For the two people who actually read my posts, you know that I blogged about how I look at the value of a server. Basically, it should be valued by the cash flow it produces. Without a customer to use the server, the cash flow it generates is negative, i.e., less than $0 due to the costs of keeping it racked up, powered up, and connected.
So, how do you place a value on a customer? Customers and servers are not a one-to-one connection because many customers have more than one server. They also buy more than just servers, such as additional software and/or backup services.

Like most of us in the industry, I spend a few minutes each day scrolling through the customer forums, both ours and 3rd party sites – you probably know which ones . I look at the customer comments and sometimes I wonder if the folks in our industry understand the value of these customers judging from the way some customers are treated.
Granted, some customers are abusive and need to be fired, so to speak. Others appear to be high value customers with multiple servers and solid business models where someone has dropped the ball and caused them to seek greener hosting pastures. If companies understood the dollar figure valuation of each customer, they might think twice about their next course of action with a particular customer.

To value a customer, I look at the statistical expectation of how long that customer will stay with the company, how much the customer currently buys with us, the statistical expectation of how much additional business they will place with us, the gross profit generated by the customer, and that old stand-by — the minimum acceptable rate of return for an investor in the company. From these data points, I do a simple Present Value calculation and arrive at the value of the customer, which is the amount of cash that would have to be invested to yield the economic equivalent of the expected gross profit that the customer will produce. I’d give you a sample calculation, but a) it would make this post even more boring, and 2) some things we like to keep secret .

This is important because it can make the growth of a hosting company less “slippery” — sort of like when Eric takes off from a red light in this:

For example, if you sell 100 new servers but customers release 90 back to you during the same period, your growth doesn’t have the traction it would have if only 10 servers were released back to you. By retaining valuable customers, you don’t spin your wheels as much. Spinning the tires at a hosting company is not nearly as much fun as watching Eric drive.

Now that I’ve ranted on a few accounting shortfalls for the hosting industry I’m going to rant once more. I think that the way hosting companies must book the value of their assets per accounting rules shortchanges hosting companies. Some basic rules of finance clearly show the likelihood that significant value is missing on the financial statements.

Let’s consider a mythical server that costs the company $10,000 to buy and the company depreciates it evenly over 3 years. After year one, the value on the financials is $6,667. After year two, its book value is $3,333 and finally $0 after three years. Suppose that the company deploys the server for five years. In reality, after three years, the server’s true value is certainly above $0, and the hosting company is shortchanged by not being able to reflect this value on its financial statements. Multiply this effect by thousands of deployed servers and you can see that there is significant value in hosting companies that just isn’t found on the financial statements.

So how should we reflect the value of a server? I would propose the use of a “capitalization rate” or “cap rate“. This is a common method of appraising real estate and the formula is simple: take the projected net cash flow over the next 12 months and divide by the cap rate, and that’s the value. So, what would happen if we applied this to a server?
Looking at our mythical $10,000 server above, for simplicity’s sake, let’s ignore any allocations of the switches, routers, generators, HVAC, etc., needed to operate it. Let’s also assume it produces net cash flow of $100 per month and will do so for 60 months. Its 12 month projected net cash flow is $1,200. We would divide this by the cap rate to find its value.

Naturally, the next question is “what do we use for the cap rate?” For a given investment, the cap rate is the lowest return that an investor will accept for the given risk of that investment. In our server’s case, the $10,000 investment produces a return of $1,200 per year. How much would an investor need to invest in lower risk alternatives to get the same return? For a risk-free investment of the same 5 year duration such as a 5 year Treasury Note at 4.25%, you would have to invest $28,235.29 to get $1,200 per year in return. If we use 4.25% as the cap rate in our scenario, the value of the server becomes $28,235.29. However, investors in hosting companies generally look for returns far above 4.25% and these returns are not without risk, so this is not the appropriate cap rate. For simplicity’s sake, let’s assume that the hosting company investor’s minimum acceptable rate for the investment is 10%. In other words, if his investment in the hosting company was expected to return less than 10%, the investor has other lower risk options to invest and get a 10% return and he would not invest in the hosting company.

