Amazon vs Walmart

Amazon vs. Walmart: Bezos Goes for the Jugular with Whole Foods Acquisition

Key Highlights

  • On Friday, June 16, Amazon announced it was acquiring Whole Foods Market for $13.7 billion, the largest acquisition in the online retailer’s history.
  • Just a few hours later, Walmart announced the completion of its $310 million acquisition of the men’s apparel direct-to-consumer retailer Bonobos.
  • Whole Foods’ prime real estate allows Amazon to finally get into last-mile delivery, something the online retailer has historically struggled to do. Whole Foods has a 456-store footprint in the US, Canada, and the UK, mostly in upmarket, urban areas.
  • The significant implications of the Amazon/Whole Foods deal for the grocery and retail spaces explain why many retailers’ stocks took a big hit after the news (down 5-10%).
  • Walmart is pushing a strategy to buy vertically integrated companies because of higher gross profit margins. Whole Foods has some private label, but it accounts for only around 15% of revenues.
  • Groceries is an important category – a recent report by the Food Marketing Institute (FMI) found that US grocery sales could grow five-fold over the course of the next decade, with spending estimated at more than $100 billion by 2025.
  • The FMI survey highlighted how 69% of shoppers valued the store’s reputation when choosing which store to buy groceries at, making Whole Foods’ brand an important asset for Amazon to leverage.
  • Walmart is the nation’s largest seller of groceries, selling over $170 billion last year, and the category is a key driver of store traffic and customer loyalty. Walmart has invested and tested in click-and-collect programs, stand-alone grocery pick-up sites, and even testing of an automated kiosk for 24-hour pick-up.
  • Many voice concerns that not only do Walmart and Bonobos customers not overlap, but that Walmart’s acquisition may in fact push several away.

In just the space of a few days, the retail world was shaken by two big acquisition announcements from the industry’s goliaths: Walmart and Amazon. The latter grabbed the lion’s share of the headlines, announcing its acquisition of Whole Foods Market last Friday for a whopping $13.7 billion, making it the largest acquisition in the company’s history (dwarfing their $1.2 billion acquisition of Zappos in 2009).

As the markets were still coming to terms with the news, Walmart quickly followed up with its announcement of its acquisition of Bonobos, the direct-to-consumer (DTC) menswear retailer, for $310 million. As Fast Company highlighted, “The move threw into relief exactly how fiercely [Amazon and Walmart] are competing for the American consumer by working to seamlessly integrate online and offline shopping experiences.”

As the dust settles, it does seem clear that Amazon’s move will be far more significant, influential, and disruptive than Walmart’s. With the acquisition of Whole Foods, Amazon is possibly embarking on a radical disruption of brick & mortar retailing in the US, leaving Walmart to play defense.

Amazon Buying Whole Foods Is a Big Deal

Consensus is overwhelmingly that Amazon’s acquisition of Whole Foods is a big deal. “Amazon buying Whole Foods is incredibly interesting, highly strategic, and definitely not standard” said Toptal Finance Expert Josh Chapman. Recalling the video introducing Amazon Go (below) which surfaced at the end of last year, Chapman believes “[it was] Amazon’s vision all along and I believe it is front and center in their vision for Whole Foods. Amazon Go will now become the tech that will engulf every Whole Foods store across the country. I’ll be as bold as to say that Amazon buying Whole Foods is the start of an incredible wave of innovation across the grocery/shopping landscape.”

The belief in Amazon’s capacity to revolutionize the in-store grocery experience (on the tails of Amazon’s other recent foray into brick-and-mortar bookstores), is echoed by several others. Toptal Finance Expert Sebastian Fainbraun, who is an investor and board member of Dolcezza Gelato, a distributor to Whole Foods in the Mid-Atlantic, envisions a radically different in-store experience: “Imagine going to Whole Foods to get fruits, meats, and vegetables, plus other cool impulse buys, but also at your checkout having a bag of your monthly automated items waiting for you. Amazon has the analytics as well as the logistics. It’s going to revolutionize shopping. For Whole Foods, they have prime real estate and eventually can use that space for things other than food. If I were a retail landlord, I would be very worried unless I have those types of properties. Imagine the same model but at a mall with clothing and accessories.”

Putting aside the potential for change in the retail experience, both see implications that go far beyond. Chapman, a former investment banker at Morgan Stanley turned entrepreneur with experience across retail, real estate, energy, and SaaS industries, believes that “after Whole Foods, Amazon will probably replicate this exact acquisition strategy by buying a convenience store (CVS), major clothing retailer (Macy’s), then perhaps a tech appliance retailer (Best Buy). This shift will have enormous impact on job redistribution and will also create a wave of new tech and apps that will be ‘service providers’ for this new shopping experience.”

The view that Amazon’s tie-up with Whole Foods marks the beginning of a bigger push into traditional retail is shared by Fainbraun: “If this works out, Amazon will eventually buy a retailer like Nordstrom as well. It’s all about optimizing retail space with the right items and experience and having delivery options and automation for the rest.”

The widespread potential implications for the grocery and larger retail space might explain why so many retailers’ stocks took a big hit in the aftermath of the news (Chart 1). Toptal Finance Expert Neel Bhargava, whose experience in private equity and management consulting focused particularly on retail companies, points out: “Whole Foods is a major category leader that allows Amazon to enter the brick-and-mortar space in one fell swoop, and they can leverage for a lot of other things. This is why other grocers’ share prices are getting hit. It will be very hard to compete with.”

However, some are a bit more cautious in drawing conclusions too quickly. Toptal Finance Expert Ethan Bohbot, an investment banking and hedge fund analyst turned entrepreneur, says, “I think the initial drop in retailer stock prices is an overreaction and it is still to be determined if that large of a move is justified—Amazon has long tried to break into grocery and has basically admitted they need help by acquiring Whole Foods, so their success doesn’t seem like a guarantee. The market seems to already assume Amazon is going to significantly disrupt the market and take a big chunk of share, when a scenario that the impact is only incremental is not unreasonable, particularly in the near-term. At the same time, if things go well for Amazon, we could look back and say it was an underreaction, but just given the uncertainty, I think the magnitude of the move was excessive (not the direction—this is certainly a competitive threat).”

Walmart’s Acquisition of Bonobos Is More Incremental

Turning to Walmart’s acquisition of Bonobos, most agree that this acquisition is more additive than it is game-changing. Chapman says “Walmart buying Bonobos makes sense just because it’s an extension of Walmart’s clothing portfolio. This acquisition feels much more standard, cookie cutter, and kind of “boring,” honestly. The Bonobos brand will probably remain the same, hopefully not sacrificing quality (who knows), but now it will be integrated in a major way into the Walmart ecosystem.”

Fainbraun agrees: “It’s more like a hedge. Like McDonald’s buying Chipotle. Investing in a new model to learn. Amazon/Whole Foods is to completely change the model or take it to the next level—total sales channel/analytics/logistics optimization.”

Expanding on the strategic rationales of the deal, Bohbot outlines, “This just seems like a bolt-on to their eCommerce business. I understand the strategic rationale in getting talent from a successful online-based retailer, but they have made several similar acquisitions (and at larger scale) in the past that would seemingly achieve the same goal (, ModCloth, etc.), so I am not sure the incremental benefit is going to be as great as Amazon/Whole Foods.”

Figure 1: Walmart's Acquisitions in eCommerce

A perhaps underestimated—and certainly underreported—component of the Walmart/Bonobos deal relates to margins. On this, Toptal Finance Expert Tayfun Uslu points out that “it is important to mention that Bonobos is a vertically integrated company and, as a company that is both brand and distributor of its products, this means very high gross profit margins that cannot be easily achieved by buyers and resellers or marketplaces (i.e., Whole Foods and Amazon). Whole Foods has some private label, but it accounts for around 15% of revenue. Walmart is pushing a strategy to buy vertically integrated companies because, in the end, they do have higher gross profit margins.”

