Humans are lazy. Or, well, maybe lazy isn’t the right word. We optimize around short-term variables. We heavily discount how much we’re going to enjoy something in the future, and over-estimate immediate gratification. Study after study has demonstrated how profoundly this impacts our decisions, but we can see it more immediately in our normal day to day decisions. Go to the gym? Nah, I feel like an ice cream.
Much of this makes sense in a pure darwinian context. Long-term thinking isn’t particularly relevant when you have to outrun a sabre-toothed tiger, or don’t know where your next meal is coming from. We made decisions on the fly, and those who were most adept at managing that series of decision were those who were most likely to be fruitful and multiply.
In early career days, this short-term penchant tends only to effect our personal lives. In careers, our managers keep us on track with KPIs and feedback. Good managers design these tools to focus our attention on the long game without even thinking about it.
But as we continue along the path to ever more complex roles, roles in which our ability to add value is increasingly tied towards our ability to prioritize and make decisions in uncertain scenarios and plan and invest and build, these human challenges become more important to resolve.
Internal discount rates vary somewhat between people, but I’ve noticed that the people who are most successful at getting things done have, rather than changing that internal calculus of now vs future, instead have leveraged effective coping methods to trick their minds into getting out of its own way.
Two main ones I’ve made heavy use of myself include the following:
In all cases, the psychological principle we’re tying into is that identified by Robert Cialdini as Consistency. We have a view of our self, our identity, our values. When we behave in a way inconsistent with our self-perception, a powerful sense of discomfort, a cognitive dissonance, forces a self-correction. Either we modify the behavior, modify our view of self, or continue in a state of discomfort (the latter being the least likely).
Marketers have tied into these powerful forces for years - using them for our own benefit to manage our behaviors can be a great way to nudge our behaviors in productive directions.
In lieu of exposition, I thought I’d offer up an important essay that I make an effort to read every once a year or so.
Charlie Munger’s Worldly Wisdom speech
Fantastic insight from an underappreciated businessman on a beautiful Saturday afternoon in SP.
"We choose to go to the moon in this decade and do the other things, not because they are easy, but because they are hard, (…) because that challenge is one that we are willing to accept, one we are unwilling to postpone, and one which we intend to win!"John F. Kennedy (September 12, 1962)
One year ago we had a simple realization: fixing a cell phone is a nightmare. We, the founders of Pitzi, had collectively broken more than 5 phones, so we knew how frequently phones break. We knew that with the advent of the iPhone and its beautiful, but fragile, glass that accident frequency was only increasing. And yet in Brazil it costs R$500+ to fix a screen, takes 4-8 weeks, and can be unpredictable in what form you get your phone back. So frustrating.
So we set out to change how things worked, and from there Pitzi was born. We dreamed of a system where, when your phone broke, it was an easy and simple process to get it fixed. We created a service that we would want to be customers of, one that was fun and fast and affordable, that focused more on creating an incredible experience for every single customer. On that day we knew it would be hard, but we accepted the challenge.
Today marks another important day for Pitzi: the day we announce that, after months of building, we are officially open for business in São Paulo. Anyone buying a new phone in São Paulo can join Clube Pitzi and get access to mind-blowing service.
What does mind-blowing mean? For us, it means incredibly fast turn around. It means covering accidents, the things that actually happen most to phones, like when you get thrown in the pool at a party while your phone is in your pocket. It means useful and cool content, and fun, interesting tips on how to take full advantage of our phones. Friendly people, ones who care, and constantly have their customers’ best interests at heart. And a service is perpetually and purposefully improving.
Most companies spend huge amounts of money on ad campaigns when they launch. We didn’t want to waste money we could spend on making an even better service for our customers. So our launch is different. We took Gabriel’s iPhone, tricked it out with a Case-Mate “Tank” case and an array of Pitzi-colored helium balloons, and launched it into the sky of São Paulo to record a bird’s eye view of the city. Take a look:
Why did we do it? Because it’s fun. And because cell phones are magical, powerful things, devices that enable creativity and connectivity and joy. And that should be taken advantage of. We believe that when you live in fear that your cell phone is going to break, you’re never going to be able to take full advantage of the magic it has to offer. Pitzi was designed to help unleash our creative potential, use our technology to the fullest.