So if we use 10% for the cap rate in our mythical server scenario, the true value of the server is $12,000 ($1,200 / 10% = $12,000). As long as the 12 month projected net cash flow stays above $1,200 then that value holds constant. Check out the graph below to compare the value of this server from both the cap rate perspective and the accounting rules perspective over the five year life.

From month 36 to month 49, there’s a $12,000 difference in value between the two methods. If a hosting company has a thousand servers like this, that’s $12 million in value that isn’t reflected in the company’s financial statements. That’s huge.

Just like any company, the search for ways to increase revenues and lower costs to make more money never ends. In the increasingly competitive hosting environment, raising prices is rarely an option but finding ways to cut costs while making the experience better for the customer can and must be done on an ongoing basis.

We have achieved some success to date with the provisioning of nearly 10,000 servers; however, the end game is far greater as the ultimate goal is to become a multi-national corporation serving markets all around the world. In the hosting space, you don’t really have a choice, you either innovate and get bigger or you get out. The complexities are just too great to have the luxury of maintaining the status quo. The technology landscape is littered with companies that started reading their own press clippings and got fat, dumb and lazy. And keep in mind that copying your competitors only delays the inevitable; the “me-too” companies eventually go away. In the technology world, you must innovate and push the envelope to survive.

While we are constantly looking for new and better ways to serve the customer, a great deal of time is spent improving internal reporting systems. I work with a management team that understands the importance of budgeting and tracking various financial and operational metrics. To that end, we have made a substantial commitment in systems and people to gather data to help make the best decisions for us and most importantly, for our customers.

I would love to reveal all the data we have at our fingertips but for competitive reasons, I don’t want to give away too much but let me leave you with this tidbit: I wonder how many of our competitors’ CEOs can, from his/her desktop, drill down to any one of 10,000 servers in multiple data centers and know exactly how profitable each individual server is with the click of a mouse.

The best companies in the world are all supported by world-class accounting and finance departments providing pertinent financial and operational data to all its stakeholders. The right information gives you a tremendous advantage over your competition.

Find someone good to count and analyze your beans. Wal-Mart did and turned the world of retail on its head. With a little luck, we might be able to do the same to hosting.

For the third (and final!) installment in this likely sleep-inducing trilogy of hosting and accounting blog posts, we’ll cover Current Ratio and how it doesn’t treat hosting companies fairly. Bear with me – this rant may run a bit longer than normal.

Current Ratio is easy to compute – simply go to the balance sheet and divide current assets by current liabilities and voila! You have the Current Ratio. OK, so what does it mean?

So why is this unfair to hosting companies? Well, where does most of the cash of a hosting company go? Into servers and networking gear! But guess what? These don’t fall under current assets on the balance sheet and thus are excluded from the Current Ratio calculation. As a result, I’d wager that most if not all hosting companies have at some point been in the position of current liabilities being greater than current assets, where conventional wisdom says “the company may have problems meeting its short term obligations.”

How does this hurt hosting companies? Suppose the company could use some short term financing for a network upgrade. If they go talk to a banker about this the banker might throw up his hands and say “I can’t help you…you’re in financial distress according to your Current Ratio.”

I would argue with the banker that this is not necessarily so. Traditional GAAP places servers and networking gear in the bucket of long term assets along with things like buildings, bulldozers, cranes, heavy machinery, etc. For a hosting company, this placement just doesn’t make sense.

Long-term assets, or capital assets, are things that typically can’t be reconfigured, can’t be easily converted into cash, and are used for a long period of time. A hosting company’s, buildings, generators, HVAC gear, etc., is rightly classified in long term assets. But servers and networking gear are quite different in that they exhibit more traits of current assets than long term assets. Check out this definition. It would take far less than a year for a hosting company to convert its server fleet and networking gear into cash and these assets are the key source of funds for day-to-day operations.

