The top-down approach to investment For a systematic approach to investing, there are two approaches that one may follow. The first approach, known as the ‘top-down approach,’ recommends starting with a capital allocation decision, then asset allocation and security selection. Capital allocation decision essentially involves considering the choice between investing in a risk-free asset and a risky portfolio. This is driven by the risk attitude of the concerned investor. The second choice is to identify the risky portfolio and the composition of the risky portfolio. This is known as an asset allocation decision. Finally, one has to go for security selection. For each asset class identified in the asset allocation stage, the security selection entails identifying the specific company’s stocks or bonds to invest in.
The bottom-up approach to investment The bottom-up approach is where we first identify the specific instruments to invest in. Once the security selection is made, we have put the required money to invest into each of these instruments, and we get the weights of money allocated to each of the broader asset classes. This step is the asset allocation decision. Finally, knowing the proportion of the capital employed in risk-free assets combined with the balance employed in the risky portfolio gives the capital allocation decision made by the concerned investor.
Capital allocation decision and risk preferences The capital allocation decision is determined by the capital available and the risk preference of the investors. There may be three types of investors: risk-loving, risk-neutral, and risk-averse. A person with a risk-loving attitude would prefer to allocate more in the risky portfolio than a risk-neutral person. Similarly, a risk-averse investor will usually invest a lesser proportion in the risky portfolio than the capital invested by a risk-neutral investor in the risky portfolio.
How do we assess risk preferences? The risk preference of any investor could be captured through an investment questionnaire. The questionnaire provides questions where a respondent has to make a decision when confronted with different investment prospects or asset classes. In asset pricing, the risk aversion is modeled using the utility function. The utility function helps to capture the preferences of a decision-maker.
So, the right way to investment is? There is no conclusive answer to that. Both the approaches of ‘top-down investment’ and ‘bottom-up investment have their pros and cons. Let us hold these ideas for a later post.
Disclaimer: The author contributed to this article in his personal capacity. The views and opinions expressed are his own and do not necessarily represent the views of the author’s employer. Any comments or suggestions for improvements are most welcome. Please leave your comments below.
Suppose you follow the startup ecosystem and the associated news actively. In that case, you may have come across terms such as funding round, pre-money valuation, post-money valuation, equity dilution, founder ownership, etc. This article will help you understand these ideas using the context of a startup going through multiple financing rounds and seeing a valuation mark-up or mark-down in each round.
A (fictitious/possible) startup Consider a fictitious startup in the party planners business. Let us name it ‘YouChillax.com,’ in short YC. The company began operation in May 2018 in the city of Cawnpore. The business idea was pretty simple. With the increasing trend of outsourcing party planning related to birthdays, weekend parties, house warming ceremonies, etc., the team YC saw an opportunity and offered a solution. It provided a platform for households to provide their requirements through the app ‘YouChillax.’ The app interface needed very minimal details to make an inquiry. The customers could leave details such as name, contact details, event name (birthday party, weekend party, full-day retreat, kitty parties, new year barbecue, etc.), expected number of guests to be invited, food preference (vegetarian, non-vegetarian), cuisine (continental, north Indian, South Indian, Chinese, etc.), beverage preferences (alcohol, non-alcoholic, etc.), the date/time of the event, the pin code or address of the location of the party, preferred time to be contacted, etc. The customers could leave the details in less than 60 seconds. Once the customer has placed a request, the business development team from YC will schedule a call over telephone/videoconferencing to understand the requirement better and provide suggestions and a quotation for the complete service.
The beginning The company was bootstrapped using the savings of 5 lakh rupees of its two co-founders (Ms. Meenakshi and Mr. Murad). The initial investment was primarily in building the website and the associated app for placing the requirement. The initial advertisement of the venture and its offerings was done through the circulation of pamphlets in the residential colonies of Cawnpore. And the first set of businesses were brought on board through visits to the households and pitching the idea of easing the party planning efforts. The company received its first customer order for a house warming ceremony-related party event on May 22, 2018. Meenakshi and Murad also used the ceremony to advertise their venture and reach out to other prospective customers. Soon, the platform enabled orders to the tune of 30+ orders per week. The numbers were minuscule, but the business seemed to be gaining traction through word-of-mouth publicity by satisfied customers (especially the households with both spouses working full time-jobs who saw the immense utility of such a service at a reasonable cost structure).
