In financial terms, a hedge is a means of protection against a potential loss. But this notion of hedging can be applied to more than just the financial markets and small business owners should consider steps that they can take to similarly reduce their exposure to risk. What if my costs go up? Will demand stay steady? Am I sure my supplier will stay in business? What’s going on with energy costs, travel expenses, and should I charge for delivery? These types of questions are important, and savvy business owners will look for ways to hedge against not knowing the answers.
Jeremy Shepherd is the founder of PearlParadise.com, in Southern California. He started the business 15 years ago when he was just 22 years old and working as a flight attendant. During a layover in China, he bought his girlfriend a strand of pearls, attracted by their delicate beauty and luster. His $25 gift was later appraised for $600 in the U.S., however, and so, sensing a golden business opportunity, he cashed his paycheck and hopped a plane back to China with $3,000—all the money he could get at the time.
“It was slow at the beginning,” he says, recalling the difficult early days of cracking a complex supply chain network and then learning how to build his first online auction website. Now his business has expanded globally, grown to 12 employees, and become an online empire with $20 million in annual sales. How this one-time flight attendant came to own the largest online pearl company in the world was by hedging his bets, so to speak.
Part of this success Shepherd attributes to his hedging strategies. For example, he learned early on that the pearl business is highly seasonal, with most of its sales centered around the holidays of Christmas, Valentine’s Day, and Mother’s Day. But when demand is low outside these peak periods, Shepherd takes advantage of a supply chain eager to unload product by buying up pearls for pennies on the dollar. In addition, because pearls have such a long production lead time—it can take anywhere from four to ten years before a pearl is ready for use in jewelry—Shepherd notes, “I learned to never have only one supplier of anything.”
This concept of buying when demand is low applies to other operating expenses for small business owners as well. For instance, purchasing energy (such as heating oil) on an annual contract with a set monthly rate is a hedge against seasonal market-rate spikes in prices. Another similar idea is setting up long-term subscriptions with vendors at lower prices. Suppliers appreciate the steady stream of cash this arrangement provides them as well as the fact that it allows them to forecast future production more accurately. Often, they are willing to negotiate customer discounts in exchange.
Trading revenue for predictability
This side of the coin, the sales side, is something Andy Sack is familiar with as a serial entrepreneur. He has launched and sold three Internet technology companies, one to New York Times Digital, one to Microsoft and one to Acxiom. “I have had a long experience as an entrepreneur building companies and raising capital,” says Sack. “About two years ago, I switched from being an entrepreneur to being an investor,” he says. And his new company, Lighter Capital, was started on the premise of a hedging strategy—that it could provide entrepreneurs with a steady source of investment in exchange for a percent of sales, rather than of a share of ownership.
“It’s a concept that has been used traditionally in businesses such as mining and entertainment—the movies,” says Sack. “It’s great for companies with seasonal or fluctuating revenue.” As an example, he points to Tomato Battle, a new client of his that—yes—has built a business around organizing giant tomato fights. Because the business is not only seasonal—based on the availability of tomatoes—but also events-oriented, the arrangement of trading a percentage of sales for a steady infusion of investment capital has worked well for both sides.
So how is business for Sack? “We plan to double in size in the next 12 months,” he says.
Get rewarded for what you do habitually
Now what about hard-to-manage expenses that seem beyond one’s control, such as the ever-rising price of a gallon of gasoline and climbing air travel costs? Travel for business purposes, in particular, has become a hot button issue in the last year, eating into many a small business’s profits. For Shepherd, who travels extensively overseas to countries such as China, Japan, and Vietnam, the answer has been to maximize his flyer reward programs. He uses airline-affiliated reward credit and bank cards for all his business expenses, paying off the balance each month. In turn, he redeems the reward miles to pay for subsequent airline trips to his supplier markets. This strategy has proven so successful that he rarely pays for tickets now, even though he traveled to nine countries last year.
Gasoline is a little trickier, however. Again, using a rewards credit card affiliated with retail gas station brands can either shave a few cents off at each fill-up or be turned into points that can be later redeemed to lower your monthly bill. For companies with larger delivery fleets, it’s possible to prepay for fuel at a fixed cost through installment payments. Fuel hedging also exists for companies who want to cap costs.