Introduction
Painting the Picture of the Ideal Business
A consistent truth exists across all small businesses: each one is different. A hamburger stand drives down operational costs through inexpensive, rapid fire delivery, a service business builds sustainability through solid, enduring relationships, a technology firm evolves through bleeding edge innovation and development. It would be catastrophic for a tax service provider to ram his clients through in sixty seconds just as it would be suicide for hamburger stand cashiers to play a round of nine holes with customers as the drive-thru line backs up. No matter how disparate the business model universe may be though, another consistent truth exists: every great business is built upon the same, core fundamentals.
There is a template.
The core of a strong business is not a mystery nor is it a complicated mess. It is found in the wisdom of Warren Buffett, a virtual blueprint to create superior business results and build a powerful small business engine. If you follow this blueprint, digest its meaning, and learn its intricacies, you can build an economically superior small business, one that Warren Buffett would love.
You hold in your hands the blueprint.
If you asked Warren Buffett what he looks for in great business, this is what he would say:
I want to see a consumer monopoly …
with a strong track record of earnings …
a healthy return on equity …
with the ability to reinvest those earnings at a high rate of return …
with little or no debt on the balance sheet …
the ability to increase prices with inflation …
and a healthy net and gross margin relative to other businesses and industries.
These statements embody the principles that Warren Buffett used to turn an initial $105,000 investment into a $40 billion fortune and if wielded appropriately, can be used to transform a small business into an economic powerhouse. This folks is our roadmap.
The Context - Focus on the Fundamentals First
Instead of hacking at the proverbial leaves of a bad business – a missing marketing plan, anemic revenues, low inventory turnover – let us first examine for cancer at the root via the Buffett principles. If a tumor is found, let us determine if intense fundamental therapy as prescribed in the following chapters can save the business and if not, then it is time to move to higher ground and seek out a better business model. Remember, parameters such as return on equity and debt to equity allow us to compare across multiple business models. If the current business is terminally ill delivering year after year of poor returns, then it is time to take a bold step.
Let us first check that we are in the right forest before cutting down the trees.
Who Says? Warren Buffett Does
Don’t take my word for it; take Warren Buffet’s. I could affront you with a spaghetti tapestry of professional credentials but why bother? Warren Buffett is available and his track record is much more stupendous than mine. He grew an initial investment of $105,000 into a $40 billion fortune over 4o years. I cut my grass yesterday.
Let us start at the fundamental fountainhead then as prescribed by Mr. Buffett before moving onto tactical measures such as forecasting financial statements or business plan development. Let us build a small business that Warren Buffett would love.
It is Easier Said than Done – A Preview
Regarding Buffett principle number two, “with a strong track record of earnings.” It is painfully obvious that a healthy business needs a strong track record of earnings in order to be viable. A business without earnings or everything left over on the income statement after all other expenses - cost of goods sold, payroll, utilities, taxes, etcetera - have taken their bite, is like a lawn mower without a lawn mower blade: It may be fun to circle the yard a few times but after a while the grass needs cutting. A for-profit business is “in business” to generate earnings which in turn, when divided by the initial investment or equity, leads to a return. The bottom line or earnings are the pulse of a business and Warren seeks out strong, steady ten year earnings track records. The entrepreneur should strive to generate strong earnings track records. If this is not a priority then perhaps your time is better spent circling the yard on a bladeless lawn mower.
Earnings lead to the second, empirical Buffett fundamental, return on equity. (remember that whole division- math stuff I brought up about four sentences ago?) Return on equity can be thought of as the common size ratio used to illustrate the productivity of the equity in the business and can be used for comparison purposes. Think of it this way: if you put premium gas (equity) in a jalopy (business), the overall performance of the car will be poor, regardless of the gasoline grade. If on the other hand you put the gas in a new Corvette, all things equal, the car performance should be much better. (you can hug corners, get stuck on speed bumps, etc.) Return on equity is used to distinguish a business jalopy from a Corvette and is found simply by dividing earnings by the amount of invested equity. (again, that pesky division)
For example, a four-plex generating $10,000 in yearly earnings with $100,000 of invested equity, is producing a 10% return on equity ($10,000 / $100,000). This rate of return is superior to a CD at the local bank that is coming in at 4%.
In the context of cash flow and financial independence, the smaller the return the greater the capital needed. For example, at a rate of return of 5% and monthly expenses of $3,000, it will take $720,000 of investment capital in order to be financially independent. At a rate of return of 10% it will take $360,000. Quite a difference … like half!
A Business Plan is Written Once
Remember this also; a business plan is typically written once, while fundamentals are timeless and diamonds are forever. Sure, it is necessary to revise and update the business plan as economic conditions and business strategies dictate, but accurate business coordinates on a compass as found in the investment principles of Warren Buffett again are timeless. Let us first build this rock solid framework before adjusting the nuts and bolts.
