Phil Knight famously turned the startup Blue Ribbon Sports into the giant company known as Nike. Knight described the market at the time he started his business in this way: “The American shoes were offshoots of tire companies. Shoes cost $5 and you would come back from a five-mile run with your feet bleeding. Then the German companies came in with $30 shoes, which were more comfortable.” During a trip to Japan after graduating from Stanford with a MBA he decided buy shoes from Onitsuka, the manufacturer of Tiger (now ASICS) athletic shoes. It took 14 months after placing the order for samples to finally arrive. Knight recalls: “I showed them to my old coach, Bill Bowerman, who was so impressed he asked me to let him in on the deal. We shook hands on a 50-50 partnership and each of us put up $500. We bought 300 pair of shoes. First year sales were $8,000. We made a $250 profit. By 1972 we got to $2 million in sales with a 3 percent net profit. But it hadn’t been easy. After all, $500 apiece doesn’t provide much equity, even for $2 million.”
“After posting eight thousand dollars in sales in my first year, I was projecting sixteen thousand dollars in my second year, and according to my banker this was a very troubling trend.
‘A one hundred percent increase in sales is troubling?’ I asked.
‘Your rate of growth is too fast for your equity,’ he said.
‘How can such a small company grow too fast? If a small company grows fast, it builds up its equity.’
‘It’s all the same principle, regardless of size,’ he said. ‘Growth off your balance sheet is dangerous.’
‘Life is growth,’ I said. “Business is growth. You grow or you die.’”
Knight has both a MBA and was a CPA when he started Blue Ribbon Sports. He knew the value of a business is the present value of expected future cash flows. He also knew the value of *free* cash flow, which is the amount of cash generated by a business that is available to pay back debt, pay investors, and/or grow the business. The challenge of scaling a business that eats cash to generate more cash is very seldom simple to solve. This is why a great CFO is so valuable to a business. Sometimes in the early stages of a business the CEO is also the CFO. For example, Bill Gates was the first CFO of Microsoft and even when Frank Gaudete was hired to be the CFO he admitted that what Bill knew about Microsoft’s finances went beyond what he knew. The venture capitalist Pitch Johnson said once: “Frank Gaudette was the first CFO that Gates hired. He’d previously been at Informatics and a number of other companies. He used to come to meetings and say that he had been in the business for years and years and thought he really knew his financial stuff but that Gates would go right by him. He said Gates really knew it instinctively.”
Fred Wilson has a great explanation of why a business benefits from having a great CFO:
“A VP Finance is what you need when you want a leader who will keep the wheels on the bus, who will make sure there are financial controls in place, who will make sure the books, records, and reports are accurate and timely and well presented, and who will make sure you have the right amount of accountants and clerical staff on hand to manage the work of the finance organization. A VP Finance is largely about “what happened” and a little about “what is happening right now?” A CFO is what you need when you have all that I described above but you also need a forward looking financial mind at your side, when you need deep strategic thinking in the financial function, when you need to do big transactions (both M&A and financings), and when you need someone to manage your relationship with investors (particularly public investors). A CFO is largely about “what is going to happen and how do we get there?”… Get a VP Finance onboard as soon as you can afford one. They will let you sleep at night. Get a CFO on board when you are ready to take on the world.”
Today the primary source of equity for a growing business is venture capital. Unfortunately for Knight, the venture capital industry was not developed enough in Nike’s formative years to be a source of capital for his business. He did try at one point to raise venture capital for Nike but had zero success. Knight had no choice other than to use loans and other non-equity types of finance to grow his business. One of the most interesting things about Knight’s story is how he bootstrapped his business in so many clever ways. While his bootstrapping approach created huge risks, the end result of not raising much equity was that he did not take a lot of dilution, which made him extraordinary wealthy as the business grew. Knight said:
“Again and again I’d gently try to explain the shoe business to my banker. If I don’t keep growing, I’d say, I won’t be able to persuade Onitsuka that I’m the best man to distribute their shoes in the West. If I can’t persuade Onitsuka that I’m the best, they’ll find some other Marlboro Man to take my place. And that doesn’t even take into account the battle with the biggest monster out there, Adidas. My banker was unmoved. Unlike Athena, he did not admire my eyes of persuasion. Equity. How I was beginning to loathe this word. My banker used it over and over, until it became a tune I couldn’t get out of my head. Equity—I heard it while brushing my teeth in the morning. Equity—I heard it while punching my pillow at night. Equity—I reached the point where I refused to even say it aloud, because it wasn’t a real word, it was bureaucratic jargon, a euphemism for cold hard cash, of which I had none.”
