Failed Startup's Final Income Statements Reveal Grave Error

Two weeks ago I took a look at a company in distress. Three years of figures: 2010, profitable, 2011, still profitable but substantially lower, 2012, huge loss. Every year their turnover grew but their margins decreased (because they had to bid lower (more competitive) on contracts in order to grow their revenues). The CEO had no idea why they were in trouble, he'd attributed it to his co-director making off with money (which in fact he did, but only relatively small sums). They've filed for bankruptcy last week and to this day I'm not sure if I've been able to adequately explain to him that if you lose more money on every subsequent project that you contract that you can grow your revenues only until your cash reserves run out. Even with the figures laid out pretty clearly I think he still does not really get it. Puzzling.

I think they thought that as long as they were winning the contracts from their competitors that they were doing well but if you don't accurately track your purchasing you will never know whether you are making money or losing money on a contract.

Among other things, the "revenue" number seems totally bogus.

Reminds me of a tactic used by Skillshare. I sent them some feedback saying the class I'd just taken was terrible. They didn't offer me a refund (I hadn't asked for one), but they did give me a "scholarship" for the course amount - $20 back to PayPal, operationally identical to a refund. This way, they get to book "my" $20 as "revenue," and the "scholarship" as a "marketing expense."

It boggles the mind that the investors, or even employees, let the margins get that ugly. When you're discounting your products/sales by $750K a month and accepting that loss, how is no one else missing that? Even if you don't see the actual income statement, you'd have to realize that you're selling all of your inventory at a discount. Not just some loss-leaders, but everything. How did no one call that out earlier?

The whole Ecomom story is tragic, and the lost life is the worst part of the whole story. Yet, I can't help but think that if someone else had been more forcefully stood up to Mr. Sherman's business model, the situation could have improved before it turned tragic.

>> A large problem was Sherman did not understand some basic business principles. "I would bring the financial statements to Jody who would glance at them so cursorily and wave me away with 'no one can understand this without extensive analysis,' Prentiss writes. "Critically, he did not understand margin. At the end of December when things were getting truly desperate, he said to me, 'Phil, just bring me a forecast that shows how much we need to sell to break even.' He did not understand, after three years of negative margin, that increased sales resulted in increased losses. He had built his house by raising money and when times got tough he went with what he knew."

If the above it's true, it's really scary. You should not be in any business, let alone commerce, if you don't get this basic stuff. Building a business is about making money - coaxing it right out of the unit economics - not raising money.

Holy mackerel, does this ring true!

Long ago, I had an internship at a company that focused primarily on daily revenue. An email would go out in the morning with yesterday's sales figures. It omitted (for reasons I don't know) the gross margins.

Someone high up figured out "Hey, we can goose the numbers by running sales!" and so the sales went up - almost daily - and yes, indeed, the daily revenue $ went up and up.

I'm not sure what happened to the business, but I'm sure if you want to maximize daily revenue you can but if you don't pay attention to margin, well - you're in trouble.

I thought this was an isolated case but clearly anyone can fall into that trap. Very weird, especially when the data is staring you in the face. Reality distortion field? Incompetence? Willful ignorance? Some of each?

This is all a very sad state of affairs obviously. I think, though, cautionary tales do have some value - and hopefully allow a small silver lining to the accompanying cloud.

In this is, as the post outlines, an important lesson to founders from the sales/marketing side to not oversell yourself, not just to others but to yourself. This is part of the reason many VCs are reluctant to back companies founded by pure sales people, because such folks will oversell their own ideas to themselves and not look as critically. You MUST get to grips with fundamentals. You MUST understand the financial details of your business and not hand that responsibility off to someone else. I would also argue, though many disagree, that you MUST understand on some level of detail the engineering behind your product, even if you are not the level of coder your engineering team members hopefully are.

Pitching ability is necessary but not sufficient qualification for success as a startup founder. It's a very sad situation when someone pitches so far ahead of the curve they feel like they have no way out. Depression and despair is a frighteningly common situation to find yourself in as a founder. Help yourself by owning knowledge of all aspects of your business and THEN let the subject matter experts own the deep dive and the execution on those.

Where the fuck was the board?

It looks like he did a "party round" with tiny investments from a lot of sophisticated investors, combined with bigger investments from less sophisticated investors, and none of them were competent and interested enough to exercise any oversight.

http://www.crunchbase.com/company/ecomom

Here's the best part from the full post mortem

"First and foremost,the VP of Sales was compensated according to sales before discounts, not according to margin or profit. Our discount strategy resulted in enormous losses, but for the VP of sales the strategy optimized his bonus. "

It's called incentive based behavior, and it goes to show you that if you reward someone for the amount of shit they can sell without any consideration for margin, they'll give the damn shit away for free!

