates (30–40% is not unusual). The hurdle rate can be calculated using the following equation.

Hurdle Rate Equation

Where r is the cost of capital and f is the failure rate. For example, if a VC firm expects a 15% chance of failure and have a 15% required rate of return, then the company they are investing in must produce a 35% return for them to consider investing.

Final Thoughts

Managers are often far better at initiating projects than killing them. It is important to identify projects that are not viable and pull the plug on them early rather than to continue to keep trying. It is something that VCs do well. Invest in lots of small companies, 9 out 10 will fail, but it just takes one to succeed to generate a lot of returns. This reinforces the point of “fail fast” which keeps popping up as a recurring theme. It is a reminder to develop and maintain a culture which accepts and celebrates failure in an effort to stay innovative.

It is also important to think deeply about the “investor protections” associated with funding agreements and see whether you can negotiate the terms. Often when founders are desperate for cash they will take any terms, but this often ends with them being heavily diluted and exiting with less than their fair share.