The launch today is one of a variety of launches to come over the next several weeks, months, years from us at Pitzi. Get ready for a fun ride.
Back in 1962, American President JFK announced to a surprised public that within 10 years he would figure out how to send a man to the moon. He didn’t know how, he didn’t know why, he just knew that setting incredible goals unleashes human potential, encourages us to dream and find solutions that we hadn’t even thought could exist.
With Pitzi, we’re creating the best service company for cell phones in the world. Full stop. Come join the fun, because this company is not like the rest.
Oh, and one more thing: this first phone attached to balloons was merely a test. By 2013 we will send a phone to outer space.
Daniel Evan Hatkoff
X-Posted on the Pitzi Blog in Portuguese
I’ve come across two veritable treasure troves that I felt compelled to share.
First, for those of you interested in entrepreneurship broadly, Peter Thiel has begun teaching a course on startups at Stanford. Successful entrepreneurs preaching the definitive way of success I find typically to be unhelpful, but the lecture notes from Peter’s class are different. They’re more philosophical, offering some helpful answers but also a large dose of frameworks and metaphors. More meta, thinking about thinking, than “this is the path.” It’s thought-provoking stuff, continuing to place Peter Thiel in my mind as one of the more interesting thinkers out there these days.
His class is still in progress, so I encourage all to search for his later lectures as they appear, but in the meantime here are the essay-style lecture notes produced to date by Blake Masters:
Second, for those of you starting businesses in Brazil, or contemplating that same insane idea, this post is a must-read. It talks about the key accounting items to think through when opening a business. I would supplement the article with a number of pointers specific to foreigners, but it’s a good starting point for understanding the steps necessary to opening a business in Brazil.
Having walked through the fundamentals of a sustainable business, we can try to apply those principles to understanding what types of businesses might be effective on the internet. Below I’ve laid out a few consumer-facing categories that I think the internet is especially good for.
The internet enables people to connect in a very cheap and easy fashion. Networks accrue value at an exponential rate, per Metcalfe’s Law, both to the owners and users of a network. The first person to have a telephone didn’t really derive much value from his phone, but once everyone he knew had a phone as well suddenly that was a very valuable network to him. The same held for Facebook.
On the internet, I think of networks as comprised of two primary categories, distinguished in my mind by the nature of use. The first is user-generated content, and the second marketplaces. Both are potentially fantastic businesses.
In the former category I’d put things like Yelp, TripAdvisor, Facebook, Wikipedia, where contributions from individuals are aggregated to provide extraordinary value to all participants in the network. An individual review of a local plumber may not seem that valuable, but when 20 locals rave about his work and complain about his competitors’ it makes the problem of asymmetric information and signaling quality much easier.
In the latter category, eBay is the go-to example, but we’ve seen a wide range of new similar businesses pop up. AirBnB allows people to rent out their apartments directly to individuals, bypassing the high-margin, high-frill hotel industry. SkillShare allows individuals to teach courses on unique subjects in their spare time to interested students.
What makes these businesses so valuable? Thinking back to our fundamentals, generally the value that people derive from these services is high. In the case of AirBnB and SkillShare, that value is great enough that people are willing to pay commissions for use. In others, having a captive audience lends itself to ad-driven and freemium models so that both casual and power users can be engaged. And the cost of the business is minimal, as the majority of the “Cost of Goods Sold” is paid for with the sweat of users writing reviews, posting updates, or offering up their apartments. The remainder is just maintenance, improving the product experience, and marketing. Returns to capital are excellent, as the businesses are not capital intensive, benefit from positive returns to scale because of the network effect, and many of these markets are valuable to massive amounts of people suggesting limits to growth that are at a high bar.
So what’s the but? It’s really damn hard to get people to use a network before it has achieved critical mass, and it’s even harder to achieve critical mass without people on a network. In the case of marketplaces things are even harder, as you need to simultaneously create two critical masses, one on the supply side and one on the demand side. I tip my hat to those who succeed in these types of businesses, because they tend to execute amazingly well, take very intelligent risks, and think obsessively about user experience. It is no surprise that this product category is where the majority of wealth has been created for internet entrepreneurs, though survivorship bias hides the immense number of crash-and-burn stories the category has spit out.