I think it's an oversimplification to say that Mr. Sherman "did not understand margin". The concept is so fundamental that you can explain it to first-graders as soon as they're introduced to a number line.

Sure, he understood it. Did he respect it as the prime directive? It seems not. But, plenty of companies would take the same approach and write down the losses to the cost of customer acquisition--pure marketing--with the idea being to recoup later.

That drive, BTW, is a side effect of high-pressure SV culture. Rather than build more methodically with an emphasis on creating rabidly loyal fans who are willing to pay a higher price for service, customer experience, etc, the goal was to grow revenue and customer base as quickly as possible by any means. In this case, it meant deep discounting.

So, instead of a simple misunderstanding of margin, the problem here seems to be more that this pressure caused him to embark on a strategy ill-suited to his product. Once he'd trained his customers to expect discounts so deep that he couldn't possibly profit, there was no turning back. It seems, instead, that the Zappos model would have been more suited to his offering.

But the relentless pressure for growth combined with the belief that he had access to more capital seems most responsible for his approach. I think it's possible that many rational people would have been lulled into making the same mistake, even with a clear understanding of margin. To say that he didn't understand that you have to sell a product for more than it costs to profit is nearly insulting.

"Grave error" implies something that a non-fool might blunder into. Fools don't blunder, per se, they simply exist.

One of the first jokes I ever heard at a startup was "We'll give the product away and make it up on volume!" Changing the joke to "We'll pay people to take the product and make it up on volume!" doesn't make it less obviously ridiculous.

I'm amazed they were able to hire employees, let alone find investors. Doesn't make the guy's death any less tragic though.

"First and foremost,the VP of Sales was compensated according to sales before discounts, not according to margin or profit"

what could possibly go wrong?

This is tough:

* Revenue $1.0MM

* Variable costs $1.5MM

* Fixed costs & admin $300K

* For a net loss of $800K

How can your variable costs exceed your revenue by so much? You might as well not be in business.

It's not just small companies.

I worked briefly for a mid-sized tech company that took a >$70 mm round, but will likely be out-of-business before year end. Like Ecomom, it is helmed by a "visionary" / fanatical leader with a "grow at all cost mentality."

To me, a big red flag is when senior managers make plans without both revenues AND costs being openly discussed.

It seems that at the core of their demise was the fact that their discounting strategy was very Groupon-esque, ie. Done using a 3rd party service and ultimately failing to capture loyalty of their customers.

The article states "when they stopped discounting, the sales stopped" but the way that reads to me is that the 3rd party discounting service was actually their only significant source of traffic.

It seems unlikely that if they were offering goods at a reasonable price that people needed with a trustworthy level of support, that their sales would completely evaporate in the absence of discounts otherwise.

If all that's true, it's simply breathtaking.

| "For example the customer would pay Plum District $20 and receive a $40 coupon to be used on our site. We would ship $40 of retail value and receive nothing from the customer, but eventually receive $20 (less some service charge) from Plum District."

So it's basically Groupon for goods? For businesses with low variable costs (like restaurants and hotels) this might actually work, but for physical consumer goods with cut throat margins? Insane.

I recommend reading the full letter from Prentiss as opposed to the summarized version on B-insider. The full-version presents a very clear cautionary tale about business strategy and management. Prentiss articulates himself well and gives you an inside look at what it's like to watch a start up fail.

I'm getting tired of seeing the never ending spin from one or another person that given that justice would be considering changes if it wasn't for the fact that jody swote the final chapter.

I don't know phillip, and I'm sure he's a nice guy, but nobody that took an accounting class at community college has a lack of financial knowledge so great that they couldn't see two trains inexorably colliding, a process that began well before 4Q12 and in fact stretched back to prior to the last round of funding closing (late summer).

A mere glance at the numbers showing 90% of the days orders a) via 50% pre-sale b) had significant coupon (often 30%) stacked on top of that that applied to the total not just their share, c) 99% got free shipping that they valued at $6 but likely ran twice that much of the time. When you add it all up you are losing money on every sale even if your product is free, you have no marketing costs, no fullfillment, no chargeback, no backoffice, no ceo's that need to bust it at yet another conference.

