Think about all of the things you buy.
This includes the products you use, the media you consume, the ads you are exposed to, the software that runs on your computer and phone, the infrastructure that powers our homes and offices, and the food you eat and drink each day.
Behind each of those items is a business – some successful, some not.
Some of those businesses have been around for a hundred years while others are just getting started.
For entrepreneurs, starting, buying, or running a successful business – one that generates profits – is the goal.
Ideally, businesses produce something that can be sold to many people over long periods of time. That durability enables consistent profits. Without durability, the laws of supply and demand come into effect as competitors sell similar products, taking market share or reducing prices.
With these basic concepts in mind, we pondered:
Can you build a perfect business?
In a way, this question is the premise for this entire site.
So today, we’ll jump into a variety of questions that will make it easier to identify the attributes of successful businesses, people like you could set out to build, buy, and operate multiple businesses as a way to increase your cash flow and build wealth over time:
What is a business for?
Businesses exist to provide value (often in the form of products or services) to customers in exchange for money.
When the money paid for those goods exceeds the amount of fixed and variable costs to produce the product, a surplus – or profit – is generated.
These profits can be used for a variety of activities including reinvestment (growing the capacity and capabilities of the business), product expansion, debt repayment, distributing profits to the owners, and more.
But as Naval Ravikant, founder of Epinions and AngelList, puts it:
You will get rich by giving society what it wants but does not yet know how to get. At scale.
Put more simply, a business rewards entrepreneurs for delivering value at scale.
What is a perfect business?
As we’ll explore, every business model is different.
But all successful businesses have similar characteristics:
- High profit margins, thanks in part to
- Limited competition, that allows for
- Persistent returns into the future
This ability to generate returns in the future is the entire reason investors buy stocks (public equities) and invest in private companies. Investors expect to capture a portion of future profits or returns in exchange for capital today.
The more perfect a business, the more likely and faster it is to repay capital that was initially invested. Put a dollar in, get two – or two hundred – back.
In his book 7 Powers, Hamilton Helmers outlines seven strategic imperatives that enable businesses to thrive. As their power grows, they approach the truest definition of a “perfect business” because their ability to generate consistent returns (profits) grows.
But if power stalls or declines, changes in their market enable competitors to creep in, steal market share, and erode the ability to generate profits.
How do businesses generate profits?
In its most basic form, a single-product business is profitable when it sells its product for more than it costs to make. The more it sells, the more profit it makes.
This is because the unit economics – the ability to generate a profit on an individual sale level – are profitable. The amount of margin from selling the product exceeds the amount of money it takes to manufacture, distribute, and sell that same item.
What are enduring profits?
Today’s sales do not guarantee the sustainability of any company.
“The only thing constant is change.” We operate in a capitalist society and, as a result, there is a constant shift in market entrants – new businesses starting and closing down – as the wants and needs of consumers chance over time.
Changes that decrease customers’ ability or willingness to buy a product – like a competitor that comes along with a better or less expensive alternative – ultimately put pressure on existing businesses’ ability to generate high levels of profit.
An enduringly profitable business may have multiple sources of income and revenue so that even if one source dries up unexpectedly or permanently, there are others which can sustain the organization long into future years (perhaps indefinitely).
The best businesses have a moat or – better yet – many moats.
How can a company build a competitive moat?
A competitive moat is an advantage that helps protect a business from competition. Like a waterway surrounding a castle, the wider the moat, the harder it is for outsiders to reach and penetrate the business.
Moats can be created in a number of ways. A business that has low-cost advantages, such as economies of scale or access to inexpensive raw materials, will likely have a stronger moat than one that does not have these advantages.
The creation of proprietary technology or intellectual property (IP), though expensive, may also help create a competitive moat over the long term. This makes it difficult for competitors to copy your products or services, thus increasing the cost required by them to enter the market and compete.
Another way to build a competitive moat is by creating an inimitable brand image that makes consumers want what you’re selling before they even know what you’re selling—think Apple’s ability to create demand for new products from their base of devoted current customers.
Is there such thing as a perfect business?
This is the question that has fascinated me for years, and one that I’m determined to pursue for the rest of my professional career.
It is also the question I hope you keep in the front of your mind as you found, evaluate, and purchase companies in the future.
Many entrepreneurs get sucked into pursuing business opportunities as they present themselves without ever asking, “Is this is business worth pursuing? How close to being a perfect business is it/could it be?”
The basic framework I use to evaluate business models is:
- High Utility – Is this product or service something that it’s customers consider a “must have”? If 40% or more of your customers would be very disappointed when asked the question, “How would you feel if you could no longer use the product?” – you’re onto something special.
- High Repeatability – Recurring revenue is the holy grail, especially in software. But all businesses that have confidence in when and where future revenue will come from are at a significant advantage over those who have to wake up each day and hunt for new customers.
- High Margins – The draw to many digital businesses is that their COGS is low because there is nothing physical to manufacture. As the saying goes, “It’s not about how much you sell, but how much you keep.” High gross and net margins are a key ingredient to a perfect business.
- High Differentiation – The opposite of differentiation is commoditization. If customers can get the same product everywhere, there will always be a competitor willing to sell it for just a little less profit. And as marketer Seth Godin puts it, “The problem with the race to the bottom is that you might win.” On the other hand, selling something unique that can’t be found anywhere else allows you to sell at whatever price you see fit.
- High Brand Affinity – If a product is something you buy, a brand is the way it makes you feel. Starbucks sells coffee, but their brand elicits an emotion from its customers and, as a result, allows them to capture more value than a generically-branded cup of joe down the street.
The best business is one that provides a sustainable competitive advantage—but it’s important to remember that these kinds of advantages don’t last forever.
However, keeping these elements in mind will help us all be better entrepreneurs. Business is inherently hard; let’s not make things more difficult than they need to be. If you’re in it for the long haul, apply these principles to your thinking and reap the rewards as your empire grows.
Here’s to more,
@PaperPursuits