A manufacturing company gets to count its inventory in current assets, whether it is raw materials, work in progress, or finished goods ready for sale. A hosting company uses its servers and networking gear in much the same way – it can reconfigure the processors and drives of servers, arrange the networking gear to offer new services, virtualize a server into several virtual machines or combine several servers into a grid. Then it can change things up next month if desired. This sounds more like current assets than a bulldozer. But according to GAAP and the 800 year old double-entry math system we must use today, servers get placed in the same bucket as bulldozers.

My question is, how do hosting companies as an industry get together and establish some specific accounting standards that will allow our financial statements to truly reflect our business? Simply moving servers and networking gear to current assets would more accurately reflect how we use them in our business.

Am I off base in asking this? Hardly. The real estate investment business has been doing this for years. Traditional GAAP simply made no sense to their business, and they developed accounting standards that fairly represent that business. See this and note this quote from the Real Estate Information Standards, which is published by the National Council of Real Estate Investment Fiduciaries and is widely accepted among the real estate investment management industry and the firms that audit that industry:

“The development of the Market Value Accounting and Reporting Standards resulted primarily from the realization that standardization of meaningful financial reporting was necessary in order to allow real estate to become more acceptable as an institutional investment asset class. Accounting standards promulgated by authoritative accounting bodies exist for various real estate entities, including public real estate investment trusts and other public and private real estate entities that utilize historical cost accounting [i.e. GAAP – my comment]. The reporting requirements and information expectations of the institutional real estate investment community required the development of a market value-based financial reporting model for which no accounting standards published by authoritative accounting bodies presently exist. Accordingly, the lack of adequate authoritative guidance applicable to market value accounting for institutional real estate investment vehicles necessitated the need for these standards to be published.”

Translated out of accountant-speak, this simply says that GAAP didn’t fit their business and they applied common sense to the situation. I suggest that this young business of web hosting also needs some industry specific accounting standards to fairly report information about the health of its companies to its investors, and that these standards do not presently exist. Finally, if you’ve made it all the way through to here, you may order a server with free double RAM up to 2 GB by using the promo code “toothpaste&OJ” anytime over the next week. [subject to approval by Lance of course]

In GAAP, net income is the bottom line. It’s supposed to tell you if you’re making money or losing money. But the amount on the bottom line is never equal to your bank balance and by itself, it’s an inadequate measure of a hosting company’s health.

For example, depreciation is subtracted before you arrive at net income. But depreciation is not cash going out the door. It represents the theoretical drop in book-value of something you own, such as servers. Ideally, the timing of depreciation should match the length of time you actually use something, so if you use a server for three years, its value would depreciate to zero over three years.

Problem is, from the years of hosting experience we have in this company, we know that servers bought in the early 2000’s are still in use today. Many were depreciated over three years, but they’re still generating sales revenue long after they’ve been depreciated to a value of $0. What this means is that net income from these servers was effectively UNDERSTATED during their first three years of use and that net income is currently OVERSTATED for the periods of use after their value has dropped to $0 on the books.

But since I have to judge a hosting company’s health based on Net Income, here’s how I do it. If net income is positive and it’s greater than depreciation expense, one of two things is going on. Either they’re knocking it out of the park in this asset-intensive business or they’re not reinvesting enough to remain technologically relevant. If net income is positive but less than depreciation expense, they’re likely healthy. If net income is negative and the absolute value of depreciation expense is greater than the absolute value of net income, the company could be fundamentally sound and worthy of receiving credit. Bankers will likely disagree with me, but my opinion here is hosting-business specific. Finally, if net income is negative and the absolute value of net income is greater than the absolute value of depreciation expense, then the company needs to adjust something to get healthy.

If you ask me, cash generation from operations is a much better indicator of the health of a hosting company. It ignores distortions like this mismatched depreciation. It will also tell you if the company generates enough cash to cover its debt service and/or to continue investing to stay technologically relevant.

Got that? If I haven’t lost you already, I’ll talk about how the normal Current Ratio calculation unfairly penalizes hosting companies next time.

Hosting and GAAP accounting go together like toothpaste and orange juice.

If you’re confused go brush your teeth and drink a big glass of orange juice. I’ve held out as long as I can, but I just cannot restrain myself from a post or two about the hosting business and accounting. So if this will make your eyes roll back in your head, please stop reading now and click here before you keel over.