Almost all of these categories are fair game in Brazil. There are several sites that have gotten off the ground, but none have the density of user-generated content needed to be un-seatable.
2. Making commoditized industries compete on price.
In some industries, there are standout products that really blow away the competition and deserve to charge a higher price. Pretty much anything that Dyson makes, for example. In other industries, every product is basically the same. In economic terms, the latter is a commoditized industry, where ultimately the marginal cost and market return threshold should determine the price of the good, and any competitors who can’t meet those thresholds are put out of business.
Somehow, that law didn’t really hold, particularly in opaque industries like financial services, transportation and utilities, until the internet came along. Airlines used frequent flier programs to lock in customers despite continuously worsening their service. Insurance companies employed expensive, captive sales forces and resorted to buying stadiums and funding massive commercials to convince people that their life insurance was somehow better than the competitions’. Don’t even get me started on the banks, mobile operators and utilities who have somehow made it their sole mission to obfuscate the various ways they are making money from their customers.
One advantage of the internet is that it can use real-time algorithms to cut through certain types of opacity, and force industries that offer commoditized products to genuinely compete on price. Looking for a new Galaxy S? The product won’t change if you buy it from a big box retailer, an online specialist, or directly from China. But the price can be meaningfully different, and the internet can help you figure that out. From a B2B perspective these are called leadgen businesses, but from a consumer perspective these are supermarkets that help us find what we are looking for and make the relevant comparisons to determine what option is best.
Once again, given the limited marginal cost nature of this business (once the algorithms are developed, they’re very scalable), this business becomes excellent at scale. Ultimately there is a question of customer acquisition (how do you make people aware of the wonderful benefits you’re offering at the site). Historically these businesses have tended to be oligopolies, rather than monopolies, as there aren’t scale benefits beyond a certain point, the way there are with networks, so these businesses require managing customer acquisition very carefully.
In Brazil, we’ve started seeing sites pop up in this vein focused on consumer products (buscapé), airlines (decolar, viajanet), financial products (escolherseguro, taclaro), but with most big companies in Brazil still earning outsized returns even these products have not brought perfect competition to commoditized markets, largely because of limited awareness still among consumers. There’s a lot of movement to come here.
3. Using data to help make hard, complicated decisions easier.
We often have to make decisions about our future behavior based on a best guess. Signing up for a netflix account requires you to choose how many films you want perpetually rented at any one time. Your phone plan requires an estimate of the number of minutes, SMS and data you will use. Your bank account has a variety of packages based on the number of services you expect to use. Your credit cards have different benefits and costs embedded.
Making decisions on any of these services is exhausting, frustrating, and ultimately what these companies count on. There’s even a term for customers’ misjudgement of how much they’re going to use a product: breakage. Until now, only the companies had good ways of monitoring this breakage, but now with the internet we can develop applications that can look at our data footprint and help us make better decisions. In the U.S., mint.com is a great example of this power. Mint tracks your spending patterns and your use of credit and savings products and makes suggestions that can help you budget and use better products.
I expect to see a lot more in this space, as it’s not expensive to do, the data already exists, the algorithms are incredibly scalable, and the benefit to consumers is very high. Companies should be focusing on providing increasing amounts of values to consumers and deriving profits as a result, not growing profits by cutting service quality and fooling consumers.
In Brazil, this concept can be applied to phone companies (pre-paid plans vs. post-paid), bank accounts, credit options, utilities (NET packages), and much more.
4. Low cost, direct distribution for a really cool proprietary product.
Historically if you had a very innovative product or service, it was challenging to make people aware of your product, or put it in a position for them to buy it. In the hey-days of the Mad Men you would invest in traditional media and buy shelf space from distributors. In those days, money bought your way into the mind of the individual.
These days, well, that’s still the case. But an increasing virality through social networks means that news of noteworthy things can spread quickly. And the ability of consumers to connect directly with product or service providers means that the traditional manufacturer —> wholesaler —> retailer —> advertising —> consumer value chain can be rejiggered if the product is interesting enough to draw a crowd.
