Our previous posts have focused on the small business – approaches to growing the business, seeking out investors, and the issues involved in formulating exit strategies. In this post we turn things around and focus on the investment side of the equation: the factors involved in evaluating a business investment and the factors involved in taking it over once it has been acquired.
There are 28 million small businesses in the U.S., but research services are few and far between. What makes one company more worthwhile as an investment target than another? Certainly there are great opportunities for above-market returns but to take advantage of this opportunity, investors must have an approach for determining which companies are worth focusing on.
Here is an initial list of factors to consider at the start, when evaluating a company as a potential investment opportunity.
- Gross Margin
Gross margin is the percentage difference between what a product sells for in the market (revenue) and what it costs to produce that product (cost of goods sold, or COGS). This ratio is critical because it is what allows a company to invest in all the other areas needed to get the product to market such as marketing and distribution.
Gross margins can vary by industry, and even by categories within an industry, but razor-thin gross margins leave no room for error. In private equity, I focused on investing in categories that had higher gross margins and thus could sustain increased costs more easily. Examples of higher gross margin categories include personal care, premium pet food, and natural and organic products.
It’s very important to keep in mind that gross margin expansion is very difficult. Focusing on creating products with better margins, automating production or getting lower prices for ingredients can help, but the instances where gross margin improvement drives outsized investment returns are rare.
- Brand Strength
This is often the toughest thing to assess in a small company, but an investor needs to ask herself, "Does this brand offer something unique?" A great example of this is Method, the eco-friendly cleaning products. The world did not need another green cleaner, yet Method created a special brand by packaging a quality product with beautiful design and distinctive packaging.
Customer and consumer surveys, "earned" media presence, and third-party data are good ways to start evaluating brand strength. In the consumer packaged goods (CPG) world, there are countless energy drinks and cleaning products. But there's a reason why Red Bull and Method have been huge successes while other products with similar recipes and formulas have failed: formulas can be copied, brands cannot. A tech entrepreneur will not put her idea for a startup on a crowdfunding site (unless all other investors pass), because any engineer can copy it. But a consumer products company with $3 million in revenue would be comfortable talking about not just the idea, but the actual performance of the business. Why? Because you can back into the recipe for Cherry Garcia from Ben and Jerry’s. It doesn’t matter. You can’t copy the brand.
- The CEO
In a small business, you are investing as much in the leadership as you are in the product or company. As a result, you need to invest behind a CEO in whom you believe. As part of your initial diligence, reference checks and third-party background checks are a must. Beyond that, there isn’t a formula for evaluating leadership talent but you should do what every investor does–spend time asking questions. Get on a conference call and probe on issues you think are important. Does this person understand their business, have a passion for the product, and have what it takes to persevere?
- Exit Prospects
Many people think that if they build a great company there will always be a home for it, but in certain industries that's not the case. If the company has visions of selling to a strategic acquirer, it should be able to (a) identify who these likely “strategics” are, (b) determine what their acquisition strategies have been, and (c) be able to explain why that business should be attractive to a strategic acquirer.
- Recurring Revenue
Recurring revenue is the portion of the revenue that is going to continue in the future. It provides a nice base (ideally a growing base) of revenue on which management can rely while focusing on ways to grow the business. It’s especially valuable because the cost of acquiring a new customer is typically about six times the cost of keeping an existing customer.
In consumer products, recurring revenue comes from repeat purchase. Maybe you bought the product once because you liked the packaging. You buy it again because the product performed. It’s not enough, of course, to look to recurring revenue; the question is how frequently that revenue will recur. At a prior firm, we invested in a shampoo company with a beautifully designed bottle (it won multiple awards) that dispensed shampoo in the exact proportions the average woman needed. The problem was that the average person usually uses a lot more shampoo than is needed. As a result, consumers took 12-18 months longer than normal to use up our shampoo. Sounds great for the consumer, but it was problematic for the company because it delayed the repeat purchase cycle.
Once you have purchased a business, the real work begins. To ensure a smooth ownership transition, here are seven steps you will need to take which will help lay a strong foundation for your new business to grow and prosper.
- Have the previous owner stay on throughout the transition period.
Make the best out of the pre-determined transition period. Prepare a comprehensive list of things you want the seller to cover like processes, USPs and flaws of the business etc. Work with the owner to learn the business plan and the ins and outs of day to day operations. In particular, you need to understand the future strategies that current owner has in mind. Some business owners may have a hard time letting go of control after the sale, so you will need to take extra care in understanding the reasons for this and to take whatever steps are necessary to ensure the owner that the business can carry on and thrive after the transition period has passed.
- Observe, ask questions, and make notes.
Observe the daily activities of the owner, the flow of communication with customers, employees and vendors. Make notes, get to know every bit of the business, continually ask questions and get answers from the owner.
- Do not make any substantial changes out of the gate.
In general, people are resistant to changes (the ‘who moved my cheese’ phenomenon). As such, it pays to go slow and avoid making changes that disrupt current business operations, or that can result in dissatisfaction on the part of employees and/or customers. You will have the chance to make changes and grow your business after you know it well enough to identify the kind of changes to avoid in this regard.
- Meet your employees.
Take the time to get to know the employees and their roles in the business. Convey to them that they will be an integral part of your business, and that you have no plans to make staff changes in the short term. Get their thoughts and perceptions on the current business operations and how things can be improved to make their jobs more efficient and effective. This kind of feedback from your new staff is crucial to formulating your business plans and strategies going forward.
- Make your customers aware of the new ownership.
Get to know your customers, and review the customer service policies and the procedures. Let your customers know that you are the new owner, that you are committed to providing them the service they have come to expect, and that you intend to improve on this as you move forward. Gestures such as special offers or a giveaway, something that you think your customers will appreciate, can go a long way toward maintaining good will with your customers.
- Don’t forget the vendors!
Just as you will rely on your customers and employees to maintain the business, the suppliers for your business are equally important. Schedule meetings to get to know the major suppliers of your business, and make contacts with the others as well. If possible, avoid making any long term commitments to them which can hinder your new strategies. Later, when you feel comfortable, look out for other suppliers to get better pricing and terms for future deals.
- Give your premises a makeover.
Once you have settled in, make some changes to the office: get the walls painted, re-arrange the settings, and get rid of unproductive assets. This will help to make the business look new and different, and it will help convey your commitment to making a go of your new business. This will also have a psychological effect on yourself, reinforcing for you that the business is now yours, to take in the direction you see fit.
Work out your action plan around these seven steps to get things going in the right direction. Use the transition period wisely and build a thorough understanding of all the relevant facets of the business. Effective implementation of the ownership transition process will go a long way towards making your new business a success.