What drives your business?
May 20, 2023 | Issue #85
Big Deal Small Business: What drives your business?
May 20, 2023 | Issue #85
If you are a new reader / new searcher, I recommend starting with the New Searcher Reader Guide.
Welcome! Before I dive into today’s post, I have one personal plug. I volunteer at The Hatch School, a brand new (the first cohort of 9th graders are about to finish the first school year) independent high school focused on centering girls in education. Pairing high expectations with excellent support.
To the extent their mission & vision resonate with you, please consider supporting the school with a donation.
Let’s dive in! (Slightly longer post, but it’s Saturday. Read with a coffee.)
People Gotta Eat
When folks casually talk about what makes a good business, they tend to use truisms.
Why is a plumbing contractor a good business? “Toilets are always going to break”.
Why is a landscaping a good business? “Grass just keeps growing.”
I don’t want to needlessly overcomplicate business analysis, but that just isn’t a good mental model.
Everyone knows that restaurants are a tough, low-margin business. But… “people gotta eat, right?” No one uses that truism for restaurants because they intuitively know that it doesn’t matter in this niche.
But why doesn’t it work? People do gotta eat after all.
Industry Structure vs Specific Business
Think of any business in two ways:
Industry Structure (aka Business Model)
The Specific Company You’re Buying / Operating
The business model of a restaurant is roughly:
Rent real estate in a good location
Buy raw food & labor at a reasonable cost
Turn it into good finished food & service
Sell it for more than the cost of your materials & rent.
The core issue with the restaurant industry structure lies in #1 and #4:
If you can rent real estate in a good location such that the four bullets above result in consistently strong profit, your landlord will see that. They will raise rents accordingly — they know the location they provide you is a core driver of your elevated profits.
Your ability to sell for more than the cost of materials & rents is a function of 1) what other restaurants in the area charge for similar food and 2) how local diners value your type & quality of food. These are not generally drivers you control.
You are competing against a large number of family-owned restaurants, where the operators don’t really “bake in” the cost of their time into the direct costs of the business. They’re not charging a markup on their time, so their pricing is structurally lower than yours (assuming you’re trying to own a standalone business, not one that depends on your labor to succeed).
Despite all that — when we diligence a business, we usually focus on the #2 and #3 , which are more fundamentally the “operations” of the business or “quality” of the service. You look at how efficiently they buy produce. You taste the dishes the chef puts out. You examine the menu structure. That’s focusing on the Specific Company You’re Buying/Operating.
But when you buy a business, you’re buying the whole industry structure too, which is #1 & #4.
Don’t get me wrong — the specific business & its operations are important too. You want those to be excellent (or good enough). But you have to get all four bullets somewhat “correct” to generate an enduringly profitable business.
Understanding industry structure can be less intuitive than understanding business operations, so let’s drill into that further.
Industry Structure Dynamics & Shifts
I want to lay out an example of industry structure dynamics & shifts to make this concept clear.
Let’s think about the mattress industry. An old-school industry for a long-time that depended on brick & mortar retail locations to sell mattresses.
The industry was structured around retail distribution. This required a layer of costs for stores, employees at the stores, inventory being held at the store, etc. A single business couldn’t compete unless they conformed to that industry structure — no matter how smartly you managed those costs, the costs existed on your P&L.
So, if you owned a mattress company, you had to price your mattresses at a markup to ALL those costs.
Enter eCommerce / Direct To Consumer distribution. This stripped away a layer of retail costs (partially offset by shipping & return costs, of course). That allowed companies to lower their prices while generating the same profit margins.
This is a fundamental shift in industry structure — it’s not a change in any single business, but if each individual business doesn’t figure out how to catch up, they’re in trouble.
Take a step further — the companies that innovated DTC mattress sales were actually reliant on two concepts external to even their own operations or industry:
Consumers had to be comfortable making large purchases online.
Consumer had to be comfortable buying a “touch & feel” product without having touched & felt it (meaning they had to be comfortable with the return logistics process).
That consumer comfort was a function of exposure over time. Consumers had been trained on eCommerce by Amazon and clothing retailers that moved to DTC first.
Think of Warby Parker, which modeled the “test before you buy” concept that eased customers into making big purchases without a retail step. I don’t think it’s a pure coincidence that Warby Parker was founded in 2010 and the first DTC mattress provider Casper was founded in 2014.