It was so bad that you could easily within seconds spot the real transactions - people paying ~70%-~%80 of list and shipping. because you;d only see one once a day if you were lucky.

There's a phrase accountants use when they really wan to to say a certain word but it gets you sued if you do. So here we go. There was an obvious material weakness present in absolutely everyone conducting the business of the board and the c level posts. As much as nerds want to believe that crap about how dumb the population is, people aren't that dumb.

Make no mistake, there was something completely unmistakable for incompetence at the very best at work here. Sure they wasted a bunch buying customers, but thats not how you go from $5+1secured in a few months.

This money walked out the door. Where'd it go? Well it turns out that post crisis the lead investor and secondary spot of the board poured over books day in day out withe the brand new "fall guy" president, elected by the board two days after jodys death. They amounted to the entirety of the forensic accounting done and found that no money was missing though employees never saw the books.

Then, 28 days after his death they transferred all shares and assets without prior announcement to in effect liquidate without the oversight of the court. The key part there is oversight - a court appointed trustee would have the obligation to claw back money, especially from insiders. The Instead in this case the insiders paid a significant amount of their cash on hand (six figures) as they wrapped up to provide sherwood partners a hefty cash guarantee on their liquidation expenses, and likely covered some of their secured debt as well to buy the ascent of the major secured creditor. While that happened in secret they continued to ensure contractors that'd be paid and enough was there. Now that's 0 for the benefit of bankers. For no more than 100-200 gained off of misclassified 1099s.

That substantial fraud occurred goes essentially unquestioned in those circles. That the active member of the board from cue ball was at least guilty of gross negligence seems difficult to argue against.

And yet nobody in the whole process is willing to stand up, investors, employees, the many parties only speaking through lawyers, about it because of the code of silence in vc-istan. Which is absolutely real and will absolutely fuck you.

If you're doing venture backed lottery schemes for a living you should make sure find some of the contrarian stories and listen - when things don't work out the windowns are far from having free snacks.

I hope no one forgets we often value companies (in an overly simplified way) by a multiple of their revenue. Of course other things are taken into consideration but had they kept their discount as a marketing expense they could have gotten away with it in going on to next steps like a potential IPO. What the article highlights is that the wrong variables were taken into account when calculating margin, and this could happen very easily/could be debated both ways.

The thing I'm curious about is their balance sheet. If someone buys from a site like plum district a gift certificate for $40 that they paid $20 for, California residents are entitled to at least $20 of goods for an unlimited time... What a nightmare!

I don't get it. The guy was an idiot, and the people who funded Ecomom were blind. A high school student could have pointed out the flaws here.

Re: "Our discounts are meant to be one time only, but we can't limit them by customer so every order ends up sold 50% off"

Sounds like a technology problem.

Reading the Ecomom story it reminds me of Zappos. That company too was losing a lot of money. It only sold to Amazon after their investors refused to put more money in.

The Ecomom story is pretty mind boggling from a sound business perspective, but then so is Zappos. And look how celebrated Tony Hsieh is. And guess who was also an investor in Ecomom?

Seems like he was using a groupon like service to sell $40 coupons for $20, and then only getting part of that $20 back from the marketing company. Built in 66%+ loss on every sale.

Those coupons have hurt many a business. People buy only $39.99 and not a penny more since the coupon anchors the price and the expectation.

Can someone please help me understand what I'm missing? When I calculate the Net/Profit Loss on the first income statement I get ($521) and not ($548).

I don't see anything in the article that accounts for the missing $27K. What kind of accounting is that?

Investors must invest responsibly and don't give money to clueless entrepreneurs.

These misguided investments pushed that clueless & reckless entrepreneur toward suicide.

Irresponsible investing is similar to irresponsible lending during the housing bubble (pre-2008).

The reality is that small online retailers have no chance against amazon unless they sell at a loss. The delusion is to think that the losses are an investment.

    Prentiss also says Sherman drew up a will one week before he died and gave it to his secretary.

And they didn't consider this a massive red flag?

How did the "outside accountant" miss this :S.

So the "grave error" is a lack of simple understanding of what a margin is? Seriously?

School should teach critical thinking skills and I guess the concept of profit/loss...

Multiply by a negative number - and guess what? You get a bigger negative number.

I assume "Magneto" is in fact "Magento".

Wait, are you telling me I'll LOSE money if I sell things below cost? That's not a "grave financial error", it's an egregious violation of common sense.

He was basically running a Groupon for moms, and no one stopped to say "Hey, Groupon never turned a profit. What makes you think your company will?"