Whatever one thinks of Walmart’s strategy of diving into eCommerce via fashion, it is clear that the general trend in this space has been moving towards DTC. Established brands have been steadily increasing their share of sales from this channel as opposed to the traditional retail channels (Chart 2). Building a strong online presence in fashion in many ways necessitates a strong positioning in DTC, something which shines through in Walmart’s recent acquisitions in the space.

Chart 2: Proportion of Revenue from Direct-to-Consumer Segment

Compared to Amazon’s recent move, from a margin perspective, Walmart’s strategy certainly seems more accretive. Bohbot sums it up as follows: “This specific transaction for Walmart is negligible, and given the stage/scale, it may not even impact Walmart’s margins, but the overall goal is to bolster the eCommerce business, which will theoretically have higher margins and provide uplift to the overall company as the mix continues to shift towards eCommerce.”

Bohbot goes on to say: “For Amazon, the Whole Foods acquisition is a different story—brick and mortar channels have a lower margin profile than online channels given higher fixed and variable costs, so by increasing the mix of brick and mortar, Amazon is seemingly diluting their margins. Additionally, across the retail sector, grocers have a pretty poor margin profile, so increasing grocery mix of revenue will further prove to be dilutive.”

The lower margins in groceries were something that Jeff Bezos himself highlighted earlier this year. Turning to Twitter to respond to a NY Post article that claimed that Amazon Go had operating profits of more than 20% and could operate with just three human workers, the Amazon CEO had this to say:

Figure 2: Jeff Bezos on Grocery Margins
Figure 2: Jeff Bezos on Grocery Margins
Source: Twitter

But Bohbot doesn’t seem to be concerned about this latter point. Aside from the fact—as the Wall Street Journal points out—“Whole Foods […] operates at much higher profit margins than other grocers, thanks in part to the higher markups it gets for many of its upscale items” (Chart 3), Bohbot believes “I don’t think you can simply apply Whole Foods margins to the incremental revenue Amazon is acquiring and say that will be the incremental profits – there are undoubtedly synergies (supply chain, etc.), and further, we don’t know what future Whole Foods stores are going to look like once Amazon gets in there. It is possible Amazon cuts the footprint across major stores dramatically, takes out labor, and automates a lot of the day-to-day operations such that the margins are a lot higher than Whole Foods stand-alone (reasonably somewhere in between margins achieved by online-only and brick-and-mortar-only sales channels). How much higher Amazon can drive margins is still to be seen, but I think Whole Foods stores will look very different under Amazon, and likely in a way that cuts costs and improves margins from the status quo.”

Chart 3: Trailing Gross Profit Margins for US Grocery Retailers

Amazon’s Acquisition Has a Strong Strategic Rationale—Walmart’s Less So.

Comparing the two moves from a strategic standpoint, Amazon’s acquisition of Whole Foods clearly comes out on top. Finance Expert Alex Graham, a former fixed income trader who has moved into venture capital, points out, “Walmart wants to buy a brand and get some soft learning from their tactics, backing them up with cash and logistics if necessary but largely treating it as a quasi aqui-hire/financial investment. Amazon probably wants to come in more directly and harness the fixed assets of Whole Foods.”

Important Real Estate Component For Amazon

The importance of the real estate component in the Amazon transaction is widely acknowledged. As Figure 3 below shows, Amazon is acquiring a strong retail footprint in many major geographical markets. Toptal Finance Expert Jeffrey Mazer, a financial expert and lawyer who has served as a transactional and valuation expert witness in the past, weighs in on this, saying, “The Amazon/Whole Foods possibilities are endless. With Whole Foods’ footprint in affluent areas and Amazon’s expertise in supply chain and delivery, they could upend both food retailing and food delivery.”

Figure 3: Combined Amazon/Whole Foods Footprint

In particular, the key benefit that many have pointed to is that acquiring prime real estate allows Amazon to finally get into last-mile delivery, something the retailer has historically struggled to do. Alex Graham delves further into this: “Last mile delivery is a critical component that startups in the grocery space have been able to capitalize in Amazon’s absence. Buying an upmarket chain of supermarkets in upmarket urban areas will allow Amazon to significantly enhance its hub and spoke approach. For that reason alone, the physical assets of whole foods are a key component of this deal (and potentially a future source of contention between the two management teams if their dual use compromises the activity of the other).”

Fainbraun, however, takes a higher-level view: “I’m not so worried about grocery retailers themselves. It’s the other retailers that will be hurting more. People will still go to grocery stores for location and convenience. The ones who suffer will be the Walmarts of the world—Home Depot, big box retailers. Amazon is eating their lunch and will have class A retail location.” He continues, “Retail of the future will be about Class A experiential real estate, and Class C convenience. If Whole Foods ends up working out for Amazon, I think they will buy Nordstrom and Kmart. Nordstrom is the best department store and very efficient with space and creating stores within a store. And Kmart is cheap, good big box real estate. If I’m right, Amazon will have lifestyle center real estate, big box, and inside malls. All as drop off and pick up locations and showrooms for online ordering.”

Strong Move into Groceries

The other major benefit most Toptal Experts see is that the Whole Foods acquisition will significantly help Amazon push into a difficult niche: groceries. Groceries is an important category—a recent report by the Food Marketing Institute found that US grocery sales could grow five-fold over the course of the next decade, with spending estimated at more than $100 billion by 2025. While currently, around 25% of US households shop online for groceries (up from 20% three years ago), that number will grow to more than 70% within the next ten years.

Figure 4: Grocery Market Forecasts

Toptal Finance Expert Ethan Bohbot had this to say on the matter: “I think that the Amazon/Whole Foods tie-up has the potential to prove more beneficial to Amazon [than Walmart’s acquisition of Bonobos] and more disruptive to the broader grocery industry. The general shift of buying groceries online has been happening for a while if you think of platforms like Fresh Direct or Blue Apron, but it has been slow and, based on Amazon’s historical execution across other business segments and now accelerated push, I think that bodes well for them to do something game-changing—but, of course, this is still to be determined.”

Part of the reason why Amazon has had such difficulties in breaking into the online grocery shopping space comes down to trust. The FMI survey highlighted how 69% of shoppers valued the store’s reputation when choosing which store to buy groceries at (Chart 4). Bohbot sees Amazon’s acquisition of Whole Foods as beneficial in this respect, “To me, Amazon is validating the brick-and-mortar channel for grocery and acquiring a quality brand with a large footprint, which is accelerating their push into grocery by allowing them to overlay their insights and supply chain/eCommerce dominance on top of an existing strong foundation.”

Chart 4: Store Behaviors That Make Shopper More Likely to Shop at a Particular Store

Limited Customer Overlap for Walmart and Potential Backlash by Bonobos Consumers

As far as Walmart’s acquisition of Bonobos is concerned, Bohbot thinks that it was motivated by the following factors: “Acquisition of eCommerce retail talent, acquisition of proven hybrid channel (physical storefront + online fulfillment), acquisition of a quality brand, and customer acquisition of Bonobos’ client base—outside of that, I am not really sure. This would certainly expand their eCommerce presence, which theoretically would have higher margins, but given stage/scale, that may not hold true for this acquisition.”

The issue of overlapping (or lack thereof) customer bases comes up several times. Many are concerned that Walmart and Bonobos customers lack overlap, and that Walmart’s acquisition might in fact alienate them. Toptal Finance Expert Jeffrey Mazer says so himself: “I’m a customer of Bonobos, Amazon, and Whole Foods. I can’t see that I would ever purchase anything from Bonobos again. Too many stories of acquirers seeking cost savings and other synergies by cutting quality. Men’s clothing has a lot of players; it’s lower risk to just start buying from someone else.”

And he doesn’t seem to be alone. A Business Insider article recently highlighted similar sentiment by looking at the Twitter-verse post announcement (Figure 5).

Figure 5: Customer Reactions on Twitter to Bonobos/Walmart Deal
Figure 5: Customer Reactions on Twitter to Bonobos/Walmart Deal
Source: Business Insider

Graham says, “Strategically, I think Amazon/Whole Foods will prevail, as it seems like there are more exciting overlaps between the customer bases of the two businesses—i.e., a Whole Foods customer probably shops on Amazon. Not sure if the same can be said about Walmart and Bonobos and that will be Walmart’s issue to contend with. And if Walmart tries too hard to force through some unnatural synergies between these two groups (like moving Bonobos’ online store into their system) they may ultimately jeopardize it all.”

