Hi, it's CJ Gustafson and welcome to Looking for Leverage.

Today’s topic: what a layoff costs. The same reduction produces three different numbers, and they hit at three different times.

I knew we had to cut some expenses. My sponsor never gave me a headcount number, per se. But what I did get was an EBITDA margin target for the year. And it needed to go up faster than we could move revenue without changing our cost structure… Which meant people.

On one hand this felt horrible. I knew this would change a number of people's career trajectories. And each person has a story and a family. 

On the other hand, we hadn't done any sort of performance management in 18 months (probably closer to 24 months if I’m being honest). We absolutely had 5% of staff that should not be aboard the bus given where the org was going or based on their current performance.

Since headcount was the only lever large enough to get there, I worked backwards from a percentage to a total dollar number based on my forecast. And then worked with my CEO to split that number across the C-suite, allocating the reduction down to the department leaders.

Each leader got a dollar target, rather than a headcount number. For example, marketing was on the hook for $500K. It's better to put this in dollar figures rather than heads because they know their org at that level better than the CEO or CFO. And $500K out of marketing is two people or four depending on who they are, and the CMO is the one who should be making that call.

I also had a second budget, separate from the run rate payroll savings. That was the cash I could spend to make the changes. So there were two numbers in flux, which would impact three different “views” of our results once they were settled.  

This is what it costs you in real dollars to make the changes, regardless of how you contemplate it on the P&L (adjusted or unadjusted). The cash hits typically span one or two quarters and then are done. The majority of it is immediate. 

What's in it:

Some of that is set by law and some is your decision. California and Colorado require vacation payout regardless of your policy, and other states vary, so have someone confirm the rules for every state you employ people in. In most states your unemployment rate is experience rated, so a wave of claims can raise it for years afterward. Weeks of severance, health coverage and outplacement are yours to choose.

A lump sum clears the whole amount in one quarter. Salary continuation spreads it over two, and keeps people on your health plan while it runs.

My advice: push on this number before it's approved to ensure you have enough to be fair. Once it's set you're limited to rationing inside it.

Severance is an operating expense on your income statement. Two factors decide how it looks: where it sits, and when it hits.

Where it sits is your call. Leave it in the departments those people worked in and if anyone was in customer support your gross margin drops in the quarter you cut, and your CAC Payback will look a little better if Sales and Marketing payroll drop. Or, show it as an aggregated lump sum restructuring line. Gross margin stays clean, but you've created a line item people will ask about (“what’s in there?”). Both are defensible. Just agree on the treatment with your auditors, then apply it consistently.

When it hits is not your call, and this is the part that surprises people. If you have a written severance policy, or you've paid severance consistently enough that it counts as an established practice, the expense is recorded once the layoff is likely and you can estimate the amount. That can be a quarter before anyone is told. If you're designing the package for this one event, it's recorded when you tell people. If they have to work through a transition period to collect, it spreads across that period instead.

To restate something that’s often confusing: the expense can land in the quarter you decided, rather than the quarter you executed. Your auditors have a view on which applies to you. Get their opinion before you print the financials to avoid rework.

The savings on this page also comes in smaller than the number you promised to your investors from a run rate perspective (which we’ll cover in a sec), for three reasons.

Some salaries were never in operating expenses at all. If engineering time was capitalized, that cost went to the balance sheet and comes back as amortization in later periods. Cut a $200K engineer whose time was 60% capitalized and operating expense falls by $80K. You can’t double dip.

Similarly, bonus and commission accruals may reverse for people who leave before the payment date. Check your plan language, because commissions are often earned when the deal is booked and owed regardless of who is still there. Where the accrual does reverse, it’s a credit in the quarter you cut and it happens once.

And if we’re being honest, while not a P&L move at the moment, some of the work is coming back as contractor spend to plug any gaps in operations, and typically in the same department you just cut. 

This is the figure your investors work from, and it answers a different question: what does this company cost to operate going forward.

Severance comes out, because you don't pay it every year. It’s a one time cost. The payroll reduction goes in at its full annualized value, because that's what you'll save over a full twelve month period. Sponsors and bankers present it this way as a matter of course. Buy-side diligence, on the other hand, often pushes back on savings you haven't realized yet, so keep the support for where reductions were made.

Differences here come down to timing. If you announce on April 1st and execute notice periods and final pay, your payroll actually stops around June. You get seven months of savings this year, rather than a full twelve because of when you made the move.

So a “$2.5M reduction” is worth $1.4M in actual in-year run rate savings, compared to the full annualized figure. Nonetheless, the run rate page for PE reporting typically shows $2.5M starting in April, looking at the company on more of a “go forward basis”.

There's a second nuance worth knowing about. The run rate number is built off gross payroll, so it counts the full salary of anyone whose time was capitalized, even though that salary was never in operating expense. The page overstates the EBITDA improvement by that amount, and almost nobody adjusts for it. Net net, the run rate adjustment is the largest of the three.

Here’s an llustrative company, not mine. 

Cash out the door: roughly $500K for severance, vacation payout, payroll taxes and continued benefits, most of it in the second quarter. Payroll stops, saving $1.4M over the rest of the year. Net cash effect for the year, about $900K positive, with the money going out before it comes back.

The P&L view: $1.4M of payroll savings, less $210K that was capitalized and never in operating expense, less $150K of contractor backfill, plus a $180K bonus reversal. That’s $1.22M of savings, minus the $500K of severance. EBITDA of $10.72M.

The run rate view: $10M plus the full $2.5M annualized reduction. $12.5M, which is the target exactly. On a like for like basis it’s closer to $2.29M once you take out the capitalized payroll, which would put it at $12.29M, but nobody builds the reduction that way.

The layoff hits the target from the investor’s perspective, but could also be looked at as only $1.8M if you’re being academically honest. And it really only puts $900K in the bank if you’re checking the balance. But knowing which number your investor cares about, and how they calculate it, ensures you don’t have to cut deeper than you have to.

Wishing you don’t actually have to do a RIF.

CJ

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