Need for Capital The initial six months went through multiple hiccups, as one would expect for any startup, but the lean idea of this business seemed to be working well. Confident with the initial success, they felt the urge to take it to more cities (multiple locations). To achieve this goal, they needed access to capital to grow the seemingly successful business idea rapidly. Meenakshi and Murad, for the first time, felt that they had made it but felt the need for capital. They were pondering how to approach the potential investors and other financiers to raise the required money for the first time.
Founders’ ownership, funding rounds and equity dilution They approached a few family members and friends for funding. But they could not extend support in the situation. Meenakshi and Murad currently owned 50% each as ownership in the firm. The co-founders assessed that they might need capital up to INR 25 lakhs to achieve their goal over the next six to eight months. After meeting multiple angel investors who were willing to offer them the required capital but asked for a varying percentage of ownership in the company. Worried about losing some control in their company, they sat down to evaluate Mr. P. R. Tijoriwala’s proposal, who offered INR 25 lakh for a 20% stake in the company in December 2018. Meenakshi and Murad needed it very urgently and hence accepted this offer. While they accepted this offer, it also led to the dilution of their equity by 20%. After this funding round, their equity ownership in the company stood as 40% [~50%*(1-0.2)] for Meenakshi, 40% [~50%*(1-0.2)] for Murad, and 20% for Mr. Tijoriwala.
Time
Owners/Investor category
Ownership
Time 0
Co-Founders (Meenakshi and Murad)
100%
Time 1
Angel Investor – Mr. P. R. Tijoriwala
20%
Time 2
Series A Investors
10%
The simple arithmetic of pre-money and post-money valuation At INR 25 lakh, the stake that Mr. Tijoriwala asked for was 20%. This translates into him placing a post-money valuation of INR (25/0.2) lakhs ~ INR 1.25 crore for YC. Therefore, the pre-money valuation turns out to be INR 1 crore (post-money valuation minus the capital offered ~ 1.25 crore – 25 lakhs = 1 crore). The post-money ownership is 80% for the co-founders and 20% for the new investor Mr. Tijoriwala.
Owner/Investor category
Time 0
Time 1 (Funding by Mr. Tijoriwala)
Time 2 (Funding by Series A investors)
A) Offered capital and stake asked
A1) Offered capital
INR 25 lakhs
INR 2 crores
A2) Stake asked
20%
10%
B) Equity dilution after each round
B0) Co-Founder (Meenakshi)
50%
40%
36%
B0) Co-Founder (Murad)
50%
40%
36%
B1) Angel Investor – Mr. P. R. Tijoriwala
NA
20%
18%
B2) Series A investors
NA
Not participated
10%
Total
100%
100%
100%
C) Valuation
C1) Pre-money
NA
INR 1 crore
INR 18 crores
C2) Post-money
NA
INR 1.25 crores
INR 20 crores
Subsequent funding rounds and valuation mark-up or mark-down YC grew and succeeded in the newer locations. The firm was now gaining more comprehensive visibility through word of mouth and social media posts by satisfied users. YC was receiving inquiries from different cities and contemplated expanding across multiple metropolitan towns. This next phase of growth again needed additional capital to the tune of INR 2 crores. Meenakshi and Murad were passionate about taking their firm to the next level and were willing to dilute their holdings to raise extra capital if needed. In August 2020, the founders could generate interest from the Venture Capital community and angel investors (founders of some of the recent unicorns) in this proposed Series A funding. The funding round closed with new investors getting a 10% share in the company. The round effectively closed at a post-money valuation of INR (2/0.10) crores ~ INR 20 crores for YC. The firm observed a valuation mark-up since the funding round of December 2018. The valuation shot up to INR 20 Crores from INR 1.25 crores in 20 months. The equity ownerships changed to 36% each for Meenakshi and Murad, whereas Mr. Tijoriwala’s ownership fell to 18%. The series A investors had 10% ownership.
Lets see some real-world examples I hope this simple illustration should have clarified the pre- and post-money valuation ideas and associated equity dilution. I encourage you to read some of these articles published in popular financial dailies to see this concept in practice.
Disclaimer: The author contributed to this article in his personal capacity. The views and opinions expressed are his own and do not necessarily represent the views of the author’s employer. Any comments or suggestions for improvements are most welcome. Please leave your comments below.
Have you ever wondered what all business decisions can cost data help us undertake? The decision to price a product or a service; the decision to outsource or produce internally; the decision to do differential pricing for a domestic versus an export order; the problem of identifying most profitable customers in a B2B market; a possible metric to do the appraisal of different divisions operating in a company and much such decision need to ascertain the cost data as accurately as possible. The area of cost accounting, which provides ways to do a proper costing for any product or service, offers many analytical decision-making capabilities that the domain of management accounting entails.
