Reason to Exist, Part 1
Big Deal Small Business: Reason to Exist, Part 1
One of the first principles I learned as an investor was to confirm if the business had a reason to exist.
This is a difficult, subjective question even though it boils down to a yes or no answer.
The question is really asking if the business deserves to earn its profits. This is not a given!
I break down “reason to exist” into two pieces: unit economics and customer proposition.
Today I’ll cover unit economics; later this week I’ll cover customer proposition.
Unit Economics
This is a fraught term, with folks defining it in a multitude of ways. My framework for identifying strong unit economics is:
Current Check: The business consistently generates gross profit on every customer and product
Growth Check: The gross margin profile is repeatable and scalable as the business grows
Industry Check: The value chain around the business is stable
Let’s dig into each one.
Current Check: A business consistently generates gross profit on every customer and product
The purpose of this check is to understand the business unit economics as they currently look and identify red flags.
First keyword is “consistently”. This requires a review of pricing and input costs. If a company is exposed to commodity raw materials (cough cough…lumber…), do the company have an ability to pass through material cost to customers? Is it immediate or is there a 3-6 month lag? Do they just eat the price increase until material prices come back down?
Said differently, how resilient are gross margins to a wide range of scenarios?
Another way to test “consistently” is by examining trends over time. Have there been significant changes in the margin profile over the past 2-3 years? If so, why? We’ll get to industry dynamics below, but companies can have internal issues driving gross margin volatility. Maybe they switched to a new inventory tracking system and now do a better job managing inventory. Maybe they weren’t adequately insured, so that’s a new cost in recent months. You need to know the “why” for changes in margin.
Second keyword is “every customer”. This requires a review of top customers, ideally all customers. We tend to focus on customer revenue concentration. We should be focusing on customer profit concentration.
Are there a bunch of breakeven customers with just a few customers generating most of the gross profit? If so, why are those customers willing to pay the company a margin when others can get the product for no margin? This is a red flag – if those few high-margin customers realize the others are not paying any margin, won’t they revolt?
Third keyword is “every product”. Same idea as “every customer” but now defined from a product lens. Does any given product/service generate a majority of profits?
Let’s say you’re a pool installation & maintenance company that generates $3 million in revenue and $1 million in profits. You earn $1 million/year in installation revenue that generates $100K in profits (10% installation margin). You earn $2 million/year in maintenance revenue that generates $900K in profits (45% maintenance margin).
In that scenario, you’re a pool maintenance business that uses pool installations as lead gen for maintenance contracts. That isn’t a red flag, but it tells you that you need to diligence the maintenance business as the core “reason to exist”, not the installation business. You need to diligence the installation business as a lead gen device for that maintenance business.
Growth Check: The gross margin profile is repeatable and scalable as the business grows
The purpose of this check is to confirm if the unit economics will hold up as you grow the business.
First keyword is “repeatable”, which is distinct from “scalable”. Repeatable means the business can take its business model and replicate it in new geographies, customer segments, product lines, etc.
For example, a manufacturing company that punches out the same widget day in / day out likely has repeatable margins. To enter a new geography, it needs to invest in a new logistics & sales footprint, but the core product continues to generate the same margin.
By contrast, an architectural design firm might generate 3% margins on some projects and 50% margins on others because it struggles to accurately scope & estimate a project in advance. As a result, even if the blended margin is 25%, you can’t confidently chart out a growth plan and make new investments if you’re not sure whether your new projects are going to generate 3% or 50% margins.
A tour business may have repeatable margins within its geography thanks to strong brand recognition, organic customer traffic, and supplier relationships. Each new tour customer can reliably generate a similar margin. But if the company expanded to a new geography, you’d be starting from scratch with new vendor relationships and branding, so you could not reliably bet on generating the same margin per customer.
Second keyword is “scalable”. Does the margin profile hold constant and ideally expand as the business grows? The holy grail is software, where each new product has next to no marginal cost. This is why SAAS companies have such great business models and trade for high multiples.
In SMB world, you may be able to get away with high margins if you operate in a niche, underserved market. But if you want to grow and serve a wider market, you may find yourself fighting against scaled competitors that won’t allow you to earn the same margins you’re accustomed to.
For example, you may have built a niche providing janitorial supplies to dentist offices in Des Moines. You have great relationships with the dentists and they are willing to pay you strong margins for strong service levels. But if you try to scale the business by expanding to dental practices in Kansas City and St. Louis, you may find larger competitors and more price conscious customers. It could require years for you to rebuild the customer relationships that allow you to generate high margins in Des Moines. Doesn’t mean you can’t grow, but it means your margin profile is not scalable.
Industry Check: The value chain around the business is stable
The purpose of this check is to confirm the ecosystem, and then your margins, won’t crumble under your feet.
Industries are constantly evolving, with margin moving from one piece of the value chain to another piece as dynamics change.
Look at sports TV rights. They have significantly increased in value over the past 10 years as it’s become clear how many cable TV viewers subscribe to the cable bundle purely for live sports. This is an example of margin moving from the cable companies to the sports leagues.
Roku used to ask for very low revenue shares from streaming apps on its platform. They were focused on building a customer base and wanted to make the platform as valuable as possible for end customers. At that stage, margin on a streaming subscription went to the streaming platforms.
Now, Roku is a gatekeeper for streaming apps – they cannot achieve scale without having distribution on Roku. As a result, Roku can demand much higher revenue shares, effectively moving margin from the streaming apps to Roku.
Another classic example is a franchisor / franchisee relationship. For a franchisor business to have stable margins, it needs its franchisee base to be healthy. If all its franchisees are struggling to get by, eventually the franchisor will have to cut its royalty rate or invest in the franchisee base to maintain its royalty rate. There’s a fine balance to the ecosystem.
You can’t control where an industry is headed. But you can do diligence to figure out if it’s reasonably stable or pointed in the right direction for your business.
In SMB world, the biggest source of value chain instability seems to be labor. Your employees are a supplier to your business – they supply you with their time, expertise, and effort. Again, you can’t control the labor market, but you can be aware of if your target business has unique labor dynamics that make maintaining margins harder.
For example, if plumbing companies are facing rising labor costs, they will be looking for places to replace the margin they have to cede to labor. If you’re a plumbing parts distributor, they might come after your margins.
Lastly, you examine competitors. Start with the presumption that two businesses operating in the same industry should earn the same gross margins. If they don’t, you should be able to explain why your business deserves to earn a different margin. If you can’t, your margin and your competitor’s margin should converge over time, likely to the lower of the two.
Think about a landscaping business with low route density versus a landscaping business with high route density. If both are generating similar margins (as a % of revenue), this should raise a red flag or highlight a growth opportunity.
Interpretation #1: High route density company has the “right” margins, so low route density company is over-charging its current customers and will eventually get squeezed on price.
Interpretation #2: Low route density company has the “right” margins, so high route density company should be increasing prices and generating even higher margins given its route density.
As an aside, this is a benefit of deal reps. Over time, you start to build an intuition as to what the business margins “should be” based on deals you’ve seen in the past.
Conclusion
This is the unit economics side of confirming if a business has a reason to exist. Later this week I’ll dive into the customer proposition, which will explore if the customer is receiving enough value to justify the company’s margins.
As always, would love feedback or ideas for new posts. Hit reply to this email or find me on Twitter.
Thanks,
Guesswork Investing