“We weren’t broke, we just had no money. Lots of assets, no cash.” “I spent most of every day thinking about liquidity, talking about liquidity, looking to the heavens and pleading for liquidity. My kingdom for liquidity.”
Issues related to the timing of the arrival of cash can result in the death of a business even though it is actually creating shareholder value. Cash is like oxygen for a business. Without this oxygen, a business dies. Cash flow timing issues create a need for finance which has been satisfied since before recorded history by moneylenders and investors. Michael Milken describes the process of finding the optimal solution:
Financing is an art form. One of the challenges is how to correctly finance a company. In certain periods of time, more covenants need to be put into deals. You have to be sure the company has the right covenant — to allow it the freedom to grow, but also to insure the integrity of the credit. Sometimes a company should issue convertible bonds instead of straight bonds. Sometimes it should issue preferred stock. Each company and each financing is different, and the process can’t be imitative.
Fred Wilson writes: “Great CFOs are few and far between. And in order to recruit one of them, you will need an interesting business and a meaty role. VP Finance talent is in larger supply and they can take you very far.” A talented CFO adds huge value to a growing business. Investors often fail to pay enough attention to a company balance sheet and instead focus on the income statement. The recent collapse of the UK based construction group Carillon is an example of cash management gone wrong among other problems. The business had been struggling given that it had £900m of debt and a £587m pension deficit before it failed. The Independent newspaper wrote: ”This is a company that is expected to pay back something like 1p on the pound to creditors after its liquidation and that had just £29m left in the bank at the end. That might sound like a lot, but for a company of its size it is pin money.”
“Any dollar that wasn’t nailed down I was plowing directly back into the business. Was that so rash? To have cash balances sitting around doing nothing made no sense to me. Sure, it would have been the cautious, conservative, prudent thing. But the roadside was littered with cautious, conservative, prudent entrepreneurs. I wanted to keep my foot pressed hard on the gas pedal. Somehow, in meeting after meeting, I held my tongue. Everything my banker said, I ultimately accepted. Then I’d do exactly as I pleased. I’d place another order with Onitsuka, double the size of the previous order, and show up at the bank all wide-eyed innocence, asking for a letter of credit to cover it. My banker would always be shocked. You want HOW much? And I’d always pretend to be shocked that he was shocked. I thought you’d see the wisdom… I’d wheedle, grovel, negotiate, and eventually he’d approve my loan. After I’d sold out the shoes, and repaid the borrowing in full, I’d do it all over again. Place a mega order with Onitsuka, double the size of the previous order, then go to the bank in my best suit, an angelic look on my face. I was forever pushing my conservative bankers to the brink, forcing them into a game of chicken. I’d order a number of shoes that seemed to them to be absurd, a number we’d need to stretch to pay for, and I’d always just barely pay for them, in the nick of time, and then just barely pay our other monthly bills, at the last minute, always doing just enough, and no more, to prevent the bankers from booting us. And then, at the end of the month, I’d empty our accounts to pay Nissho and start from zero again.”
In addition to having challenges related to cash, a business like Blue Ribbon Sports can have little or no current accounting “earnings.” This is upsetting to some people since current earnings are easy to determine and are simple. Unfortunately earnings are backward looking and can be manipulated. In his book Expectations Investing Michael Mauboussin points out the problems with just looking at earnings rather than discounting expected free cash flows:
“Shareholder value only increases if the company earns a rate of return on new investments that exceeds the cost of capital. Management, however, can achieve earnings growth not only when it is investing at or above the cost of capital but also when it is investing below the cost of capital.”
To illustrate this point, Eugene Wei describes the Amazon business model:
To me, a profitless business model is one in which it costs you $2 to make a glass of lemonade but you have to sell it for $1 a glass at your lemonade stand. But if you sell a glass of lemonade for $2 and it only costs you $1 to make it, and you decide business is so great you’re going to build a lemonade stand on every street corner in the world so you can eventually afford to move humanity into outer space or buy a newspaper in your spare time, and that requires you to invest all your profits in buying up some lemon fields and timber to set up lemonade franchises on every street corner…”
Warren Buffett sets out the right test for a business owner: “We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.” Knight definitely met Buffett’s test at Nike and so is someone like Jeff Bezos at Amazon.
When you have no cash you must watch every penny and do an opportunity cost analysis with every expenditure. Knight said about the early days in an early Nike office:
“We couldn’t afford to fix the broken glass, so on really cold days we just wore sweaters. Meanwhile, in the middle of the room I erected a plywood wall, thereby creating warehouse space in the back and retail-office space up front. I was no handyman, and the floor was badly warped, so the wall wasn’t close to straight or even. From ten feet away it appeared to undulate. Woodell and I decided that was kind of groovy. At an office thrift store we bought three battered desks, one for me, one for Woodell, one for “the next person stupid enough to work for us.” I also built a corkboard wall, to which I pinned different Tiger models.”
