5 Essentials of Small Business Investing
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.
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.