What goes in manufacturing a product? An enterprise engaged in manufacturing a product achieves its goal through activities on which some expense is incurred. For a manufacturing process such as toy production, the expenses may be either direct or indirect costs. The direct costs will be related to the raw material used for the production, labor costs associated with employees employed in the production shop floor, and machinery (depreciation) cost. The indirect costs will be those related to the expenses incurred in the corporate office, wages of administrative department, accounting department, human resources department, house-keeping department, maintenance department. In a nutshell, all those expenses are crucial enabling functions in the operations of the company. The final product is ready after these direct and indirect costs have been incurred.
What goes in delivering a service? An enterprise engaged in delivering a service achieves its goal through activities on which some expenses are incurred. For service delivery, the direct costs may be related to the labor cost associated with employees employed, raw material, or the packaging cost for the inputs needed in delivering the service. In addition, there may be indirect expenses in training, admin department, accounts, and HR and customer service department, among others.
What earns us revenue? As we have seen in the previous two paragraphs, there are many cost items when it comes to manufacturing a product or delivering a service. A company (toy manufacturer or an IT service) earns the bulk of its revenue through sales of its final product or through fee income in delivering a service. Therefore, the company should strive to assess its true costs consisting of all the expenses as discussed in previous paragraphs to be able to identify the price of its product suitably to make a meaningful profit.
The need to assess costs and the cost accounting approaches Cost assessment is an essential exercise in any enterprise. There are multiple approaches to do the costing. The most widely used ones are ‘Job costing,’ ‘Process costing,’ ‘Hybrid costing,’ and ‘Activity-based costing.’ These approaches differ in their mechanics and are suitable depending on the exact nature of the operation. In most cases, if a product is made to order (customizable such as tailor delivering a stitched shirt, an automobile repair shop providing repair services for a bike), the standard practice is to use ‘Job costing.’ If a product is produced with a mechanized and complex process involving multiple stages and requiring several days, the standard practice is ‘Process costing.’ Some products or services may also merit a ‘Hybrid costing’ – a mix of ‘Job’ and ‘Process’ costing. In some organizations, where multiple production processes share resources and output may be achieved through a series of activities, the widely popular ‘Activity-based costing’ may be appropriate.
Analytics using cost data: The adventures of a management accountant A) The breakevenanalysis: A management accountant or a finance manager may be required to identify the production quantity which helps the company achieve breakeven, i.e., scale of production, which renders no profit, no loss scenario. The manager is aided in this decision-making by assessing the split of costs in terms of behavior. Some costs may be fixed in nature, and some may be variable. The breakeven point (BEP) may be calculated by equating the profit to zero [(Selling price – Variable cost per unit) x Q* – Fixed cost = 0] and solving for Q*, which will be the minimum quantity that should be sold to achieve breakeven. Any sales above this breakeven point (BEP) will result in the company’s profits. B) To price special orders: A new Electric Scooter venture, ‘Bijli Bike,’ predominantly sells its e-Scooters to individual customers. Suppose they are approached by a food delivery business (say, AasPaas Rasoi) operating in Uttar Pradesh with an order of 20000 e-Scooters. Due to their bulk order, the company may ask for a quotation that offers e-Scooters at a cheaper rate than the retail price available to an individual buyer. Here again, the sales manager, in consultation with the production manager, may provide a quote to ‘AasPaas Rasoi’ where the reduced price is arrived at where all the variable costs per unit are covered, but all or a part of the fixed cost is not charged from the company.
It pays to know the true cost! Need I further emphasize why cost data is crucial for a host of business decisions? The cost of all kinds – those beyond the production shop floor or the point of service delivery should be assessed to arrive at the actual price of selling a product or delivering a service. Remember, you are in business to make worthwhile profits, and for you to do so persistently, a good idea of costing comes in very handy. Further, you have the cost data at your service when you ponder over your crucial decisions related to cost savings, profit maximization, increasing utilization, performance appraisal, etc.
Disclaimer: The author contributed to this article in his personal capacity. The views and opinions expressed are his own and do not necessarily represent the views of the author’s employer. Any comments or suggestions for improvements are most welcome. Please leave your comments below.
This article is the first in a series of three articles wherein I discuss why we should understand the world of investments. In this article, I present simple ideas to understand the need for financial planning. In the second article in this series, I offer basic ideas on investment planning. Finally, in the third article, I present some of the theoretical concepts behind portfolio formation.
