5 Essentials of Small Business Investing

Method soap products (Image credit: Getty Images via @daylife)

The most important question for a small business investor is where to focus attention. What makes one company more interesting than another?  There are 28 million small businesses in the U.S., but few research services.  This provides great opportunities for above-market returns but also means investors must have an approach for determining which companies are worth focusing on.   After many years of investing in private companies, I have developed an initial framework–the first five things I look at when I see a new company.

This list is not intended to be all-inclusive; it’s intended only to serve as a starting point.  Valuation and deal structure, for example, are critical (likely an entirely separate post).  The principles behind this list could apply to many industries, but they are especially relevant to consumer and retail businesses, the industries in which I have the most experience.

1. Gross Margin.   Gross margin is the percentage difference between what a product sells for in the market (revenue) and what it costs to produce that product (cost of goods sold, or COGS).   This ratio is critical because it is what allows a company to invest in all the other areas needed to get the product to market such as marketing and distribution.

Gross margins can vary by industry, and even by categories within an industry, but razor-thin gross margins leave no room for error.  In private equity, I focused on investing in categories that had higher gross margins and thus could sustain increased costs more easily.  Examples of higher gross margin categories include personal care, premium pet food, and natural and organic products.

It’s very important to keep in mind that gross margin expansion is very difficult. Focusing on creating products with better margins, automating production or getting lower prices for ingredients can help, but the instances where gross margin improvement drives outsized investment returns are rare.

2. Brand Strength – This is often the toughest thing to assess in a small company, but an investor needs to ask herself, “Does this brand offer something unique?” A great example of this is Method, the eco-friendly cleaning products company (disclosure: Eric Ryan, the CEO of Method, is a friend, and we have a quote from him on CircleUp). The world did not need another green cleaner, yet Method created a special brand by packaging a quality product with beautiful design and distinctive packaging.

Customer/consumer surveys, “earned” media presence, and third-party data are good ways to start evaluating brand strength. In the consumer packaged goods (CPG) world, there are countless energy drinks and cleaning products. But there’s a reason why Red Bull and Method have been huge successes while other products with similar recipes and formulas have failed: formulas can be copied, brands cannot.  A tech entrepreneur will not put her idea for a startup on a crowdfunding site (unless all other investors pass), because any engineer can copy it. But a consumer products company with $3 million in revenue would be comfortable talking about not just the idea, but the actual performance of the business. Why? Because you can back into the recipe for Cherry Garcia from Ben and Jerry’s.  It doesn’t matter. You can’t copy the brand.

3. CEO – In a small business, you are investing as much in the leadership as you are in the product or company. As a result, you need to invest behind a CEO in whom you believe.  As part of your initial diligence, reference checks and third-party background checks are a must.  Beyond that, there isn’t a formula for evaluating leadership talent but you should do what every investor does–spend time asking questions. Get on a conference call and probe on issues you think are important. Does this person understand their business, have a passion for the product, and have what it takes to persevere?

4. Exit Prospects – Many people think that if they build a great company there will always be a home for it, but in certain industries that’s not the case.  If the company has visions of selling to a strategic acquirer, it should be able to 1) identify who these likely “strategics” are, 2) determine what their acquisition strategies have been, and 3) be able to explain why that business should be attractive to a strategic acquirer.

5.  Recurring revenue – Recurring revenue is the portion of the revenue that is going to continue in the future.  It provides a nice base (ideally a growing base) of revenue on which management can rely while focusing on ways to grow the business.  It’s especially valuable because the cost of acquiring a new customer is typically about six times the cost of keeping an existing customer.

In consumer products recurring revenue comes from repeat purchase. Maybe you bought the product once because you liked the packaging. You buy it again because the product performed.  It’s not enough, of course, to look to recurring revenue; the question is how frequently that revenue will recur.  At a prior firm, we invested in a shampoo company with a beautifully designed bottle (it won multiple awards) that dispensed shampoo in the exact proportions the average woman needed. The problem was that the average person usually uses a lot more shampoo than is needed.  As a result, consumers took 12-18 months longer than normal to use up our shampoo. Sounds great for the consumer, but it was problematic for the company because it delayed the repeat purchase cycle.

This list is not intended to be all-inclusive; it does include steps, however, that should definitely be considered when evaluating an investment in most small businesses.

Source : Ryan Caldbeck, Contributor, 2012, www.forbes.com