Tag Archives: ROI

How to Calculate Hourly Cost of an Employee

For the sake of occasional business analysis — such as calculating return on investment (ROI) on a project, hiring a new employee, allocating costs — here’s a simple formula for calculating the hourly cost of an employee:

cost per hour = annual gross salary/1000

calculating hourly cost

So the $75,000/year salary costs the company $75 per hour. The $30,000/year data entry person costs the company $30 per hour.

This quick and practical calculation is based on the assumption that the overhead, including payroll taxes, health insurance, benefits, office space, office equipment, telephone, Internet, electric power, transportation, and so forth costs the company about as much as the employee gross salary.

So the step-by-step calculation, using a $75,000 salary, is:

  1. Double the gross salary ($150,000)
  2. Divide by 50 because a work year includes 50 weeks ($150,000/50 = $3,000)
  3. Divide by 40 because a work week includes 40 hours ($3,000/40 = $75)
I hope that’s helpful.

Long-Term Successes Don’t Leave Out Investors

For an investor in a startup, return on investment is as simple as writing a check now and depositing some related money later.  And since startups are risky, you’d expect to hit big when you win because you’re so much more likely to lose. Does that make sense?

So when the angel investor writes a $50,000 check today to invest in a startup, getting $100,000 back out of it five years later is not bad – it’s slightly less than 14% per year return – but it’s not spectacularly good either.

After all, that same investor could buy a cool car or put a down payment on a vacation condo instead. Or she could just leave that money in a bank with decent interest and have $70,000 in five years without risking losing it all.

But here’s the counter-intuitive catch: What happens if the $50,000 creates a healthy and happy company that grows and becomes independent and never creates any liquidity for its investors? The founders don’t want to get bought, and the stock market doesn’t accept it for a public offering, so the early investors are stuck with a share in a long-term business. Growing businesses don’t generally produce dividends, so that $50,000 investment is stuck.

The return on investment of a $50,000 check that never produces a deposit is way less than zero. Getting $50,000 back would be a zero return. Getting nothing back is – well, let’s just say it’s bad. Real bad.

All of which I post here to explain this statement:

Investors are more interested in companies that will be bought. Not in long term companies.

That’s not exactly what I said last Thursday in my credibilitylive.com session for Dun and Bradstreet Credibility Corp; but it’s close enough.  If you’re curious you can click this Youtube link to go directly to seven minutes into the interview where I was was saying that.

Investors appreciate long-term success as much as anybody. But a long-term successful company finds a way to reward its early investors. Maybe that’s through subsequent rounds, a partial liquidity event, a buyout, or some other instrument. But you don’t leave investors stuck in your company with no way to exit.

When my business confronted a situation like that, we practiced then what I’m preaching now: we bought our investors back out of the company.

Big Mistake: Huge Unbelievable Sales Numbers

Jeffrey Moskovitz added an important comment to my big mistake post from last week:

I read an blog yesterday, written by someone I respect, who asserted that investors know and even EXPECT that projected sales and profits will be overstated. Aware of this expectation, the entrepreneur plays the game by inflating the numbers, fully aware that the investors will give the numbers a “haircut,” and everyone will be happy.

Jeffrey didn’t think so and I agree with Jeffrey. Emphatically agree. The idea that everybody winks at inflated numbers is a really bad idea.

My view on this hasn’t changed at all, even as years passed and I moved from entrepreneur seeking investment to angel investor reviewing business plans as part of an angel group. Here’s the way the process works, step by step:

1. Is the sales forecast believable?

Sales forecast credibility is a matter of several factors: understanding the market, size and structure of the market, selling process, channels, decision making, and so on. Granularity is really important, like the details of distribution, margins, buying points, actual names of potential buyers. Real sales already made, letters and testimonials from customers or distributors, are also important. Real Web forecasts, page views, conversion rates, and so on, are important.

If the sales forecast isn’t credible, then investors lose interest in the rest of the numbers in the plan. An unbelievable forecast voids profitability, cash flow, and supposed future valuation and investor return. The process stops.

It is true that a dumb forecast doesn’t necessarily kill potential investment. If there’s good product-market fit, scalability, defensibility, growth potential, management team, and so forth, then bad numbers are forgivable. But a bad forecast is a huge negative.

2. If so, then is profitability believable?

One of the most common errors in business plans, almost pervasive, is unbelievable profitability. As soon as projected profits go over industry averages, I disbelieve the rest of the numbers. In some rare cases (one that I posted about here Monday) entrepreneurs have real justification of those high numbers. But those are uncommon. Most of the time, it means the entrepreneurs don’t understand the business. They’ve underestimated expenses.

Even without researching the specific industry, no industry averages profits much higher than 10%. Most are closer to 5%.

If profitability isn’t believable, then I stop reading the numbers. I have no interest in cash flow or future valuation if profitability is off.

3. If so, then is cash flow believable?

Only if both sales and expenses are believable, do I look at cash flow. Does the cash flow plan recognize the impact of industry and accounts receivable? Does it show the need for investment?

And from there, to be honest, I’m back looking at larger factors, like product-market fit, management, defensibility, and scalability. I still don’t put much stock in what the business plan says the investors will get as return on investment. ROI and IRR projected out five years is an academic exercise, not a real decision factor.

Big Mistake: Business Plans And Investor Returns

Another problem that comes up a lot as I read on with my business plan marathon: too many business plans are taking too much time and effort telling supposed investors what their supposed return on investment will be. This is usually a waste of time, energy, and space. It’s certainly a mismatch between what the entrepreneurs are thinking and what the investors are thinking.

fool's goldI was surprised a couple days ago, talking to entrepreneurs, at how much emphasis they put on wanting to know what return on investment was satisfactory to investors. It was as if they thought what the plan says the company will be worth five years from now makes a difference. And it doesn’t. The illustration here is a piece of fool’s gold, iron pyrite.

It felt like these entrepreneurs are thinking: investors want to see X in returns so I have to show that in my plan. I pop up the sales forecast, pop up the profitability, and that generates a great projected valuation. So I show that I can deliver a great return.

Investors, meanwhile, are actually thinking: I want to look at the product-market fit, scalability, management team, and factors like that to determine whether the company is going to make it. If they have all that right, then they have a shot; and if not, they don’t. Projected investor returns depend on a future valuation, which depends on the sales forecast or income forecast or both. Most investors look hard at the sales and profitability projections, because they want to see credibility; I use them to get a feel for how well the entrepreneurs know the business. There’s so much cascading uncertainty on future valuation that I don’t put much stock in it.

There’s a Catch-22 about sales and profitability forecasts: credibility of the numbers means more than the numbers themselves. A plan that has both big numbers and credibility is rare.

(Image: Vakhrushev Pavel/Shutterstock)