The early years We all go through numerous years of education and strive to get into employment. Throughout the phases of schooling from kindergarten to undergraduate studies, there are considerable expenses that our parents/guardians incur for us to get a good education and possibly lead to employment. We often are not mindful of the costs that have been incurred so far. Take a pause and think about a rough amount of money that may have been spent on our upbringing. You would be amazed to realize the extent of the expenses. These expenses are indeed an investment in us. And, like any other investment, this investment in education brings benefits in our grown-up years and helps us survive and thrive.
The productive years When we start earning, say at any age such as 23 years or 27 years or above, our salary (cash inflow) often exceeds our expenses (cash outflow). We find ourselves in a comfortable situation financially. These are also years when we are in the best of our health, have almost no liabilities (unless we have an education loan to repay), and have many aspirations and hobbies (sport, travel, entertainment, etc.). As our cash inflow (salary) can absorb all these activities-related expenses, we financially find ourselves in good shape. This phase of life continues for varying years (next 20, 25, 30 years) where our income may keep increasing. We feel good about this growth. But we need to be mindful of the inflation that may be eating into the ability of money to buy goods at the same nominal rate every year. As long as our income (ideally net savings!) is growing at a rate higher than the inflation rate, we are doing good in terms of real growth of wealth.
The crucial milestones in the journey As we start growing old, there are many milestones where there is a need to shell out a large amount of money. Think of higher education (say, a master’s degree), marriage, buying a car, buying a home, childbirth, child’s education (key events such as matriculation, intermediate, undergraduate studies), in some cases also marrying them off. These events are, in most cases, achieved over 30 years or so. And by the time we are done with these responsibilities, we have either retired or are inching closer to retirement. Retirement is a significant milestone in everyone’s life. It essentially tangibly transforms our life. Just a month before our retirement date, we have been earning and meeting our expenses. And, immediate next month post-retirement, we continue to have our expenses (almost at the same level as the previous month or slightly lower if we are mindful of what is to come ahead in terms of cash inflow). There may be a few scenarios post-retirement – a) we have pension support (but a reduced inflow than our regular salary), b) no pension support (essentially no salary), c) some assets where we may have invested in (say, land, apartment, insurance-based investment product, gold, stocks, etc.), d) become dependent on our kids or other members of the family for our financial needs. Few other things may severely impact our post-retirement life. For example, we may outlive our available financial cushion (think of the longevity of age), or we may be fraught with major healthcare costs to take care of our health.
The need for financial planning The journey mentioned above is one that we can relate to if we are in the age group of 40 or above. However, it is more critical for us to be mindful of these aspects of the financial trajectory (planning) relatively early in our lives. The earlier, the better. Most of us may have seen our parents having done this planning in one way or the other. You may recollect that they maintain some amount of money in their savings bank account, invest in fixed deposits, post office savings plan, buy land, buy an apartment, invest in gold, buy an insurance product, in some cases invest in stocks etc. Therefore, it is essential to note that some planning always goes in as we proceed in our lives, which helps us take good care of ourselves and our family at different stages in life. Financial planning is, therefore, an essential and ever-pervasive aspect of anyone’s life. Adding a layer of systematic planning and thought process to this effort might increase our financial wellbeing.
And the right time? – the sooner, the better As you may have noticed in the previous paragraphs, each of the major events in our life happens at different points in time (think in terms of our age in years). They often require expenses (cash outflow) that exceeds our regular disposable income from the monthly salary available then. Any or almost every such milestone most likely exceeds our disposable income, such as buying a car, buying a house, expenses related to a child’s education at the undergraduate level, etc. Each of these is a lumpy cash outflow. Therefore, wiser financial planning is needed to have a proportional amount of liquid money or assets available to take care of these lumpy expense requirements in life. Most households usually have done some planning for the life post-retirement but lack adequate planning for meeting the expenses related to these events/milestones. They end up borrowing from friends/family or raising a loan from a bank or other financial intermediaries. Such borrowings may put us in debt, and then our whole effort goes into taking care of repayment. This adds to stress in our lives. Prudent financial planning may help avoid such a situation. Therefore, a good understanding of how financial goals could be met with meticulous planning and appropriate investment approaches becomes essential. That presents a need to understand investments.
Disclaimer: The author contributed to this article in his personal capacity. The views and opinions expressed are his own and do not necessarily represent the views of the author’s employer. Any comments or suggestions for improvements are most welcome. Please leave your comments below.