Toptal Finance Expert Zachary Elfman, however, takes a different view. “An oft-cited justification for why an acquirer is willing to pay an above-market price for a target are synergies. Synergies can come in many forms, but it is not immediately clear if any meaningful revenue synergies through complementary customer bases can be achieved through the integration of Whole Foods into Amazon. There are few if any revenue synergies that Amazon is gaining with the Whole Foods acquisition because Whole Foods has a very similar customer base, if not identical. If I were to draw a Venn diagram of the companies’ customer bases, Whole Foods would sit nearly inside the (much larger) Amazon circle. Yes, this makes cross-selling existing products and services easier, but I cannot think of too many existing Whole Foods shoppers that do not already use Amazon. Flipping this around, products from Whole Foods can be sold to the expansive Amazon customer base, but I am not convinced that the Amazon distribution channel is going to really cause much greater Whole Foods penetration in an age when Instacart already allows for online ordering and home delivery.”

The Walmart-Amazon War?

Are these moves clear shots fired in a longer-term retail war between two retail giants? Bohbot takes a more measured stance on the issue: “I don’t really see it this way. Amazon isn’t attacking Walmart; they are attacking the world. Walmart is just included and is seemingly the most likely to fall victim to this specific announcement (given their grocery share), which is why people may be seeing it that way today.”

On his last point, it is important to note that Walmart’s share of grocery is very significant (Chart 5). As Retail Dive highlighted in a recent article: “Grocery is where Walmart really shines. It is the nation’s largest seller of groceries with category sales of $170 billion last year, and the category is key to driving store visits and customer loyalty. Walmart has been investing in click-and-collect programs, stand-alone grocery pick-up sites, and is even testing an automated kiosk for 24-hour pick-up.”

Chart 5: US Food Retail Market Shares

With the above in mind, it’s hard not to see how Amazon/Whole Foods puts Walmart on the back foot. And in fact, other Toptal Experts are more sanguine. Finance Expert Tayfun Uslu thinks that “in the race to become the first monopoly, Amazon is now ahead.” And on the monopoly point, he is not alone. In the wake of the acquisition, several articles have come out assessing the question of whether the Seattle-based retailer has perhaps gone too far. Toptal VP of Business Talent Rajeev Jeyakumar admits, “I already get most of my groceries from either Whole Foods or Amazon Fresh. So they’ve got a lock on my wallet share! Especially if you throw in Alexa ordering and if they acquired Grubhub—I may never leave the couch. I might as well get my Amazon credit card now and let them take that part of the value chain too.”

So perhaps the picture is a far more aggressive one, with Amazon’s move an all-out declaration of war. Finance Expert Sebastian Fainbraun certainly seems to think so: “They aren’t declaring war—they are declaring victory. Walmart has a good web presence but Amazon runs the internet. If they integrate properly, war over. Amazon is the new Walmart and Bezos is the new Walton.”

Post originally appeared on Toptal Finance 

Glass-Steagall Act: Did Its Repeal Cause the Financial Crisis?

Key Highlights

  • The Glass-Steagall Act of 1933 effected a separation between commercial and investment banking activities. Prior to its implementation, J.P. Morgan & Co. operated in commercial banking and securities activities. Afterward, it split into investment bank Morgan Stanley and commercial bank JPMorgan.
  • After decades of erosion, two provisions of the Act were repealed in 1999 by the Gramm-Leach-Bliley Act under then President Clinton’s administration. It allowed for universal banking under one structure.
  • Two remaining provisions are still intact today: They limit investment management firms like Bridgewater Associates from offering checking accounts and prohibit commercial banks like Wells Fargo from dealing in risky securities such as cattle futures.
  • The repeal ushered in a period of mega-mergers. The new six largest banks grew their assets from 20% of GDP in 1997 to over 60% of GDP in 2008.
  • The percentage of borrowers who defaulted on their mortgages nearly doubled from 2006 to late 2007, in large part due to imprudent lending standards.
  • Debate has centered around whether Glass-Steagall’s absence led to a decline in underwriting standards. A study found that securities issued through universal banks had “a significantly higher default rate” compared to those issued by investment companies.
  • Citigroup eventually required the largest financial bailout in history, to the tune of $476.2 billion from the government and taxpayers, lending credence to the claim that Glass-Steagall’s absence caused the financial crisis.
  • However, most too-big-to-fail institutions were actually pure investment banks or insurance companies, not universal banks (e.g., Lehman Brothers, Bear Stearns, Merrill Lynch, AIG).
  • Ironically, Glass-Steagall’s repeal allowed for the rescue of some institutions after the crisis. It enabled JPMorgan Chase to rescue Bear Stearns and Bank of America to rescue Merrill Lynch.
  • Leading up to the crisis, the shadow banking repo market exploded, growing from $2 trillion in 1997 to $7 trillion in 2008. The repo market’s growth is indicative of the overall growth in shadow banking, whose liabilities had far surpassed those of the traditional banking sector by 2008.
  • Did Glass Steagall’s absence enable commercial banks to fuel the growth in the shadow banking sector? “Commercial banks could have done all of those things in the 1960s or earlier, even before the Fed and the OCC court decisions began to loosen the structures of Glass-Steagall.” –Lawrence J. White, financial regulation expert at New York University
  • Overall, while the general consensus is that Glass-Steagall’s absence was not a principal cause of the crisis, the underlying culture of excessive risk-taking and short-term profit was real. According to the Financial Crisis Inquiry Commission, “The large investment banks […] focused their activities increasingly on risky trading activities that produced hefty profits […] Like Icarus, they never feared flying ever closer to the sun.”


Over the last several years, the Glass-Steagall Act has made many headlines in the news. In 2013, it brought together Democratic Senator Elizabeth Warren and Republican Senator John McCain as they proposed their 21st Century Glass-Steagall Act. During the most recent presidential election campaign, it created an unexpected accord between political figures as varied as Donald Trump and Bernie Sanders. Since then, enthusiasm for the issue has exhibited few signs of waning. In April of this year, Gary Cohn, advisor to the president, publicly advocated for the legislation’s revival, and as recently as mid-May, Warren and Treasury Secretary Steven Mnuchin went head to head on the issue.

So, what exactly is the Glass-Steagall Act and why all the controversy?

The Glass-Steagall Act was passed under FDR as a response to the stock market crash of 1929. It effected a wall between commercial banking and investment banking, only to be partially repealed in 1999. While there exists consensus around what the Glass-Steagall Act pertains to, there’s disagreement around its influence on the financial markets. In particular, the debate has centered around the repeal’s effects on the 2008 financial crisis and whether it was a principal cause of the crisis. Notably, it remains relevant despite the introduction of recent legislation. In 2010, the Obama administration enacted the Dodd-Frank Act in response to the financial crisis. Similar to Glass-Steagall, it attempted to promote financial stability and protect the consumer, but Dodd-Frank did not reinstate the repealed provisions of Glass-Steagall.

The following piece examines the historical context of the Glass-Steagall Act, the erosion of its effectiveness over several decades, and its repeal in 1999. It then delves into an analysis of its impact on the 2008 financial crisis.

Historical Context and Components of the Glass-Steagall Act of 1933

In the aftermath of the 1929 stock market crash, the Pecora Commission was tasked with investigating its causes. The Commission identified issues including risky securities investments that endangered bank deposits, unsound loans made to companies in which banks were invested, and conflicts of interest. Other issues included a blurring of the distinction between uninsured and insured practices, or an abusive practice of requiring joint purchases of multiple products. Congress attempted to address these issues with the Banking Act of 1933 and other legislation.