The number of internet businesses capitalizing on this changing industrial structure is small but growing. GEICO was one of the pioneers, demonstrating that by advertising in innovative ways to attract insurance buyers to them they could still offer lower prices than their agent-reliant competitors. More recently, Warby Parker has been knocking the skin off the ball in the glasses space, showing that vertical integration coupled with a hot product and savvy marketing can transform an industry. BankSimple is redefining the banking experience in the US. At Pitzi we’re similarly offering an unprecedented service model for protecting and fixing cell phones in Brazil through use of the internet.
Ultimately I think the value of using the internet as a novel distribution channel is in offering a proprietary, innovative product. Lots of people are building e-commerce retailers online, seeking to dis-intermediate brick and mortar retailers by offering a wide variety of products, easy delivery, and discounted prices. That model is not a no-brainer to me financially, as it’s merely removing local advertising and real estate costs and substituting in global customer acquisition costs, decentralized logistics and free shipping. E-commerce businesses can definitely be good businesses, they just tend to require immense scale (such that One Kings Lane, with revenues in the hundred millions of dollars, is still not profitable). It’s just unclear how that equation shakes out. WIth remarkable proprietary product, the acquisition cost side of that equation goes down meaningfully over time as people buzz to their friends about the product, which is what turns the model into a wonderful business.
So there we have four key categories of consumer-facing businesses where the internet can be used to make life meaningfully better for people, particularly in Brazil. There are plenty more, but I’ll leave those to much more creative minds than mine.
It’s been several weeks since we left off (launching a business in Brazil turns out to be pretty time consuming), but now we’re back. I’d like to continue with this series, laying out my thoughts on the core fundamentals of sustainability and growth in a business, a topic typically forgone in the press in favor of billion dollar exits and capital raising activities. Understanding these fundamentals is crucial for making a measured estimation of whether an idea has the potential to meet your reasons for becoming an entrepreneur.
A good business is an amazing thing. Why? Because it’s creating value for society out of thin air. It’s taking some resource that was previously relatively worthless, adding a bit of ingenuity, and turning it into something that changes lives. This is the force that has propelled society forward when harnessed effectively and used appropriately.
Until now, we’ve concluded two critical points:
Businesses with these two key characteristics are financially viable growth businesses, powerful machines for effecting change. As with most things, though, that growth has limits. I’ve compiled a list of the most common constraints on growth of a business, ordered by how I see them impacting a business along its growth cycle.
Limit 1: Time
Hands down the first constraint any entrepreneur runs into is that there are only 24 hours in a day. Time quickly becomes the scarce resource, the metric by which most definitions of productivity are measured. Let’s think back to Adam and his pirate wood furniture company. No matter how many mentions he gets by Oprah nor how many resultant orders he pulls in, ultimately his hands can only work so fast, producing so many tables per hour. Without finding other ways to leverage his time, his success will ultimately be dictated by his level of productivity.
This limitation is felt acutely in advisory service businesses and artisan product work. In the former, a specialist provides advice to clients based upon a wealth of experience and training. Ultimately a CPA can only personally handle so many tax returns around April 15th. A furniture maker painstakingly stains his wood by hand. In neither case is the unique skillset honed by the owner easily leveraged.
There are typically three ways in which the scarcity of time as a resource can be effectively leveraged such that a business can continue growing:
Limit 2: Talent
The second most frequent limiting factor to growth is that talented people are always in demand and often hard to find. I’ve been hearing this often of late in Brazil: finding good developers is tough, expensive and unpredictable. As a result, the pace of development of many startups here is slower than it could otherwise be.
Limitations on talent can often be mitigated by developing talent internally through training, and building relationships with relevant groups, universities, or feeder firms. Finding great people is always tough though, and for entrepreneurs, who are notoriously bad at delegating and not micro-managing, having imperfect hiring options can be challenging to the growth of a company.
Limit 3: Capital
For a company to grow organically, its growth will be directly proportional to its intrinsic return on capital. If a company is founded with $100K and has a return on capital of 20%, the following year it will have another $20K to be able to invest, which will itself generate an incremental $4K, resulting in an organic growth rate of the company, all else equal, of… wait for it… 20%.
