Is your business model making you wealthy?
Throughout my 15+ year career as a chartered accountant and business advisor, I’ve worked with hundreds of businesses — ranging from small businesses and startups-all the way to publicly-traded companies.
I’ve stripped back the covers and shone a clarifying light into the darkness of their financials-helping founders and managers understand the clues that are hidden in financial statements. My skill is teaching people how to see them. I love this craft so much that I built a business around doing it.
What I enjoy most about my calling is the art of deconstruction. When I review a set of financial statements, I assess them the same way a house flipper would size up a down-trodden ‘fixer upper’.
I see opportunity.
Like stripping an old rotting house to its frame, it is satisfying to pick apart a business to its fundamental elements- identifying structural strengths and weaknesses, then suggesting remedies for improvement.
After reviewing hundreds of businesses through an analytical lens, I’ve begun to spot patterns. I’ve learned the rules that separate the superstar businesses from the average ones. The characteristics that divide the efficient, highly-profitable businesses (that seem to print cash) from the mediocre ones that struggle every month just to reach break-even.
I was surprised to learn that the differences between these businesses was not subject to the industry, company culture or even the traits of the CEO or founder (although those factors are important).
Rather, it’s mostly attributable to one thing;
The business model of the company itself.
Unfair Advantage
Time and time again, the most significant factor that either makes or breaks a company is the choice of business model. Simply put: Your product could be incredibly unique, valuable, and in-demand-but if your business model doesn’t lead you to wealth, your company will certainly fail.
When I refer to wealth, I mean financial wealth. It’s your company’s sustained ability to generate profit and cash flow.
Mind you, I’m not suggesting that your focus as a founder is always to make more money. The primary focus of your business should always be providing value to your customers and audience.
But, you need to be paid for what you’re doing to make it sustainable. Furthermore, in order to continually add value to the people you serve, whether that’s better marketing, better infrastructure or better products — you need resources. Resources in the form of profit and cash flow.
From a personal perspective, a financially successful business is directly correlated to your personal wealth. In this context, financial wealth that gives you the freedom to decide what you do with your time.
As Tony Robbins puts it:
“Working because you want to, not because you have to, is financial freedom.”
There are characteristics of business models that have an ‘unfair advantage’ compared to others.
These characteristics are:
1) Recurring Revenue
Recurring revenue is the portion of your company’s revenue that is expected to continue in the future. Unlike ‘one-off’ sales, these revenues are predictable in nature, which allows you to more easily forecast growth and therefore better understand how you should spend your resources.
In addition to predictability, recurring revenue can help you get a more accurate calculation of your customer acquisition costs. We can probably agree that it costs the same amount in time, effort and money to acquire new customers across the board. If you’re onboarding customers that are recurring in nature, the lifetime value of these customers is higher, therefore the cost to acquire them is more efficient compared to one-off sales.
In summary, Recurring Revenue is king. Every business, no matter what the industry, should strive to build recurring revenue as a component of their overall sales. Predictability of revenue is directly correlated to your business’s value.
2) Unique IP/and or Brand
How did consumer brand Dollar Shave Club explode in the ‘boring’, commodities land of men’s razor blades? I mean, razors are razors, right? Yet they pummeled Gillette, Unilever and other incumbents. Not with some crazy unique, high-tech, innovative product (Dollar Shave Club bought them wholesale from China). Rather it presented a ‘new’ way of shaving — via business model design, but most importantly — brand.
It was a viral video that launched Dollar Shave Club into this category and pronounced itself as a leader in the space. It was so successful that in 2016, it sold to Unilever for $1 billion. A remarkable story — and shows that in the absence of an innovative product, a compelling brand and alternate business model can be enough to propel your company to success.
Which takes me to the next point.
3) Scalable Distribution channels
As Reid Hoffman said, a good product with great distribution will almost always beat a great product with poor distribution. When I refer to distribution, it’s about how effectively you can get your product to market. I like to extend this to how scalable that channel is too.
If you run a traditional ‘bricks and mortar’ business, your market size is generally limited to the area in which you trade. For example, a cafe selling coffee is constrained to the local area.