Through Sections 16, 20, 21, and 32 of the Banking Act of 1933, Congress mandated a separation of commercial banks and securities firms. The following four provisions are what have become commonly known as the Glass-Steagall Act:

  • At their simplest, Sections 20 and 32 prohibit affiliations between commercial banks and investment banks.
  • Section 21 stipulates that investment banks cannot receive deposits.
  • Section 16 prohibits commercial banks from investing in shares of stocks, limits them to buying and selling securities as an agent, and prohibits them from underwriting and dealing in securities. However, certain securities are exempted from the Act, collectively referred to as “bank-eligible securities.” We’ll explore why this is relevant later.

The effects of the Glass-Steagall Act can be exemplified by a familiar name: Prior to enactment, J.P. Morgan & Co. operated in both commercial banking and securities activities. However, afterward, it split into two separate firms: the investment bank, Morgan Stanley, and the commercial bank, JPMorgan.

While the effects of the Glass-Steagall Act were wide-ranging, it is equally important to note what the Glass-Steagall Act did not do. Beyond limiting the scope of activities for commercial and investment banks, the Act was not intended to limit the size or volume of such activities. Therefore, returning to the example of J.P. Morgan & Co., while the Act prohibited the bank from conducting all the same activities within a single organization, it did not prohibit the same activities (type and volume) if carried out separately through JPMorgan and Morgan Stanley.

The Glass-Steagall Act of 1933 Deteriorates

Over the course of several decades, the intended clear-cut separation between commercial and investment activities gradually deteriorated. Multiple factors contributed to this effect, including market forces, statutory changes, and the exploitation of regulatory loopholes.

As far as market forces were concerned, economic conditions such as rising inflation in the 1960s and rising market interest rates (Chart 1) during the Glass-Steagall era caused disruptions. These meant that commercial banks struggled to compete effectively, so consumers and corporate customers increasingly turned to investment banks for more lucrative products like money market funds and commercial paper. By the 1980s, the number of failed and “problem” depository institutions on the FDIC watch list rose to record levels (Chart 2).

Chart 1: Historical US Federal Interest Rate; and Chart 2: Number of FDIC Commercial Bank Failures, 1934-1995

The financial difficulties for commercial banks led to calls for regulatory changes, resulting in several laws that added to Section 16’s list of “bank-eligible securities” and helped them compete more effectively. Between 1983 and 1994, the Office of the Comptroller of the Currency (OCC) widely broadened the derivatives in which banks could deal. In addition, another major piece of legislation—the Bank Holding Act of 1956 (BHC Act)—generally mandated that bank holding companies (BHCs) were not allowed to own companies engaged in non-banking activities. Crucially, however, the act did permit BHCs to own companies engaged in activities “closely related” to banking activities. This vague language left much room for interpretation.

The Federal Reserve Board (Fed) and the OCC agencies were tasked to implement, interpret, and enforce the legislation. In interpreting the ambiguities and subtleties of Glass-Steagall and the BHC Act, the agencies gradually permitted an increasing number of activities similar to securities products and services. Higher courts allowed for a broad interpretation of the act and stated their deference to agency interpretations, leading to further loosening of restrictions originally imposed by the Glass-Steagall Act.

Aside from the above, loopholes also allowed financial institutions to bypass the separation between commercial and investment banking. For example, Section 21 of the Glass-Steagall Act was ruthlessly exploited. As mentioned previously, Section 21 prohibited investment banks from receiving deposits. However, “deposits” were defined narrowly, leading investment banks to issue short-term debt instruments that essentially functioned as the equivalent of deposits but were technically permissible. Therefore, though the banks were in compliance with the law, they violated its intention.

Repeal of the Glass-Steagall Act

By the late 1990s, the Glass-Steagall Act had essentially become ineffective. In November 1999, then-President Bill Clinton signed the Gramm-Leach-Bliley Act (GLBA) into effect. GLBA repealed Sections 20 and 32 of the Glass-Steagall Act, which had prohibited the interlocking of commercial and investment activities. The partial repeal allowed for universal banking, which combines commercial and investment banking services under one roof.

Many experts view GLBA as “ratifying, rather than revolutionizing” in that it simply formalized a change that was already ongoing. However, GLBA left intact Sections 16 and 21, which are still in place today. These continue to have practical effects on the industry today. For instance, they limit investment management firms such as Bridgewater Associates from offering checking accounts and prohibit commercial banks such as Wells Fargo from dealing in risky securities such as cattle futures.

Figure 1: Original Glass-Steagall Act Provisions

Following the repeal, the US banking sector embarked on a period of mega-mergers, creating behemoths such as Citigroup and Bank of America. The extent of this consolidation is shown graphically below.

Figure 2: M&A Activity Over Time

After this period, the new six largest banks grew their assets from about 20% of GDP in 1997 to more than 60% of GDP in 2008, as shown below:

Chart 3: Six Largest Banks: Total Asset Value as Percentage of GDP

Central Debate: Did the Absence of Glass-Steagall Cause the 2008 Crisis?

In the aftermath of the 2008 financial crisis, there has been much discussion around whether the absence of Glass-Steagall’s provisions caused the crisis. Given the complexity of the issue at hand, a conclusive assessment of the issue is beyond the scope of this article. Nevertheless, we have summarized below the main topics of discussion, and what the two major schools of thought believe for each.

The Housing Bubble and Imprudent Lending Standards

Between 1998 and 2006, the housing market and housing prices rose to previously unseen highs. As many readers already know, the market’s later crash was a primary cause of the Financial Crisis. A major determinant of the housing boom was the utilization of imprudent lending standards and subsequent growth of subprime mortgage loans. Most of these loans were made to homebuyers with factors that prevented them from qualifying for a prime loan. Many subprime loans also included tricky features that kept the initial payments low but subjected borrowers to risk if interest rates rose or house prices declined. Unfortunately, when housing prices started to fall, many borrowers found that they owed more on their houses than they were worth.

According to the Financial Crisis Inquiry Commission (FCIC), which conducted the official government investigation into the crisis, the percentage of borrowers who defaulted on their mortgages months after the loan nearly doubled from 2006 to late 2007. Suspicious activity reports related to mortgage fraud grew 20-fold between 1996 and 2005, more than doubling between 2005 and 2009 (Chart 4). The losses from this fraud have been estimated at $112 billion.

Chart 4: Yearly Filling Trend for Mortgage Loan Fraud SARs

Did the Glass-Steagall Act’s repeal contribute to the deterioration in underwriting standards that fueled the housing boom and eventual collapse? Predictably, opinions are divided.

On the one hand, those who believe the absence of Glass-Steagall did not cause the crisis highlight that offering mortgages has always been a core business for commercial banks, and so the banking system has always been exposed to high default rates in residential mortgages. Glass-Steagall was never intended to address or regulate loan qualification standards.

In addition, while the Glass-Steagall Act limited the investment activities of commercial banks, it did not prevent non-depositories from extending mortgages that competed with commercial banks, or from selling these mortgages to investment banks. It also did not prevent investment banks from securitizing the mortgages to then sell to institutional investors. Nor did it address the incentives of the institutions that originated mortgages or sold mortgage-related securities. Because it did not directly address these issues, it’s unlikely the Glass-Steagall Act could have prevented the decline in mortgage underwriting standards that led to the housing boom of the 2000s.

On the other hand, those who argue that the absence of Glass-Steagall did cause the crisis believe that the decline in underwriting standards was in fact partially, or indirectly, caused by the Act’s absence. Readers will recall from the beginning of the article that Glass-Steagall’s provisions addressed the conflicts of interest and other potential abuses of universal banks. After Glass-Steagall’s repeal, it is feasible that universal banks aimed to establish an initial market share in the securities market by lowering underwriting standards. Separately, universal banks might also self-deal and favor their own interests over those of their customers. Both of these incentives could have led to or exacerbated the decline in underwriting standards.

A European Central Bank study compared the default rates contained in securities issued by the investment companies to securities issued through large universal banks in the ten years following Glass-Steagall’s repeal. The study found that securities issued through the universal bank channel had “a significantly higher default rate” than those issued through pure investment companies. While the authors found no evidence of self-dealing, they did find evidence of underestimating default risk.