The same holds true if the company is an internet e-commerce busy using Google Adwords to sell haute couture. Ultimately if you need to invest money to grow, the amount of money you have on hand will be a limiting factor to that growth. To grow faster, the company would need to get extra money from somewhere to fund that greater growth. In the “grow really fast!!!1” world of Silicon Valley, that usually means selling a piece of your company to a venture capitalist in order to fund growth. In other circles, it can mean taking out a small business loan from your local bank. In any case, it typically requires some money to grow, which means money is a limiting factor to growth.
Limit 4: Demand
A fourth limit to growth is the actual size of the opportunity you are addressing. If you are Sergey Brin, and you are trying to “organize all of the world’s information”, you have a pretty long runway before you starting hitting market size limitations and are forced to move into things like energy and cell phones to continue your world domination. If, however, you’re the greatest performer of the Glass Armonica (a way underrated instrument invented by none other than Ben Franklin), the growth of your business will ultimately (unfortunately) be constrained by the limited demand for performances.
Market size constraints usually only come into play when a company is having meaningful success, but it is a very relevant concern for venture capitalists as they think through whether a business can ever become big enough to generate the 5-10x returns their limited partners require for the risk of investing in startups.
Limit 5: Organizational Scale
This fifth limit to growth is one that is currently being tested globally, and is less relevant to most first generation entrepreneurs, but for the sake of completeness I thought it interesting enough to include. There are certain mathematical and physical constants in nature that we don’t really understand. Trees don’t grow to infinity for a number of reasons, but principal among them are the laws of gravity and the resultant exponential instability attribute of growth. We humans also have a number of constraints. Our short term memory has trouble juggling more than 4 items at once. We have difficulty managing stable relationships with more than 100 people. Through management research and real-world experimentation we have developed processes and structures to stabilize ever larger organizations. but as the term Too Big To Fail has entered informal vernacular it begs the question of whether at some point there are negative returns to scale.
That is, at some point the limit to growth may simply be growth itself.
These three posts have been long, but they have laid out a basic process for (1) deciding whether an idea is even viable, and (2) testing whether an entrepreneurial venture is aligned with the rationale for starting the business in the first place. To sum up, I’d say that any potential entrepreneur should submit themselves to the following four step process before they reach any conclusions about their business:
Have things that you think I’ve missed? Let me know in the comments! Up next is applying these rules to the new frontier of internet business.
On Wednesday, Slate featured an interesting article by a NY coffeeshop founder that provides a great real world example of the two points of my past two posts on building a sustainable business. In businesses with high fixed costs (coffee shops, for example), you need to be able to sell enough volume at a high enough margin to make a profit. In the author’s unfortunate case (and the case of most of the coolest coffeeshops), this business model is just not viable without subsidizing heavily the cost of labor by having the owners work around the clock.
Entrepreneurship is exciting, but it’s far from easy. An understanding of the economics of a business model is crucial before trying to start a venture to assess whether it can be sustainable as a lifestyle business, let alone whether it has the return on capital attributes required to become a wealth creating business.
Next up we’ll discuss the limits of growth.
When we left off last week, we’d concluded that for a business to be sustainable two conditions were necessary:
If these two conditions are met, your business has the ability to sustain itself. This is often what is known as a lifestyle business, one in which growth isn’t likely or expected but it is sufficient to provide for its proprietor’s survival. Think barbershop, accountant, local drugstore, ice cream parlor, haberdashery, or pirate wood furniture.
Many aspiring entrepreneurs have more than purely self-bosshood on their list of motivations however, so the question of growth is never far from mind. And so, we move on to…
Step 2: Sustainable Growth
The most important factor for a business to have sustainable growth is its return on invested capital. This is a super-financey term that ironically even most finance professionals don’t often look at, but it is definitively the most fundamental factor in the quality of a business.
In most businesses, it takes money to grow. If you want to expand the number of customers your hot Williamsburg restaurant can serve, you have to rent more space and upscale the kitchen. If you’re an e-commerce company and you want to increase sales you need to build a bigger warehouse, store larger amounts of inventory, invest in logistics infrastructure, expand your server capacity to handle the increased hits. The relationship between capital needed to grow and the profits generated by that investment are what dictate the sustainability of a business’ growth. Ok, that was a mouthful. Let’s talk examples.