Contrast that to an Ecommerce business, whose market size is the world. Scalable distribution channels allow your business to expand its market size efficiently and effectively.
4) High Gross Profit margins
We’ve all heard the cliche ‘sales fix everything’. Indeed, sales fix a lot of problems. As long as you have sales, you have the cash flow to invest in your team, tech, and sales & marketing. But like every piece of advice from business gurus, take it with a grain of salt.
Sales don’t fix everything: gross profit dollars do. Let me explain.
A dollar is a dollar, right? One dollar of sales is the same in comparison to another? Not quite. Not all revenue dollars are created equal, but all gross profit dollars are.
Personally, I think measuring gross profit is more important because it shows the quality of your sales.
As a rule of thumb, you should always strive to achieve high gross profit margins. In fact, the higher the better. This is because a high gross profit allows for more earnings to be reinvested back into the growth of your business, increasing areas such as customer acquisition and product development.
Gross profit margins will vary depending upon the industry and market size you operate in. Software companies, for example, have high gross profit margins (around 80%) compared to wholesalers that have low margins (closer to 30%). To build a defensible business model, target Gross Profit margins above 50%.
5) Low to negative Cash Conversion Cycle
Your cash conversion cycle can be measured as the number of days it takes to convert your profit to cash.
It’s a simple metric to measure the overall liquidity and capital efficiency of your business operations. In essence, the fewer days it takes to convert your profit into cash, the better.
We can think about the Cycle in mathematical terms, being:
CASH CONVERSION CYCLE = ACCOUNTS RECEIVABLE DAYS + INVENTORY DAYS — ACCOUNTS PAYABLE DAYS
Having a low cash conversion means your business is ‘capital efficient’. In other words, you effectively translate sales into cash that you can reinvest back into growth.
The rule of thumb for a Cash Conversion Cycle is the lower the better. Lowering the amount of days it takes to convert your profit into cash means you can use the surplus cash to reinvest back into your business and avoid facing a cash flow crunch.
According to an analysis of Amazon’s 2012 financial position by Forbes, the internet giant has a cash conversion cycle of -14 days. Yes, that’s right — it’s negative!
Amazon manages to hold inventory for 28.9 days plus 10.6 days to collect receivables, then squares its accounts payable in 54 days.
All together, this adds up to a cash conversion cycle of -14 days.
That means that Amazon’s suppliers are basically funding the operations of the business. It’s one reason why they’ve become a behemoth company in a relatively short amount of time.
6) Moderate to high barriers to entry
As Silicon Valley icon Peter Thiel famously said ‘’Competition is for losers’’.
I wouldn’t take that literally (every business has competitors), but what he’s saying is you should aim to build a business that is sufficiently differentiated from competitors. As explored in Point 1, a unique brand or IP is one way to do that. The other way is to operate in an industry where barriers to entry are moderate to higher so it reduces the likelihood of other entrepreneurs competing in your niche.
Let’s use as a bank as an example. Banks are great business models. Their capital is funded by individuals depositing their money. Banks then lend that money to other people at an interest rate premium. Of course, I’ve simplified this, because there are hundreds of hurdles and complexities in between. The average punter can’t just one day decide to set up a bank as it’s laced with regulation, fees and licensing.
Contrast that to starting a cafe. The barriers to entry for starting a cafe are almost nil. Assuming you can muster up the capital to fund some equipment and working capital, you could technically start one today.
Think about how you can build a ‘moat’ around your business.
In Summary
You hear a lot of stories of financially successful entrepreneurs. When asked about their key success factors, the typical narrative is about hard work, discipline, patience, luck, good timing etc.
Well, yes, there’s no doubt that all the above are important. But I think this only makes up like 50% of the ingredients.
IMHO — building a financially successful business comes down to mostly what business model you choose to operate.
I see many founders operating business models which are unnecessarily complicated, or just plain hard to nail.
I see their Sisyphus-type struggle, constantly pushing boulders up-hill.
Every now again and I need you to stop and ask yourself: is this business model I’m pursuing actually worth my time and energy?
An even better question is, what business model can I operate that allows me to push boulders down-hill?
How can you design it to have more or all of the above characteristics?
Originally published at https://sbo.financial on May 21, 2019.