And while this was happening, UPS/FedEx/USPS/Amazon were reshaping our country’s distribution network to allow for quick & on-time deliveries & return logistics.
The core driver behind this shift in mattress industry structure was a fundamental shift in consumers’ comfort with online purchasing coupled with distribution network upgrades happening in tandem.
So…if you’re about to buy a business or already run one, do you understand your industry structure? Do you understand how it may be shifting? Do you understand your core drivers?
What Drives Your Business?
Your profit is a function of your costs & revenue.
Your revenue is a function of volume of products/services sold and the price at which you sold them.
The volume & price of products/services sold is a function of consumer demand.
Consumer demand for your products/services at a specific prices can be a function of SO many things, and it’s very different for each business.
For example — if you own a residential roof replacement contractor. Your core driver is the # of homes in your service area, and the # of years between needing a new roof (set aside storm damage for simplicity).
Let’s say the average replacement cycle of a roof is 15 years.
In that case, consumer demand for your business each year is driven by how many new homes were built roughly 15 years ago.
Let’s say you operate in a service market with 90,000 houses, that were all built in the last 30 years (from 1992 to 2022). Let’s simplify further and say it was built in uniform distribution of 3,000 homes / year for 30 years.
In that case, in this purely theoretical world, your potential consumer demand in 2023 is 6,000 homes / year. You replace all homes built in 1993 (for the second time) and 2008 (for the first time).
That’s a really nice, stable demand profile for an industry.
But in reality, we know homes were not built on a consistent pace like that. There was a massive homebuilding boom in 2002-2007.
Let’s say the distribution of new homes built is really more like this:
3,000 homes / year from 1992 to 2001 = 30,000 homes
7,300 homes / year from 2002 to 2007 = 44,000 homes
1,000 homes / year from 2008 to 2023 = 16,000 homes
In that case, in 2022 (15 years after 2007 and 30 years after 1992), your demand would have been:
3,000 homes from 1992 (2nd replacement cycle)
7,300 homes from 2007 (1st replacement cycle)
==10,300 homes
But in 2023, your demand will look like:
3,000 homes from 1993 (2nd replacement cycle)
1,000 homes from 2008 (1st replacement cycle):
==4,000 homes, down over 60% from the year prior.
Look — this is an EXTREMELY simplified demand model. It’s meant to serve as an illustration of how the drivers of your business may be deeply out of your control.
Let’s say your small business does 100 roofs per year. In 2022, your market share was 1% (100 / 10,300). In 2023, to hold volume flat, you have to increase your market share to 2.5% (100 / 4,000).
That may be doable, but it does have to come out of someone else’s specific business. It may require more marketing spend, meaning your profits on 100 roofs in 2023 may be lower than on a 100 roofs in 2022.
Most importantly — going into 2023, did you know that this demand situation was about to play out? If not, you could be caught flat-footed not realizing you need to more than double your market share just to stay flat on volume. The operators who do know that going into the year will win.
You don’t know what levers to pull in your business if you don’t understand what drives your business on an industry-level.
I’m not going to belabor this with further examples, but one more variable to consider — what if starting in 2008, houses moved to a new roof material that had a replacement cycle of 20 years rather than 15 years? That’s another industry structure shift that changes your demand picture in 2023.
Conclusion
A lot of the SMB buying / ETA world is focused on the searcher/operator journey. That focus is not misplaced — it’s a deeply personal, entrepreneurial undertaking.
In fact, one of the best parts of small business is that a dedicated, hard-working operator CAN overcome massive industry shifts by being quick & nimble. They can take market share.
But — there’s an appropriate Buffet quote here (honestly, I’m not sure if it’s accurately attributed to him or not, but it paints a good picture): “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”
You’re the “management” part and the industry structure of your business is the “fundamental economics” part. When a good manager meets a bad business, the business usually wins.
So while the focus on entrepreneurship is super fun & why we’re here — let’s not delude ourselves about the quality of the businesses we consider buying. Make sure you understand the industry structure & core drivers of your business BEFORE you buy.
That’s a wrap! One last plug to donate to The Hatch School.
For thoughts or feedback, just hit reply to this email or post/DM me on Twitter.
Thanks,
Guesswork Investing
P.S. I run a local building maintenance contractor in Seattle, WA that focuses on single family residential & commercial properties. To the extent you know folks in the RE industry in Seattle (both homeowners & property managers), I’d always appreciate intros.