Reason to Exist, Part 2

Big Deal Small Business: Reason to Exist, Part 2

The threshold question in my diligence process is confirming if the business has a reason to exist.

I come at this from two angles: unit economics and customer proposition.

I covered unit economics earlier this week, check it out here if you missed it. That issue considers 1) how does the business currently make margin, 2) will the business make margin as it grows, and 3) are there ongoing industry dynamics that might change its ability to make margin.

In other words, Part 1 was all about the business itself and the value chain around it.

Today I want to focus on the other end of the equation: customers.

I want to learn 1) what the customer is really paying for, and 2) if the price & margin profile of the business jibes with what the customer is really paying for.

What is the customer really paying for?

Let’s start with the obvious. Consumers buy Louis Vuitton bags because 1) they need somewhere to put their sunglasses and 2) they want to rent the status of the brand.

There’s some dollar margin in selling bags for sunglass storing purposes (which is why companies sell bags for $25 at Target). But it’s apparent that Louis Vuitton earns the vast majority of its dollar margin from its brand value.

Pretty clear concept, but let’s take it to SMB world.

A plumber is selling their 1) expertise and 2) speed.

The actual replacement work might not seem difficult or require much time. The margin comes from knowing which pipe to replace.

Further, when something breaks, it needs to be replaced immediately. Every hour without hot water or a working toilet has real value to the customer. The margin on a 24-hour turnaround business should be higher than 72-hour turnaround business.

By contrast, a lawn mowing business (not landscape design) is selling 1) time, 2) effort, and 3) equipment.

The lawn mowing business is giving customers back time & effort that they would otherwise expend taking care of their own lawn. They are also renting equipment in the form of lawnmowers that the customer no longer needs to own. As a result, this business tends to be commoditized relative to a plumbing business, so pricing and margins are likely more standardized across the industry.

A trickier business I’ve seen is oil lab testing. This business takes a sample of oil off an oil tanker, takes it to its lab, tests the contents, and confirms the quality of the oil. After that’s completed, the tanker offloads the oil to the customer.

On the surface, it appears that the company is selling 1) lab testing equipment and 2) oil testing expertise. Upon further diligence, it became clear that the company is selling only one thing: speed.

An oil tanker costs $15,000 to $50,000/day to charter. The oil seller can stop paying the tanker charter rate the moment the cargo is offloaded to the customer. As a result, as long as the customer believes in the inspection company’s results, all the oil seller cares about is how fast the oil inspection company can turn around the oil test.

The point of figuring out what the customer is really paying for is to clarify what you need to diligence.

For a plumbing company, you need to diligence the expertise of the plumbers and the quality of their dispatch operations.

For a lawn mowing company, you need to diligence route density and their pricing relative to competitors.

For an oil inspections company, you need to diligence their turnaround time on inspections relative to competitors while confirming they don’t cut corners on actual testing.

Does price & margin match what the customer is paying for?

This is a difficult, subjective question to answer.

Taking the plumbing example – we’re trying to compare the value of getting your toilet fixed within 24 hours versus the price of that plumbing service.

If those values are similar, the customer proposition is valid and the business has a clear reason to exist at its current profitability levels. But if the price of the service far exceeds the value to the customer, something is broken and eventually that margin may go away.

When I was looking at a tour operator business, the customer was paying for 1) convenience of not planning every element of the trip and 2) having a single person to call if something went wrong during the trip.

To validate that customer proposition, I put myself in the shoes of a customer. I pieced together a similar itinerary to see how much that would cost. The single tour package cost more than all the individual items stitched together, but the delta was small on a per-day basis relative to the cost of the whole trip.

This is clearly a subjective view, but I could understand why a customer would pay the small per-day upcharge in exchange for the two values I noted above. That’s how I got comfortable with the tour operator business having a valid customer proposition.

This comparison is easier in some businesses – lawn mowing can be a comparison of the customers’ time value and cost of renting equipment at Home Depot. It’s harder in businesses where the value is more qualitative, such as the peace of mind that comes with an alarm monitoring system.

When you buy a business, you’re putting a stake in the ground that the customer proposition is valid. Even if you can’t prove it with dollars & cents, the above framework should help examine customer proposition a layer deeper.

Conclusion

Between Part 1 and Part 2, a business has a reason to exist if it has strong unit economics and a reasonable customer proposition. I broke both of those down further in these two posts – you will have to massage the frameworks into a structure that makes sense to you, but I hope this helps your diligence efforts.

Let me know if you think I’m missing something or am off-base in any of this! Hit reply to this email or find me on Twitter.

Thanks,

Guesswork Investing