While these results are not entirely conclusive, it does suggest that Glass-Steagall’s absence could have worsened underwriting standards. Had Glass-Steagall been in place, these universal banking institutions would not have been created. Nevertheless, the regulation would not have prevented new, investment-only entrants also looking to gain market share. And as we’ve already mentioned, the Glass-Steagall Act never directly addressed loan qualification standards or prevented non-depositors from extending, repackaging, and selling mortgages. It’s therefore unlikely that the Glass-Steagall Act could have prevented the decline in mortgage underwriting standards, but its absence could have aggravated the situation.

“Too Big to Fail” and Systemic Risks

The second major topic of discussion related to Glass-Steagall and the financial crisis surrounds the issue of “too big to fail” and systemic risks. When the failure of an institution could result in systemic risks, whereby there would be contagious, widespread harm to financial institutions, it was deemed too big to fail (TBTF). TBTF institutions are so large, interconnected, and important that their failure would be disastrous to the greater economic system. Should they fail, the associated costs are absorbed by government and taxpayers.

The relevance of TBTF to the financial crisis was outlined by Ben Bernanke in a 2010 address, which is summarized as follows:

  1. These institutions will “take more risk than desirable,” expecting to receive assistance if their bets go bad;
  2. It creates an uneven playing field between big and small firms, which increases risk and raises the market share of TBTF firms to the detriment of financial stability; and
  3. Just as it did in during the crisis, the failure and near-failure of TBTF organizations disrupted financial markets, impeded credit flows, induced sharp declines in asset prices, and hurt consumer confidence.

If one accepts that systemic risk and TBTF institutions were major contributors to the 2008 crisis, then the debate turns to whether the absence of Glass-Steagall contributed to the creation of TBTF institutions and their disastrous effects. After all, the repeal of Glass-Steagall in 1999 set in motion the wave of mega-mergers that created huge financial conglomerates, many of which fall firmly within the TBTF camp.

Proponents of this philosophy point to the plight of Citigroup. The absence of Glass-Steagall permitted Citigroup (Citi) to be born through the merger of Citibank and Travelers, an insurance company. In years leading up to the crisis, Citi made huge proprietary bets and had acquired heavy exposure to securities based on subprime mortgages, eventually becoming the second largest underwriter of such securities by 2006. As the housing crisis shook the markets, Citi was hit hard, eventually requiring the largest financial bailout in history, to the tune of $476.2 billion in funding from the Troubled Assets Relief Program and taxpayers’ wallets.

However, aside from Citigroup, most of the other severely distressed institutions in the financial crisis were not commercial banks. As financial columnist Andrew Sorkin points out, Bear Stearns and Lehman Brothers were both pure investment banks with no ties to commercial banking. Merrill Lynch, another investment bank that ended up being rescued, was similarly unaffected by Glass-Steagall. American International Group (AIG), an insurance company, was on the brink of failure, but it sat outside the purview of Glass-Steagall. As for Bank of America, its major issues stemmed from its acquisition of Countrywide Financial, a subprime lender that had made poor loans—something permissible under Glass-Steagall.

Ironically, Glass-Steagall’s repeal actually allowed for the rescue of many large institutions after the crisis: After all, JPMorgan Chase rescued Bear Stearns and Bank of America rescued Merrill Lynch, which would have been impermissible prior to the 1999 repeal. Both were already involved in commercial and investment banking when they saved the two failing investment banks. On balance, therefore, the evidence does not seem to support the view that Glass-Steagall’s absence was a cause of the financial crisis.

Shadow Banking and Securities Market Turbulence

Another topic related to Glass-Steagall and the financial crisis revolves around the rise of shadow banking, which many believe was a primary cause of the crisis. According to Ben Bernanke, shadow banking typically involves financial intermediaries that carry out banking functions but operate separately from the traditional system of regulated depository institutions. These activities generate liquidity through capital markets and are not FDIC-insured.

Chart 5: Shadow Bank vs. Traditional Bank Liabilities

Practical examples of what sort of institutions and activities operated in the shadow banking sector are varied. Let’s examine the repurchase agreement market (repo market), a market for short-term, collateralized loans. The repo market works as follows: Depositors (institutional investors and large corporations) need a place to park liquid funds that pay an interest rate higher than that offered by commercial banks. Bankers (investment banks and broker-dealer firms) are willing to provide such a product in the form of repo transactions. In return, the lender receives safe, liquid collateral, so that if the borrower is unable to return the funds, the lender will simply seize the collateral.

In the years leading up to the crisis, the repo market exploded, growing from $2 trillion in 1997 to $7 trillion in 2008. Consequently, the demand for safe collateral for these repo agreements grew too. Mortgage-backed securities, an innovative financial product, helped satisfy this demand for collateral. Commercial banks make loans to consumers and business, but instead of holding these on their balance sheets, they can sell them to shell companies. Shell companies fund the acquisition of these assets by issuing asset-backed securities (ABS) such as mortgage-backed securities that become the liabilities of shell companies and are sold to investors in the capital markets.

The example of the repo market is relevant for several reasons. First, the growth of the repo market was indicative of the overall growth in the shadow banking market (Chart 5 above). Second, it played a particularly significant role in the crisis: the aforementioned US housing boom was financed largely in this way. Lastly, and perhaps most importantly, the repo market and the related MBS markets are illustrative of shadow banking’s complexity (Figure 3). At each step in the process, the true quality of the underlying collateral is further obscured and more loans are included with each link added to the chain. While, in theory, this diversifies risk, it also obfuscates the evaluation of the quality of individual pieces. The result of all this, of course, is that when confidence erodes, the structures come crumbling down as investors are unable to assess the true extent of the risks involved in these transactions.

Figure 3: The Shadow Banking System Process

It is generally accepted that shadow banking was an important determinant of the financial crisis of 2008. However, many debate whether Glass-Steagall would have curtailed shadow banking’s growth and, consequently, the financial crisis.

At a surface level, the shadow banking activities linked to the financial crisis were not prohibited by or relevant to the Glass-Steagall Act. As more activities previously conducted within the commercial banking sector shifted to this parallel and unregulated market, riskier behavior emerged and underwriting and lending standards slipped. But crucially, these new shadow banking markets were outside the purview of Glass-Steagall and the Banking Act. If anything, many argue that the real regulatory culprit was the Commodity Futures Modernization Act of 2000, which deregulated over-the-counter derivatives. Banning regulators from restricting these activities sent a strong “anything-goes” message to the derivatives markets.

However, on a deeper level, many question whether the absence of Glass-Steagall indirectly allowed for shadow banking to propagate. And crucially, it comes down to whether the commercial-banking sector, using its FDIC-insured consumer deposits, funded the sector’s growth, and whether this would have been permissible under the Glass-Steagall Act.

In a January 2016 interview, Bernie Sanders charged, “Secretary Clinton says that Glass-Steagall would not have prevented the financial crisis because shadow banks like AIG and Lehman Brothers, not big commercial banks, were the real culprits. Shadow banks did gamble recklessly, but where did that money come from? It came from the federally insured bank deposits of big commercial banks—something that would have been banned under the Glass-Steagall Act.” Warren Gunnels, Sanders’ chief policy aide, further explicated, “Commercial banks provided the funding to shadow banks in the form of mortgages, repurchase agreements, and lines of credit. Further, commercial banks played a crucial role as buyers and sellers of mortgage-backed securities, credit-default swaps, and other derivatives. This would not have happened without the watering down of Glass-Steagall in the 1980s and the eventual repeal of Glass-Steagall in 1999.”

The general consensus among experts is that these allegations are incorrect. According to Lawrence J. White, an expert on financial regulation at New York University, “Commercial banks could have done all of those things in the 1960s or earlier, even before the Fed and the OCC court decisions began to loosen the structures of Glass-Steagall.” Phillip Wallach, Brookings Institution fellow, adds that “The rise of mortgage-backed securities doesn’t strike me as obviously inconsistent with Glass-Steagall.” However, commercial banks were not blameless. Commercial banks used the shadow banking system to move liquidity and credit risk off their balance sheets, transferring it outside of traditional banking—risks that were not eliminated from the financial system. Still, these activities likely would have been permitted under Glass-Steagall.