Every startup or business that raises a financing round has a certain “runway” to retire risks and achieve progress. Any cash not spent on achieving those goals increases the probability that it will fail to “graduate” to the next level. The odds of failure are already high. Not spending cash on high rent exposed brick office space and free Kind bars is wise because it shortens the runway. Shorter runways are a bad idea because they pressure people to do things like falsely believe they have product/market fit which can be fatal. A Herman Miller Aeron chair is especially expensive if the $1,000 used to buy it is raised in a financing at a $5 million valuation and the company eventually does an IPO. It’s way too easy to justify expenses like free Kind bars and expensive view office space one by one. As Charlie Munger says: “Intelligent people make decisions based on opportunity costs.” The best businesses make wise choices. You can’t have everything. A company that dies but everyone has a $1,000 chair until then is tragic. If you buy the chairs maybe don’t buy something else. Life is full of trade offs. Being an adult is about making hard choices. A startup having a longer financial runway is not achieved without making hard choices.
“My search for credit put me in touch with Nissho Iwai, the sixth largest Japanese trading company with annual sales of $100 billion. We began developing a positive relationship. We were no longer limited to track and field shoes. So we brought in wrestling shoes, tennis shoes, basketball shoes as well. Sales grew to $3.2 million, but we had our first-ever loss, plus one other little problem. We got kicked out of our bank. Too much leverage, not enough cash. The state of Oregon only had two big banks and we’d been thrown out of the other one just two years before. Nissho Iwai stood in for the bank until we found one: The First State Bank of Milwaukie, Oregon. It was a small bank, but we made it work.”
Knight was very wise to have a backup source of finance for Nike. As I wrote above, cash is like oxygen for a business. Even if there is only a small probability of something happening, if the magnitude of that outcome is large, you must act to create a margin of safety to mitigate that risk and uncertainty. Seth Klarman makes the key point: “A margin of safety [accounts] for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” There are many ways to use the margin of safety concept that have nothing to do with finance. For example, can you think of a system that had no margin of safety that was located in located in Hawaii that sent an alert about incoming ballistic missiles? Sometimes a margin of safety is as simple as a pop up on the screen that asks: “Did you really mean to send notice to everyone in Hawaii that a ballistic missile is on the way and that this is not a drill?” An engineer named Rob Pike said something once that applies to the user interface of the system that failed so badly in Hawaii: “Failures happen no matter what you do. That means the software you use has to cope. That means replicate everything. Two pieces of crap are better than one.”
“Supply and Demand is always the root problem in business.”
There are some aspect of a business that really can’t be fully understood until someone actually operates a business. Charlie Munger likes to say operating a business is about microeconomics and that he and Warren Buffett ignore macroeconomic factors. Do they keep track of the business cycle? Sure. They do that by staying disciplined about the price they pay to buy businesses. If you focus on the micro the macro takes care of itself. “My partner Charlie Munger and I have been working together now 55 years. We’ve talked about every business you can imagine and stocks. We have never had one decision that involved a macro factor. It just doesn’t come up.” But they do think about microeconomics every day. In his classic “Five Minute University” routine on Saturday Night Live the comedian Father Guido Sarducci pointed out: “Economics? Supply and Demand. In my profile of Harvard Business School professor Michael Porter I wrote:
What Michael Porter did after graduating from Harvard Business School was to go across the Charles River and get an Economics PhD. Porter came back to the Harvard Business School to teach as a professor yelling: “Hey people, *supply* matters too when it comes to generating a profit.” It’s that simple. If you have too much supply, then price drops to a point where there is no long term industry profit above the company’s cost of capital. That Michael Porter’s most important insight was to teach business school academics that demand *and supply* matters in determining profit is shocking, but there it is.
“At first, we couldn’t be establishment, because we didn’t have any money. We were guerrilla marketers, and we still are, a little bit.” “It’s alright to be Goliath but always act like David.”
Necessity is the mother of invention. A business that has very little cash for marketing must figure out some way to scale. In the beginning months and year of a business that may mean doing things that do not scale. As an example, Knight sold shoes himself at first from the trunk of his Plymouth Valiant at track meets and other events. As another example, the AirBnB founders went door-to-door with a rented camera to generate their first few listings. When a business like Nike is trying to find out what customers want to buy there is no better way to get the right answer than actually talking directly to customers.