Bad Pizza Joint … Bad
I have worked with numerous struggling businesses lacking solid underlying fundamentals that could use a healthy dose of Buffett. Case in point: I recently met with the owner of a local pizzeria whose business has very little differentiation from the local mega chains. Net, net, his operation is embroiled in head to head competition with the likes of Domino’s and Pizza Hut. Although the owner of the small shop works night and day is very passionate about his business, over the past five years Domino’s, has spent an estimated $1.4 billion in national advertising in the United States. Although I am always fond of the underdog and tend to root for him, this is just one battle the small guy cannot win … at least not on this battle field.
What he can do, in following our plan to build a business that Warren Buffet would love, is create consumer-monopoly differentiation and distinguish his business from the mega chains. Currently his model is very similar to the delivery, standard quality pizza of Domino’s. For our small guy, this results in head-to-head failure. Even loyal fans will eventually capitulate, making the switch based on Dominos systematized, superior delivery framework with its built-in, machete price slicing offers. As it stands, our pizza guy does not have a chance (Mama Mia!) and must differentiate his model lest he sits stagnant in a slowly spiraling vortex of death. Perhaps he can implement a Hawaiian luau theme complete with a tomato sauce spewing volcano that erupts every hour on the hour. An Elvis impersonator can perform a couple of numbers (Live! Via Satellite!) before gorging himself on a fried peanut butter and banana pizza just to show the customers how good it is.
I kid a little of course but this concept is founded on the same consumer monopoly concept that Warren Buffett loves to see in a business. Coke is Coke because the company has built up an endearing consumer brand over the past one hundred and twenty years and if the cans, bottles and two liters disappeared off of the shelves of the local super-market warehouse tomorrow, most would take note. The same can be said for the local Hawaiian themed pizza shop that spews pizza sauce every hour while a fat guy in a jump suit obliterates a Chicago pan to the tune of See See Rider. If that went away, people would notice.
How to Paint
We have a road map courtesy of Warren Buffett but what do we do with it? How can we take the principles of a consumer monopoly, with a strong track record of earnings, a healthy return on equity, with the ability to reinvest the earnings at a high rate of return, with little or no debt on the balance sheet, the ability to increase prices with inflation, and a healthy net and gross margin relative to other businesses and industries and wire it into a small business in order to build a small business that Warren Buffett would love?
First we take a step forward, and then backwards, and now we are cha-cha-ing!
Seriously, let us look to the small business revenue projection methods for inspiration.
The Small Business Revenue Projection Methods – Get Inspired!
The million dollar question asked by most start-up owners is “how much will I make?” And the million dollar answer: “if I knew, I would have a million dollars.” Revenue projections at best are an accurate forecast and at worst, a good guess. But, if revenues for a financial forecast can be filled in then can the picture of the entire business be painted as well?
Here are the five brush strokes for revenue forecasting:
1) Gather consumer spending data for the proposed product or service and divide this figure by the total number of competitors.
2) Determine the breakeven point of the new business.
BE = FC / 1 - (VC/Sales)
Can this be achieved?
3) Survey the target market and ask them, “how much and how often will you spend with me?”
4) Take a friendly non-competitor out to lunch and ask for pertinent sales data.
5) Conduct a small trial run.
No single stroke by itself paints a complete picture nor do the strokes combined guarantee complete accuracy. The more the merrier though. These questions, in order, can be answered using public data, the forecasted business expenses, by asking the target market and by opening and operating the business on a small scale. Methods one, three and four answer how much you should make, method two answers how much you need to make and method five says “hey, you are making money now, here’s how much you are making.”
Together, the answers should paint an overall powerful landscape that answers the question “how much revenue can I expect to generate,” … kind of. Remember, this is a forecast, no guarantees here and certainly crystal balls that predict the future do not exist. If anything, at the center of our painted landscape is a close estimate of the number.
Using our virtual, business paint brush and the five colors mentioned above, we have painted in from the top, the corners and the bottom, filling in just about every space except the small space lying at the center. That small space in the center is the million dollar question and we’ve gotten very close to answering it.
The same “painting” methodology used in forecasting revenues can also be applied in building a fundamentally sound, economically strong small business. We are going to get out our brushes, our palette and paint, a giant canvas and Warren Buffett (don’t worry, we have a hand truck.) and then we are going to paint our bloody hearts out until all that we have left is a small, tiny spot in the center. Once we have painted a beautiful business landscape, we will hold in our hands the picture of a superior business and revel in the confidence that we have built a small business that Warren Buffett would love.
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