Regarding Sanders’ specific mentions of Lehman Brothers and AIG, the FCIC concluded that Lehman Brothers relied primarily on non-bank sources of funding, therefore not endangering deposits. As for AIG, which eventually required a $180 billion federal bailout, “enormous sales of credit default swaps were made without putting up initial collateral, setting aside capital reserves, or hedging its exposure—a profound failure in corporate governance.” The FCIC concluded that this was possible due to the deregulation of derivatives, specifically the aforementioned Commodity Futures Modernization Act of 2000.

While one could make a case that shadow banking markets were the product of a deregulatory environment, further reinforced by the repeal of Glass-Steagall, strictly speaking, the absence of Glass-Steagall cannot be considered as a cause of the market’s growth. Had the Glass-Steagall Act been in full force, its prohibition of commercial and investment banking affiliations would not have prevented the opaque transparency in product risks and the subsequent investor panics that resulted.

“Like Icarus, they never feared flying ever closer to the sun”

It is difficult to reach a definitive conclusion regarding the impact of Glass-Steagall’s absence on the financial crisis. The culprits and causes of the crisis were many and varied, and to single out one factor would be to oversimplify the truth. With that said, the general consensus among academics and finance experts seems to be that Glass-Steagall’s absence was probably not to blame for the 2008 crisis. Even Elizabeth Warren, champion of its revival, acknowledged that the crisis could not have been avoided even if Glass-Steagall had still been in place. Former Treasury Secretary Tim Geithner also dismisses its role in the crisis. And Paul Krugman, a strong proponent of financial services regulation concurs: “Repealing Glass-Steagall was a mistake. But it did not cause the financial crisis.”

Ultimately, one cannot overlook the findings of the Financial Crisis Inquiry Commission, a nonpartisan institution whose 500-page report concluded that “Neither the Community Reinvestment Act nor removal of the Glass-Steagall firewall was a significant cause. The crisis can be explained without resorting to these factors.”

Still, there is credence in an oft-overlooked, indirect cause of the Act’s absence: the creation of a reckless, risk-taking, profit-focused culture on Wall Street. In fact, economic Nobel Prize laureate Joseph Stiglitz included this cultural shift as one of his five major contributing factors to the recession: “The most important consequence of the repeal of Glass-Steagall was indirect—it lay in the way repeal changed an entire culture […] When the repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risk taking.”

This mindset and resulting reckless culture, though intangible, were undoubtedly real. As some experts assert, the investment banking culture of risk-taking, focus on short-term profits, and deprioritization of client interests was at the heart of the crisis—which may not have been present, or would at least have been minimized, with Glass-Steagall. The FCIC report sums it up best: “The large investment banks […] focused their activities increasingly on risky trading activities that produced hefty profits […] Like Icarus, they never feared flying ever closer to the sun.”

This article is originally posted in Toptal.

How Long Can Your Startup Survive Without a Full-Time CFO?

The value of a CFO for a young company is a hotly contested topic. Many argue that they are unnecessary add-ons and that a small, savvy, well-trained financial team can satisfy the business’s needs. On the other hand, CFO’s bring a deeper and more strategic financial perspective that can help companies prepare for the future and optimize their current operations.

The crux of the predicament is that whilst CFOs add significantly greater value than a more “junior” financial team, they are expensive resources.

For a business to successfully navigate this dilemma, it first requires understanding which roles, needs, and paths the business is likely to encounter. Eventually, most successful businesses will outgrow their initial accounting staff and need greater depth in the ranks as the number of dimensions in the financial function increase. If they understand what their eventual needs will be in advance, there are many ways that businesses can hedge their risks and get what they need, when they need it, without financially overcommitting.

The real question might not be how long can you survive, but how soon will you start benefitting from the contributions of an experienced financial leader. In my 15+ years of experience as a finance director and financial consultant, I have found that the best way to judge whether or not a company needs to hire a CFO is by assessing where they stand on “the hierarchy of needs,” which I explain below. The following analysis will help businesses identify where they are in the hierarchy and be a guide to hiring options that best address their current needs and how to move to the next level.

The Hierarchy of Needs

Much like Maslow’s Hierarchy of Needs, a business has a hierarchy of financial management needs. These are displayed in the chart below.

The more basic the needs, the more basic the skills needed to perform them. As the needs progress so do the skills, as well as the insight required to satisfy those needs. The basic needs are clerical and can be met with technical training, but the more advanced needs add a strategic component that is best met by someone with extensive business experience. Different businesses’ needs grow at different rates based on industry, market opportunity, ambitions, and resources. One need cannot be met if a preceding need is left unmet.

Level 1: Transacting

The most basic need of a business is the ability to conduct transactions. By conduct transactions I mean buying and selling goods and services and entering into contracts.

Basic transactions require basic record keeping – what I refer to as checkbook accounting. This can be done by anyone in the business and requires no accounting or financial knowledge. It usually involves a business only recording transactions in the checkbook and then using the change in the opening and ending balance(s) to judge its success and financial health.

The advantages of checkbook accounting are clear. It’s cheap, and it requires little effort. It can be done quickly, and it doesn’t require a specialized resource to do so. Businesses that are just getting started are therefore likely to resort to this type of activity, which makes sense. Nevertheless, even with only basic transactions, many businesses find themselves in serious trouble because they have conducted such transactions without graduating from using checkbook accounting to using “real” accounting.

A fledgling business may find that it can get by operating this way for a short period of time, but it is not sustainable and will not work for any business that intends to survive, much less thrive.

Level 2: Record Keeping

Real accounting is built around the need to record transactions correctly and can be performed by either a bookkeeper or, as the transaction complexity increases, an accountant. An owner can certainly fill this need as time and skill allow, but should be aware of the opportunity cost of doing so.

The role of a bookkeeper is to record activity from transaction sources, such as bank balances and inventory. Usually, a bookkeeper requires management and is overseen by an external accountant or the business owner. Using an outsourced bookkeeping service gives the business better flexibility but requires more detailed communications and review.

While both a bookkeeper and an accountant are focused on recording historical transactions and activity with varying degrees of accuracy and compliance, an accountant differs from a bookkeeper in that they are trained to higher professional standards. This training and education gives them the skills to better guarantee that the completeness and timing of financial activity has been properly recorded. Accounts prepared by an accountant should be prepared in compliance with GAAP and should meet the more stringent reporting requirements of a company that will one day seek external financing.

I recently worked with a client who not only had very good, GAAP compliant record keeping for an early stage business but also surprised me by having a complete catalog of all of their contractual obligations. While there weren’t many, their founder was a former CFO and knew that when the time came, lenders and investors would require full disclosure of all contractual obligations. By recording their contractual transactions from the start they are in much better shape for an eventual capital raise.

For businesses that want greater oversight without significantly greater costs, it often makes sense to use an external resource to periodically review the bookkeeper’s work, especially if, unlike my client, the leadership doesn’t have accounting experience. This can be bundled with tax preparation work or by a retained fractional CFO.

Fortunately for cost-conscious firms, the ability to capture transactions has changed significantly in the past decade. No longer is it a manual data entry world. Much of this has now been replaced by software applications and other IT resources. This of course has implications on a business’s cost structure (the point being that software replacing labor helps to save costs).

Generally speaking, businesses that are at this level in the Hierarchy of Needs can get away with not having a CFO. After all, the principal requirement is just a correct recording of the transaction(s) that the business is performing. Since this task is still fairly basic and can be done either with in-house trained labor, or by hiring part-time external labor, it will likely not require the services of a more expensive, dedicated CFO.

The Illusion of Fintech

As financial and operational data is drawn from many sources into hosted accounting systems, the focus has shifted from manual data entry to ensuring and assessing the quality of the data and how it is captured.

However, when not properly implemented, these software applications can mislead businesses into believing that just because the data is in the system, it is correct, when in fact it isn’t.

In many ways the adoption of Fintech has become the new Checkbook Accounting for some businesses – the accounting data being the shoebox of receipts, in the system but not adding value.