“We used to think that everything started in the lab. Now we realize that everything spins off the consumer.” Now we understand that the most important thing we do is market the product. We’ve come around to saying that Nike is a marketing-oriented company, and the product is our most important marketing tool.”
The first person Nike hired to endorse its products was the Romanian tennis professional Ilie Nastase. He signed an endorsement contract with Nike in 1972. Nastase was particularly interesting and newsworthy since he was a rebel and liked to stir things up. I can’t resist telling a personal story about Nastase. His first wife was Dominique Grazia, a Belgian fashion model who he married at the age of 26. He was playing in a tournament in the 1970s at a tennis club that I belong to that still requires everyone to wear white. Dominique did wear white, but her top was fully fish net. I remember the commotion her transparent outfit caused at the club even today. I loved what she did even though certain conservative elderly club members nearly fainted. Of course, Nike has had a parade of athletes who have endorsed its products over the years. Steve Prefontaine the American middle and long-distance runner who competed in the 1972 Olympics famously signed with Nike in 1974. Eventually Nike would sign Michael Jordan to an endorsement contrast and the rest is history.
“It’s hard enough to invent, manufacture, and market a product, but then the logistics, the mechanics, the hydraulics of getting it to the people who want it, when they want it—this is how companies die, how ulcers are born.”
Operating a business is much harder than people imagine and a company like Nike with an international supply chain to manage is a particularly challenging business to manage. Nike’s most famous supply challenge happened in 2004. At the time a Nike spokesperson said that the supply chain software “didn’t deliver on performance or functionality.” Knight said about this software problem on a earnings call: “This is what you get for $400 million, huh?”
“For an Entrepreneur, Every Day Is a Crisis”
I’m looking forward to Scott Belsky’s book on what he calls “the Messy Middle.” He has written about this topic on his on his blog:
In reality, the middle is extraordinarily volatile—a continuous sequence of ups and downs, expansions and contractions. Once the honeymoon period of starting a new journey dissipates, reality hits you. Hard. You’ll feel lost and then you’ll find a new direction; you’ll make progress and then you’ll stumble.
Knight’s book about his journey in creating Nike has some very influential admirers among them are Bill Gurley and Bill Gates. The Microsoft founder says about the book: “Shoe Dog, Phil Knight’s memoir about creating Nike, is a refreshingly honest reminder of what the path to business success really looks like. It’s a messy, perilous, and chaotic journey riddled with mistakes, endless struggles, and sacrifice. He tells his story as honestly as he can. It’s an amazing tale.” In his review of Knight’s book Bill Gates writes: “There are no tips or checklists. Instead, Knight accomplishes something better. He tells his story as honestly as he can. It’s an amazing tale. It’s real. And you’ll understand in the final pages why, despite all of the hardships he experienced along the way, Knight says, ‘God, how I wish I could relive the whole thing.’”
“Someone somewhere once said that business is war without bullets, and I tended to agree. ” “Like it or not, life is a game.” Play by the rules, but be ferocious. Dream audaciously. Have the courage to fail forward. Act with urgency.” “I wanted to leave a mark on the world. I wanted to win. No, that’s not right, I simply didn’t want to lose.” “You only have to succeed the last time.”
