I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

I work for ThoughtWorks, the global leader in software delivery and consulting.

Sunday, July 31, 2011

Annual Budgeting and Agile IT, Part I: Why the CFO Isn't Impressed with Agile

I’ve been asked by a number of people recently how we can reconcile Agile IT, which shuns long-range deterministic planning, with annual budget & planning cycles, which are dependent on it. This 3 part series will look at the CFO's perspective on the business, the inherent conflict in IT investments financed through business operations, and what CIOs can do to decouple IT finance from IT operations.

Let’s look at things from the perspective of the CFO.

The CFO needs to be in front of a lot of things over the course of the year, notably earnings and cash flow. He or she wants as much future indication of what we want to spend and when we want to spend it, so he or she can determine how that spending will be financed: from cash already in the bank, from collections made throughout the year, through a short term credit facility, long-term debt, paid-in capital, or any of a number of sources of funds.

Businesses are held to specific reporting cycles, but not every month or quarter is going to be the same: businesses that are seasonal such as retail or cyclical such as railroads will go through longer spans of time before they know whether their forecasts about revenue prove true or not. Of course, many businesses are neither cyclical (most of the luxury sector seems immune to the fact that there is a recession) nor particularly seasonal (airlines spike with holidays and such, but revenues are consistent quarter-on-quarter). These businesses have far more immediate indication of the accuracy of their revenue forecast and collections. More frequent feedback might allow people in a company to reprioritize more frequently what they buy and how much they spend month-on-month, but CFOs of such firms will still err on the side of making decisions consistent with long-term expectations.

When operations are consistent in their financing demands, the CFO doesn’t have to crisis-manage the checkbook day-to-day; they can instead guide the business by getting in front of financing needs or investing opportunities. Clearly, it isn’t good if we spend money in anticipation of cash flow from future sales only for those future sales to fail to materialize. CFOs tend to not to like to go hat in hand to credit markets to raise cash, or immediately contract spending across the business. They particularly don't like having to answer questions from analysts during earnings calls about having needed to make such sudden changes, because it indicates those in charge of the business aren’t very capable at running it.

Consistency is particularly important for CFOs of capital intensive firms, companies with high asset value and a lot of equity or debt. The people who financed the acquisition of those assets will want to know that the firm earns more from what it does with the assets than the assets themselves are worth, and those to whom the firm owes money (such as bondholders) want to know that the company is going to be able to service its debt. The CFO is, in many ways, the voice of those who provide capital to the business, and has a fiduciary duty to them all.

The CFO perspective is also compounded by the fact that we are increasingly financing businesses with complex instruments to provide working capital and hedge risks. While this may reduce the cost of capital, complex corporate treasury operations leave the CFO with less time and less patience for cash flow from operations being inconsistent with expectations.

This isn’t to say that our numbers are locked for the year. We revisit the numbers every month and quarter But those numbers are still revised to a baseline, for the aforementioned reasons: e.g., we need to hit a target return to satiate bondholders or equity holders, we don’t want to overheat spend before our big revenue cycle in the event our forecasts are wide of the mark. Only if the business environment has completely changed – think about what firms in everything from retail apparel to investment banking did in Q3 2008 - will we throw out the baseline.

Banks make money by borrowing short and lending long. Most businesses follow the same pattern, using month-to-month cash flow (short) to meet the demands of the firm’s investors and creditors (long). This requires a very well oiled short-term cash generating machine to sustain the demands placed on the firm from their long-term financing. This is particularly obvious in firms that are highly leveraged e.g., where private equity has taken out money from a business by borrowing against future cash flows, and then sweating the business to maximize cash flow quarter-on-quarter. But this is true in any business beholden to outside capital.

Along comes the CIO with the good news that we're adopting Agile practices, which will do away with predictive planning and instead constantly re-scope and re-prioritize to maximize use of capital.

To a CFO, the prospect of financing captive IT operations that can only determine their financing requirements by muddling through is not particularly attractive. Vague financing requirements threaten to introduce volatility in financial demands of business operations. The CFO doesn't have a lot of tolerance for anything that could upset the tuning of the short (cash flow) / long (debt and equity) financing behind the business. Any short-term capital optimization the firm stands to gain from Agile is appreciated, but it pales in comparison to the long-term capital monster that needs to be fed.

If anything, the CFO wants greater certainty in operational forecasting so that he or she has one less thing to worry about. Not less.

Financing Agile IT thus has a steep hill to climb.

In the next part, we'll take a look at the conflict in financing day-to-day IT operations as capital investments.