When Building a Business, Keep it Basic
When you're building a business the best advice that I have been given is to keep it basic. That sounds a lot easier than it is because oftentimes we put so much thought into what the outcome will be that we fail to consider who, how, where, when and what we will begin with. So let's start there.
I will use a model that I was taught when I obtained an MBA in Marketing from Babson College Graduate School of Business. The Timmons Model, by entrepreneur Jeffry A. Timmons, author of New Venture Creation, and a pioneer in entrepreneurship education and research, who passed away in April 2008 is very basic. I reference this model because it is not only basic but to the point.
According to Timmons, any business opportunity can be viewed from three areas: Opportunity, Resources and the E-Team.
The Opportunity is the what, where and when. Assessing a business opportunity involves deep diving into the following:
The Market - Are the customers reachable and will the user payback happen within one year? In today's hyper-information world of the Internet, I would say that all customers are reachable.
The Market Structure - Asks is the market in which you are entering fragmented or emerging? Only you can answer that question but if I we use Matter Planet as an example, the answer is both. Matter Planet is an internet offering that showcases companies that sell to local people. It is in a fragmented (local companies do not have the collective power that big boxes have, and it is fragmented, as the company is a retail model in an emerging distribution channel, i.e. the Internet.
The Market Size - In order to be profitable (Revenue - COGS = Profit or Loss), the market size must be at least $50 million with a potential to reach a $1 Billion. Again, according to Timmons there are some very basic numbers to consider to determine if the market size is profitable. They are: Growth: 25% + Annually, with a 20% share attainable. Can you grow your company 25% annually and ultimately, attain 20% share of the total market?
Break-even: Can you break-even on your investment in 1.5 years or less with a return on your investment of 25% or more?
Low Capital Required: Can you enter and sustain your business with low capital? Some industries that are emerging, i.e. the Internet have very low costs and barriers to entry; while some industries i.e., Wind and Energy, may in fact have medium to high costs to enter due to the initial investments of the plant, materials, labor and other costs to get the product or service to market. Low Cost Provider: Can you be the lowest cost provider? That is a depends question, however, it is possible in every industry, you just have to be smarter than the current offering. An example, Wal-Mart is the low cost provider for an all-purpose big box store. Their sales results also show this to be the case. Another way to look at it is Apple grosses the most per square foot than any other retailer. In terms of the products that Apple sells, it is not the low cost provider, however, it makes more money per square foot than any other retailer, so Apple makes more than any other retailer per square foot, and therefore they are the lowest cost provider from a back-end (profit relative to operations) costs versus Wal-mart's front-end (sales to consumer) costs. Gross Margin: When all is said and done the equation is very simple (Revenue minus Cost of Goods Sold equals your Gross Margin). The figure here to watch for is 40% and durable. In other words, can you sell 100% with your cost to sell being 60% and you end up netting a gross margin of 40%? If you can attain and maintain margins of 40% or better you have a very successful opportunity to pursue.
Low Fixed Costs: Are your fixed costs low? Fixed costs are items that you cannot change regardless of sales. Examples of fixed costs include office space, payroll, insurance, interest payments, etc., that generally don't change over time, or at least during a given accounting period. If you can keep your fixed costs low, in other words pass on that beautiful downtown office space, for something in a lower costs rent district, you will have managed to keep your fixed costs for office space low. Another factor within the low fixed costs scenario are the proprietary barriers to entry. By that we mean is there some technology, intellectual knowledge, or other barrier that you have and is not readily available to anyone else who might enter the business that you are in. Examples of proprietary barrier(s) to entry would be a patent, a software program, or trademark that is uniquely yours and that no other company can use. P/E ratio of more than 5: To get this ratio the calculation would be: Market Value Per Share divided by Annual Earnings Per Share which equals your company's Price per Earnings Share or simply, (P/E). Market Value Per Share = P/E
Annual Earnings Per Share
Your P/E is based on how many shares you have assigned to your company, assuming that it is privately held, divided by the amount of net income your company brought in over the past 12 months. In general, a high P/E suggests that you're expecting higher earnings growth in the future compared to companies with a lower P/E. You should note that the P/E is a relative number and should be compared to something, either your own historical P/E, or the P/Es of other companies in your industry. Be sure to compare apples to apples, i.e. a small retailer such as Earl Campbell Hot Links with Sylvia's Gourmet Links. The companies are in the same industry food with specific product lines. Comparing a software company that would have a high P/E to a sport wear company which would have a low P/E adds no value to your analysis. Also, the P/E is sometimes referred to as the multiple. In other words, a P/E of $5 for each $1 value of the company, suggests that an investor is willing to pay five times (5x) the current $1 value of the company. Lastly, within the P/E analysis you are ultimately reviewing a viable exit strategy because any company that you create must have a value and must have an exit strategy, either you are going to pass it on to an heir or sell it.
In this analysis, we looked at the Opportunity which is based on the market, the market structure, the market size, growth, break-even analysis, ROI, low capital requirements, low cost provider, sales growth, gross margins, low fixed costs, proprietary barriers to entry, and your P/E, and an exit strategy. In my next blog we will assess the resources needed to build a business.
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