This is sort of a grab bag of quotes, but it give you a sense of what Knight is like as a competitor. Adidas, Puma, Under Armor and other companies are formidable competitors and yet Nike has thrived. Knight’s business did hit many speed bumps on its way to success, some of which could have been fatal. One fun story about a potential speed bump is told by Doug Houser (Knight’s first cousin) who was at one time acting as the lawyer for the company in important litigation:
In 1973, Blue Ribbon Sports and Knight filed a lawsuit in federal court in Portland against Onitsuka. The lawsuit “alleged that (Onitsuka) had breached their contract by soliciting new distributors and demanding that Knight sign over control of BRS for the right to go on distributing Tigers,” says Kenny Moore’s book, Bowerman and the Men of Oregon. Federal Judge James Burns ultimately issued a ruling that entitled Blue Ribbon Sports to damages but allowed both the U.S. company and Onitsuka to continue selling identical shoes. Critically, though, only Blue Ribbon was allowed to sell them under their U.S. trademarked names, including the Cortez. Onitsuka appealed but eventually sought an out-of-court monetary settlement rather than re-fight in court. Houser said: “they came up with a figure we felt was great. At the time it was an awful lot of money and it was to be confidential. And still is. Knight and Houser were asked to come to the San Francisco office of the law firm that represented Onitsuka. The pair was under the impression that they’d sign papers and there would be a transfer of funds into a Blue Ribbon account. “So Knight and I go down and we appear in the San Francisco lawyers’ conference room,” Houser said. “And they have an old steamer trunk. Looks like a casket. A big steamer trunk, filled with cash.” The Onitsuka lawyer explained the unorthodox payment method as the result of the difficulty of transferring money out of Japan. He encouraged Knight and Houser to sign some documents. “And I said, ‘Is that X dollars?’” Houser said. “And they gulped and said, ‘Well no. It’s illegal to bring that much money out of Japan. And we couldn’t’ bring it all. That’s all you get. But it’s a lot of money and you ought to sign.’ They knew we were desperate and needed money badly. “But it was grossly unprofessional. Grossly wrong. Morally wrong. Everything about it stunk. “And Knight said, ‘Eff you. We’re out of here.’ “And we left the conference room and went out into the lobby, punched the elevator button and just like in the movies, just when the elevator opened, the conference room door opened and they hollered, ‘Don’t’ leave. We’ve got the rest of the money.’ “So we went back into the conference room, they opened a door to an adjoining conference room where there was a second steamer trunk and they said, ‘Now sign the papers.’ “And at that point we said, ‘We’re not signing anything until a bank has counted the money and we have a certificate of deposit in the company’s name. This could be counterfeit for all we know and you guys have no credibility whatsoever.’ “I called the Bank of America, explained our problem at, maybe, 4 o’clock in the afternoon and they said, ‘It’s going to take a while to count that. But we’d be delighted to stay open late and we’ll have an armored car there in about five minutes.’ (The money was in $100 U.S. bills, Houser said.) “And they came and got the steamer trunks and we went to the bank and waited and they gave us our certificate. We signed the release papers. The case was over. We had the certificate of deposit. We went out to celebrate. Had a wonderful dinner and drank too much.”
What Onitsuka tried to use with Knight was a particular style of negotiation known as an ultimatum strategy. My co-author and I wrote I wrote about this sort of approach to a negotiation in our book The Global Negotiator which is available as a PDF for free here.
“I’d like to publicly acknowledge the power of luck. Athletes get lucky, poets get lucky, businesses get lucky. Hard work is critical, a good team is essential, brains and determination are invaluable, but luck may decide the outcome.”
Luck determines so any things in life. There is of course the saying “the harder you work the luckier you get” but that is not quite right. Michael Mauboussin points out that if you can alter the outcome with work it is not luck but rather skill. Knight knows he has been the beneficiary of many types of luck. I have found that people who understand how lucky they have been in life are more likely to give back to others. I have certainly been lucky which is why I have donated all royalties from my new book to charity.
“Your goal should not be to seek a job or even a career, but to seek a calling. That search has just begun. In your time here [at Stanford Business School], you’ve probably gone through 50 or 100 case studies. And in the years ahead you’ll probably go through thousands more. Most case studies are not about decision-making, not even about judgment. They are about a search, for wisdom.”
Knight came up with his plan to create a business by importing running shoes from Japan while he was a student at the Stanford. He believed that the shift from Germany to Japan that had taken place in the camera business was possible in running shoes. His knowledge of and passion for running shoes and sports came from being a middle-distance runner for the University of Oregon track team. He knows and loves his business. He said once that if he had worked at Microsoft he would have been fired since technology is not his strong suit. Software is also not his passion. Knight is a Shoe Dog and that was critical to Nike’s success. A final quote from Knight from his book on this point is appropriate:
“Driving back to Portland I’d puzzle over my sudden success at selling. I’d been unable to sell encyclopedias, and I’d despised it to boot. I’d been slightly better at selling mutual funds, but I’d felt dead inside. So why was selling shoes so different? Because, I realized, it wasn’t selling. I believed in running. I believed that if people got out and ran a few miles every day, the world would be a better place, and I believed these shoes were better to run in. People, sensing my belief, wanted some of that belief for themselves. Belief, I decided. Belief is irresistible.”
Extra Phil Knight quotes:
“We have a small percentage of our shoes right now that are made by total automation. We can’t scale it overnight, but in 10 years that will probably be scaled.” Technology that used to be fodder for science fiction stories is soon to become a reality.”
“I do not follow conventional wisdom.”
“Don’t tell people how to do things, tell them what to do and let them surprise you with their results.”
Shoe Dog: https://www.amazon.com/Shoe-Dog-Memoir-Creator-Nike/dp/1501135910/ref=tmm_hrd_swatch_0?_encoding=UTF8&qid=&sr=
Expectations Investing: http://expectationsinvesting.com/