As a result of this, the accounting systems and the operational interfaces need to be set up by someone with a strong understanding of the accounting principles. Quickbooks, one of the most popular accounting software solutions around, says so itself: “As your business — and revenue — grow, managing your financials may become a task you don’t have the time or knowledge to manage. Specifically, when it comes to avoiding legal and compliance issues, accountants can be worth their weight in gold.”

This is a time where it would make sense to a company to pull in an external financial consultant to ensure that the applications are integrated properly and that there are policies setup to ensure that the usage of the applications supports the financial reporting function.

Another company that I recently consulted with needed to fix a faulty inventory tracking software implementation. The company had experienced significant growth in its first four years of operation but had failed to properly set up sales tax schedules and taxable items. This resulted in incorrectly reporting a rapidly increasing amount sales tax over a period of years.

I worked with the business to fix the implementation, and file the corrected returns. Unfortunately, for many months, the cost of the penalties and interest exceeded the actual sales tax due. While fixing the implementation, other opportunities for improvement were identified and implemented. The client is now able to better report real-time profitability by product line through their accounting system. It has also used this to make adjustments to its product mix at a significant savings to the business.

Nevertheless, the project served as a great example of the potential problems related to Fintech. Even an adequately connected IT-based financial system will require a regular review of the data and account reconciliations. These activities require not only a good understanding of accounting but also an ability to assimilate operational data into the financial records.

Level 3: Trusted Reporting

With transactions being properly accounted for, a business can start reporting on the activity of the business. The key difference here being that the reports start to take the shape of business lines (e.g. the sales department’s revenue and costs) or specific business tasks (e.g. customer service), as opposed to simply just reporting the transactions of the business (e.g. revenue).

Again, FinTech has made it so that comprehensive reporting is more affordable and robust than ever before. Business schools have been evolving in recent years to ensure graduates have a strong understanding of Fintech and its myriad applications. Dedicated courses have even been popping up.

That being said, it is important to know how the reports are going to be used prior to putting in place a reporting system. Although accuracy is always a requirement, reporting for internal purposes doesn’t need the same approach and level of review as reporting used for external purposes. Depending on how the activity was captured, the reports can be presented in a number of ways but always with the caveat: “Garbage in = Garbage out.”

The main purpose is to communicate transactional information in the appropriate level for the audience in question. If this can be accomplished by the bookkeeper and/or accountant, their job is done. If not, the business will need to have someone who can properly convert the accounting information into meaningful communications.

A common problem I see with earlier stage businesses is that they use disparate systems as sources for their reporting, and as a result, they are never really sure if they have captured the data properly in their reports.

Not having a single source of data leads to either capturing less than 100 percent of what was intended, or in some cases, duplication and more than 100 percent of activity gets reported. Successful reporting needs to be thorough, accurate, and complete, especially as these early stage businesses are preparing to raise Series A funding.

It is usually at this stage in the Hierarchy of Needs that a CFO starts to become more relevant. After all, taking the records of transactions and slicing and dicing them to start to satisfy and guide the business’s day-to-day involves deeper knowledge and judgement. Nevertheless, one common option here is to seek part-time help from an external CFO. In my experience, this is usually when I get involved with the business. It is also where I find I can start adding the most value.

Financial Reports, Ends or Means?

Every business owner who has been handed a stack of financial reports by their accountant will tell you that financial reports on their own are frustrating and of little value. In most instances, they actually create greater ambiguity for the owner, and make their job more difficult.

Reports on their own are not the end goal. They are supposed to be a means with which to understand business activity. For example, it’s not enough to know that the ending cash position for the period changed by a certain amount if you can’t identify which activities drove the change.

Earlier on in my career, I worked with a client who didn’t understand that being a seasonal business caused sizeable fluctuations in the working capital needs as accounts receivables and inventory positions grew during peak periods. Their bookkeeper provided them with cash balance reports but with no explanation. I worked with them to identify metrics, such as inventory turnover and days sales outstanding that they could track to give a better reflection of how the business was doing and to also help forecast future cash positions.

As mentioned, reports created for external use serve a different purpose than management reports, which are created for internal use. If they were created for internal use, they are the means by which the business learns about its activities and uncovers opportunities that can be acted upon.

A business is more likely to thrive when reports are generated by a person who is skilled at analyzing and interpreting the financial data contained in the reports. This person can identify when standard reports need more details and can create ad hoc analyses when it makes sense. Knowing when to take this next step and how to go about it only comes with experience.

In particular, businesses experiencing rapid change cannot afford to skip interpreting the information contained in the financial reports. In fact, they should be strongly relying on these (and on things such as dashboards of KPIs) to help them navigate their way. But creating meaningful dashboards is not as simple as it sounds. It requires understanding what factors drive the business and what signals they send off. Some KPIs may be purely financial whereas others might be a mixture of operational and financial data. An experienced finance leader will know how to pull together this critical information or direct others in doing so.

Level 4: Financial Planning

With an accurate record of historical activity and analysis of the factors that influenced successes and shortcomings, a business can use the information gathered to develop financial forecasts. As the cliché goes, “You can’t know where you are going until you know where you have been.”

The process of creating a forecast is nothing like the steps for recording accounting activities and requires a different set of tools and skills.

Companies with rapidly changing business models benefit the most from regular forecasting and again, should not be skipping this step. The faster the business is changing, the greater the risk associated with not planning, and the greater the need for frequent updates on progress toward the plan.

A forecast ideally would be a rolling forecast and should always be projecting 12 months out at any given time. This is especially true for seasonal businesses. The forecast should include three financial statements: profit and loss, capital expenditures, and cash flows. Leadership can then work with the rest of the business to ensure that the business has sufficient resources to meet its goal-based needs. The finance team seeks to scale business resources to meet the plan with no more and no less than what is needed, so that opportunities and/or resources are not wasted.

Companies that are at this level of the Hierarchy of Needs will almost certainly require a CFO. As mentioned above, a part-time CFO may be enough, but there would need to be a close working relationship and collaboration with management in order to achieve meaningful, and hopefully accurate, financial forecasts.

Level 5: Strategic Partnering

Businesses that aspire to continually grow and improve will seek the most from their financial management team. The ultimate deliverable of the financial management team is strategic partnering, where the financial function partners with other areas of the business and is an integral part of the strategic planning process. This can only be achieved once the business understands where it has been and where it is heading.

Strategic vision includes long-term pricing decisions, scenario analysis, international expansion, acquisition decisions, as well as many other higher level decisions. Strategic partnering results in the assimilation of new frontiers into the long-term financial goals of the business.

A seasoned finance leader who can partner with the business to create a financially viable strategy is a must at this level.

Choose Lean Finance

In today’s business environment, lean organizations are proving that with the right financial discipline, companies can achieve significant results with far fewer resources than what was once possible.

As noted by Christian Gheorghe, the CEO of Tidemark, “Even a mid-level finance pro can move an organization’s planning, budgeting and forecasting processes beyond Excel spreadsheets so managers have the data and analytics needed to understand those ‘what-if’ scenarios and utilize predictive analytics and forecasting.”

By increasing the yield from labor and financial resources, high growth businesses are more agile and better able to respond to changing business conditions. While FinTech does have limitations, it is becoming a tremendous enabler. It for instance gives the business the ability to embrace remote working which allows for it to retain higher quality talent at a lower cost of compensation. Software that manages accounting and finance better supports the use of outsourced shared service centers.

Collaborative technology has made it easier for businesses to hold off on hiring full-time finance resources while still having access to a worldwide pool of highly talented individuals. Businesses can now engage fractional CFO’s and advisory boards and get around to hiring a full-time CFO later, while still meeting their needs for more sophisticated financial leadership.

That being said, as concrete milestones approach, a seasoned finance leader, who can create a financially viable strategy, is a must. This is especially true when a business is trying to rapidly grow through a series of external financing rounds. While advisors, VCs, and consultants can get a company through early stage investments, waiting too long can result in the CFO not having sufficient time to learn the business before pre-IPO activity begins.