In many ways, good ole GAAP just doesn’t treat the hosting business fairly. Relative to accounting, hosting is a new phenomenon with roots dating back only into the 1990s. This is ancient in Internet time but double-entry accounting dates back to the 12th century, and the first accounting textbook describing the double-entry system was penned by Luca Pacioli in 1494. The double-entry system was used because mathematicians denied the reality of negative numbers until the 16th century and the double-entry system was used as a workaround for the lack of negative numbers.

So, why must we account for paradigm-changing Internet businesses with an archaic 800 year old math system? It’s a classic example of the old “square peg – round hole” cliché. Toothpaste and orange juice.

Applying this 800 year old system to the hosting business often paints a flawed picture of the financial position of a hosting company. And there are a lot of folks in the financial world that either can’t understand this or don’t want to understand this by thinking outside the normal accounting paradigm.

I’ll blog about two examples of this: 1) Net Income and 2) Current Ratio. My next post will cover Net Income and we’ll discuss Current Ratio thereafter.

Thanks to my financial brethren at Enron, Worldcom, Barings, BCCI and all the companies currently embroiled in the stock back-dating scandals, I have sit through an ethics seminar every other year to maintain my status as a certified public accountant.

In my position as Chief Financial Officer, ethics and integrity are of paramount importance and as a company, we work hard to hire staff with these characteristics. Keeping that in mind, a survey was taken in 2005 by Deloitte and Touche of American youth between the ages of 13 and 18 in which they were asked the question, “If your boss told you to do something you thought was unethical, would you do it anyway”? An astounding (at least to me) 53% of the kids said they would do what their boss asked them to do.

As a technology company with a work force that gets ever younger as kids become more and more technologically savvy, that is frightening statistic. However, what it points out is the need for us to set the behavioral standards and to train our staff in what those standards are.

What are those standards? For every company those will differ somewhat but a recent survey points out the types of unethical behavior every company faces on a daily basis. In 2005, the American Management Association’s Human Resources Institute asked companies why their employees behaved unethically. The top five reasons:

1. Pressure to meet unrealistic business objectives
2. Desire to further one’s career
3. Desire to protect one’s livelihood
4. Working with a cynical, demoralized environment
5. Ignorance that the act was unethical

We have all faced having to make decisions in light of one or more of those five reasons at some point in our lives. How we have reacted to those situations has helped define each of us as we moved through our careers.

How will you know what the ethical choice is when you are trying to make a decision? Let me leave you with one final quote from Potter Stewart, former U.S. Supreme Court Justice on his definition of ethics:

Ethics is knowing the difference between what you have a right to do and what is the right thing to do.

Are you doing the right thing? And are you demonstrating that to your peers and those you lead? The world is watching.

Q4U – Y don’t finance guys blog much? If j00 post “IAAA” and talk of KPIs, EVA, and other TLAs, readers think listening to this llama is a CWOT and say “CYAL8R”. CMIIW but hosting demand r0×0rs. The SMB market sk00lz all else but there are other factors. I’ll mention just a couple here:

I’ll call one the “middle school” factor. I have a 13 year-old boy. He and his classmates are absolutely addicted to Internet chatting. He’ll open six or more windows at once and at least four of them are girls who are also chatting with IDK, their BFFs AFAIK. They will ROTFLOL for hours even if OMG, PAW. It’s NBD to them.

I doubt that as these kids grow up they’ll give up the chat habit, and the n00bs that come along will only add to the ranks. Thus, another driver of internet fundamentals grows seemingly forever and demands more servers to relay the ever growing messages.

I’ll call the other factor the “mullet factor”. I knew our CEO back in the 80’s and he sported quite the mullet, I can assure you (see image to the left for proof).

Punch in the word “mullet” into Google and in .05 seconds you’ll get links to about 3.8 million web sites somehow related to mullets. w00t! A few are related to the fish, but most have to do with the hairstyle. YKW, these websites have to live on a server somewhere. Strange websites like this only seem to proliferate over time. AWHFY?