Back to Adam, our furniture maker. Adam’s got a relaxed wood shop where he’s churning out his repurposed pirate wood furniture, and he’s doing pretty well at it. Since it takes him about 20 hours per table, he’s able to produce around 7 tables a month (he weekends on Shelter Island and it takes him a reasonable part of Monday to recuperate). With a $1K gross profit per table after marketing costs, he’s making about $7k per month in gross income. After $4K of rent and utilities, he’s bringing home about $3K per month pre-tax in his current arrangement.
But business is booming. He was featured in Thrillist, so he lost a bit of NY street cred, but now he’s got clients lining up for his custom work. Backlog city. He’s got two choices: he can dial back his marketing to slow his sales, or he can kick his business up a notch. Being the ambitious entrepreneur that he is, he decides to expand.
To double the numbers of tables he can make, he’ll need to expand his studio and utilities costs and hire another Adam, but’s lets assume that those are variable costs that basically will double along with his sales. More importantly, though, to slice and dice wood you need serious machinery. Tim the Toolman Taylor kind of stuff. In the wonderful world of finance jargon we call this a capital expenditure. Let’s imagine Adam has to buy a precision cutting saw, planer, wide-bled sander, and a few things that furniture people use to make wood stick together. He works on his Mandarin, calls up some capital goods specialists in Beijing, runs the numbers, and sees his expansion costs at around $50K.
His option is to invest $50K to generate an extra $36K per year ($3K per month * 12 months). Return on Invested Capital can be calculated as annual income / investment, in this case 36/50 = 72%. Common sense would tell most people that this is a pretty good deal; common sense would be right. How would this change if instead of $50K the required investment was $500K? Well, for one it takes a lot longer to save up the money to make that kind of investment. But more importantly, the return on capital of the investment would be 7.2% (36/500).
What is really important, and often overlooked, is why this all matters.
Let’s imagine that you are running this business, and you are determined to grow it as fast as possible. You reinvest every single dollar you earn right back into the business. You do this for 30 years of back-breaking furniture making labor. You continue to expand and grow. If your return on invested capital is 7%, after 30 years of doing this you would have turned a business that’s currently generating $36K of annual pre-tax income into one that’s generating $274K per year. You might be able to sell a business with that earning capacity for $1 million. That’s a nice carrot at the end of the tunnel, but it’s not the kind of wealth creation typically associated with successful entrepreneurship.
On the other hand, a business that has a return on invested capital of 30% can sustainably fund growth much quicker than that for two reasons.
The important takeaway here is that it’s not the capital intensity (how much capital investment a business needs in order to grow) that determines the attractiveness of a business’ growth trajectory. Manufacturers, restaurants, infrastructure companies: all require lots of money to grow, but have still been extraordinary businesses when the model is right. The question is what is the return on capital in the business. That’s ultimately what determines whether it can sustainably grow.
Now that we’ve got the conditions for sustainable growth set, up next we’ll discuss the final key piece: what is the limit of growth for a business? Trees can’t grow to the sky, after all.
If you’re like me, you have had friends who would occasionally engage in an outburst of entrepreneurial brilliance: “Man, we should quit our jobs and start a furniture company that uses only repurposed pirate ship wood” or “I totally should start a GPS tracking system for musical instruments” or ”Oh, I finally have it. iLove: online dating meets the iPhone.” And then, in a flash, the entrepreneurial spark is diffused, and we continue drinking our bourbon.
I actually enjoy encouraging these discussions because creativity, even at its most ridiculous, is underrated as a muscle that needs to be exercised. This post is not about that, however. Instead, I want to talk about the process of creating a successful business. Most emphasis in entrepreneurial stories seems to be on the idea. If I’d just find that one great idea I’d be so successful! And then when that elusive great idea finally emerges, you guard it with your life. If this gets out, everyone is going to copy me!
The idea is only a piece of the puzzle though. There’s a simple formula of three things that you need to get right if you want to create a successful business: 1) the idea, 2) the model, and 3) the execution. In these terms, the idea is coming up with a concept for which you think there’s demand. Skis that unscrew like pool cues so that they can be easily carried, say. Execution is figuring out how to build your dream, and how to get others to buy into it. And squished in between the two there’s the model.