Finding the right CFO, who is willing to join the venture, can take some time. Paul Holland of Foundation Capital said that “It’s not uncommon, for it to take several months to execute on a high-quality CFO hire. The ideal time frame in which to make that hire is 12 to 18 months before the IPO.”

Another challenge for companies without a CFO in this environment is to keep track of regulation. As an example, ASC 606, when it goes into effect, will require businesses with external investors to report revenue differently from how they may have traditionally done.

In conclusion, whilst hiring a CFO need not be a top priority at the earlier stages of a company’s lifecycle, if the business continues to grow and its ambitions also increase, a CFO is required to effectively manage the business’s growing needs.

Five Questions to Ask When Building a Finance Function

Here are some key questions that a business should consider when staffing their accounting and finance function:

  • Will you be seeking outside investment? If so it is important to put the proper accounting process and policies in place as early as possible.
  • Is your business rapidly changing? A historically focused transactional mindset will be limited in its ability to help identify opportunities and threats. Additionally, as the business changes, the accounting processes too may need to change.
  • How much financial management skill do you have and how much time can you afford to spend on this? Even if you are proficient with accounting and finance, every hour you spend on the finances is at least an hour you can’t spend doing what you do best.
  • How much financial buffer can you afford to keep ready in case of surprises? With less visibility and planning, surprises are more frequent and larger. You will need a larger cash reserve.
  • How complex are your operations? Like machines and most everything else, the more complex your operations and finance the more skill and experience your business will need to adequately record, report, and plan.

Article via Toptal.

Outside the Box: Putin may be watching his brilliant American plan go ‘poof’

Getty Images

If the Michael Flynn affair is true, the Russians have seen a brilliant plan blow up in their faces.

But I have been dubious about the speculation around Flynn’s actions and motives. So let’s turn it around and assume that there indeed was a major Russian intelligence operation intended to help elect, and then control, the president of the United States. This would certainly justify the angst in The New York Times, whereas the national security adviser lying to the vice president just doesn’t make the cut. I am trying to imagine the number of times Henry Kissinger lied to Spiro Agnew or Brent Scowcroft lied to Dan Quayle.

Let’s imagine this was the most audacious intelligence operation imaginable, designed to take control of the United States government. If that’s the case, it has turned into a total fiasco. Flynn, a key recruit, is out of a job. President Donald Trump, regardless of what he promised, will be under intense scrutiny on all matters Russian.

The key to the success of this operation would have been that no one could suspect the American president and his national security adviser were under the control of Russian intelligence. Even if they weren’t Russian assets, enough people now think that they are, rendering them useless to the Russians. The CIA, National Security Council, and FBI have them — and anyone else who was part of this — under constant surveillance. It’s the agencies’ job to find Russian spies, regardless of whom those spies might be.

If all of this is true, the president now may be hesitant to make any concessions to the Russians. All other Americans involved in the conspiracy will be identified and fired at the very least. The Russian intelligence apparatus in the U.S. and the Moscow directorate dealing with the U.S. will be identified and dismantled as forensics are carried out on the failed operation. A generation of Russian operatives will be suspected by Russia’s Federal Security Service (FSB) of having been compromised by the Americans. All of these people will be looking for exciting careers in the food service industry — if they are lucky. When an operation of this scope fails, everyone is blamed except the big guy, and who knows what suspicions will fall on him.

Interesting shifts in U.S. policy already have occurred. A few weeks ago, the U.S. said it did not favor ending sanctions on Russia, something the Russians really wanted. Now there are reports that a Russian intelligence-gathering ship was identified in international waters off the coast of New England. The U.S. also charged the Russians with violating a treaty by deploying a new generation of cruise missiles — a repeat of a charge made in 2014 by the administration of then-President Barack Obama.

Who Is Trump’s White House adviser Stephen Miller?

President Donald Trump’s inner circle includes 31-year-old Stephen Miller, a California native who is behind some of the Trump administration’s most controversial policies. WSJ’s Shelby Holliday reports on the influential player’s path to the White House. Photo: Getty

It is possible to create a delightful trail of dementia here, but the fact is that I doubt the Russians had any such grand ambitions. For one thing, the level of scrutiny by U.S. intelligence — and every other intelligence agency in the world — is such that there would be no chance this type of an operation would not be detected.

If the Russians were doing anything, they were jerking the American chain with the hope of creating a domestic crisis, something which the Americans excel at. A meeting here, a hacking there, a kind word from Russian President Vladimir Putin about Trump, and then the Russians could lean back and watch the fun. But trying to control the president of the United States? I really doubt that.

Some really trivial charges were generated to sink Flynn.

What I do believe is there was an internal battle within the Trump administration, and some really trivial charges were generated to sink Flynn. U.S. intelligence was delighted to help out since they never liked Flynn, who never liked them.

For the Russians, life returns to grim reality. The price of oil is still well below the minimum needed to maintain Russia’s national budget. There are reports from areas outside Moscow and St. Petersburg that salaries are not being paid, banks are failing or being closed by the government in an attempt to create a sustainable system, and the first indicators of unrest are showing.

A newspaper in Vladivostok, for example, has reported small anti-government demonstrations gaining in popularity in a region where oil activities play a large role in the local economy. Last week, five cities in Primorsky region — Ussuriysk, Artyom, Arsenyev, Nakhodka and Vladivostok — saw people participating in “protest walks.” These walks consist of participants circulating in public areas, discussing politics and calling for a cleansing of political ranks. The decline in oil prices is not going away and is playing out its painful hand.

In Syria, the city of Aleppo has been taken, and the Russian government is trying to figure out what comes next, as well as remember why it went there in the first place. Sanctions on Russia are in place, and Ukraine, the site of the last Russian intelligence calamity, remains beyond Russian control. Russia has made a gesture at being a major power. Having made the gesture, it must now figure out how to sustain it.

The Flynn situation has been blown vastly out of proportion by the media, but the Trump administration did not practice the caution that is required in executing its foreign policy. The Russians, who undoubtedly were pleased that their intelligence apparatus had subverted the American presidency, now face problems.

First, they didn’t subvert the presidency, and if they actually tried, they failed. The blowback to their own intelligence service could be grave.

Second, and much more important, it is now time for the Russians to turn their attention to the far less-pleasant task of surviving the oil crisis and dealing with limits on their power. There is something neat in being regarded as intelligence geniuses when you actually didn’t do anything. But like all hidden pleasures, there is a price to pay, and the realities of the real world to return to.

George Friedman is the founder and chairman of Geopolitical Futures LLC , an online publication that explains and forecasts the course of global events. Republished with permission.

In One Chart: The top-performing stocks from each region around the world

It’s not Amazon AMZN, +0.11% Nor is it Netflix NFLX, +0.15% Or even Tesla TSLA, +1.22% Of course, all three of those stocks have certainly enriched shareholders in a big way over the past five years. But there’s one, in particular, that has outperformed the rest.

And it’s no tech juggernaut.

LendingTree TREE, -0.62% according to FactSet data, has surged 1,562% over that time frame. to trump all North American stocks. To weed out the penny stocks, FactSet screened global markets for stocks trading over $5 a share with a market cap of at least $500 million back in February 2012.

The online lender has ridden a healing economy and increasing loan demand to big profit growth. The stock is well off its record highs near $150 a share from last year, but it’s still top dog in the region by this metric, beating out mortgage software company Ellie Mae ELLI, -0.05% and veterinary products maker Heska HSKA, +0.85% in the second and third positions.

LendingTree, however, is runner-up to Europe’s biggest gainer when it comes to the world’s top performer in that period, FactSet noted. Danish biotech Genmab GEN, -1.81% has seen its shares explode for a 2,568% return to dwarf all others.

Taking a tour of the leaders in the rest of the regions: Brazilian energy firm Equatorial Energia EQTL3, -2.13% is tops in South America, with a 160% gain. Over in Asia, food giant SPC Samlip 005610, +0.00% and its $1,327% jump leads the way. Internet and media group Naspers NPN, -0.22% in No. 1 in Africa with a 224% advance, while Domino’s Pizza Enterprise Ltd. DMP, -1.43% is the biggest winner in the Pacific thanks to a 505% leap.