The business model is often swept under the rug in the startup world. When you’re building something cool, you can’t think about monetization from day one. “We don’t know what it is. We don’t know what it can be. We don’t know what it will be. We know that it is cool. That is a priceless asset I’m not giving up.” And I get that; the unit economics of twitter just didn’t make much sense until it achieved its network effect.
At the same time, most innovative new businesses have not been social networks, despite what the media focus would have you believe. And ultimately some factors intrinsic to a business model will dictate the viability, scalability and wealth creation opportunities that the business has, irregardless of the quality of the idea (i.e., lots of people want it) and the execution (you make it happen). I want to discuss exactly what these basic mathematical fundamentals are. They aren’t hard, and are important to think about as you try to align your choice of business model with your motivations for starting the business.
Step 1: A Sustainable Business
Do people value what you’re doing more than it costs to do? It’s a simple question, but hard to answer. Another way to frame the question: if you charge a price equal to or greater than what it cost for you to make something, can you convince people to pay for it? The unfortunate reality is that if the answer is no, your business is dead on arrival.
In accounting terms, gross profit = revenues - cost of goods sold. I am not aware of any business that has a gross profit of less than 0 that can be reasonably considered sustainable. (note: it is on this basis that I don’t consider non-profits to be sustainable organizations). On the other hand, if people are willing to pay for what you’ve made, congratulations, you’re doing something that people value!
(I often hear arguments from internet or media people citing things like network television as examples suggesting that just because people aren’t willing to pay for something doesn’t mean it’s not viable. I challenge this assertion. In television, I’d argue that viewers are the product, and advertisers the customer. Same for Facebook.)
Let’s look at an example, say my friend’s pirate wood furniture business. My friend reasons that he can produce a table in 20 hours. The wood and other pirate accoutrement he must acquire to produce the table will cost him about $1K. From his knowledge of the upper east side furniture market, he reasons he can sell the table for about $5K when it’s completed. Let’s say he wants to guarantee himself a minimum of $10 per hour of work. All in then, his cost of time and inputs is $3K, which he can then sell for $5K. Each unit he makes should generate a $2K gross profit, a 40% gross margin ($2K / $5K). If he can make and sell a couple of these per month, that should be enough to cover the basic fixed expenses of keeping his shop’s lights on (rent, electricity, etc.).
Having the potential for a positive gross margin however is not sufficient for a business to be viable, because unfortunately people won’t usually just come to buy your stuff of their own accord. Most people don’t even know your brilliant product exists! There are many options that a business has for creating awareness. Broadly these fall under the category of advertising, but the cost of these options can vary dramatically in terms of time (opportunity cost), money (actual cost), and effectiveness (conversion rate). One way to put all this together is to figure out how much you have to spend to achieve a sale, which we can call the acquisition cost per sale. If Price - Cost of Goods Sold - Acquisition Cost per Sale is greater than zero, you’ve got a sustainable business on your hands.
Back to our pirate furniture business: let’s say Adam, our proprietor, decides his best opportunity to sell tables is using Google AdWords, by which he can bid on certain search terms on Google to have an advertisement for his company show to the right of the search. One of the nice aspects of AdWords is that you only pay when someone clicks on the ad. He determines that his bid for the term “pirate table” will cost him $1 per click, and 1 out of every 1,000 people who click tend to buy a table (this is a very low conversion rate, but hey, people looking for tables made of repurposed pirate ship wood want what they want). His acquisition cost per table sale is therefore $1K. On a per table basis then, he is earning a $5K price less a $3K cost to produce the table less a $1K marketing cost per sale, earning a $1K profit on his effort after paying himself his minimum per hour cost. Adam has therefore created a sustainable business for himself that is not inevitably destined for failure, unlike 90%+ of new business ventures.
Does this mean that he’s destined for greatness? Will his business soon overtake IKEA? Not necessarily, but at the very least it means he’s created something that can sustain itself.
Next up we’ll take a look at the conditions that determine the growth potential of a sustainable business.
As I near the one year anniversary of my move to Brazil, I’ve realized how much I’ve learned about entrepreneurship both here and in general. A few thoughts on Brazil’s startup world, in no particular order: