“It’s easy to come up with new ideas; the hard part is letting go of what worked for you two years ago but will soon be out of date.” —Roger von Oech
If you are an investor, how do you identify underperforming businesses to invest in? Most investors depend on their networks for Advice introductions, Referrals, and more. If you'd like a better way, this may be the article for you.
A few years ago we began expanding our business network to include investment bankers and other business equity investors. I recognized the needed to give back to our network. As with all new people we add to our network, I began asking these equity investors, "Can you define your target customer?"
Then we could reach out to our network to make appropriate introductions.
"…can you define your target customer?"
I've found few who could. Trying to find referrals for others is a challenge, but for business investors, it was particularly tough. To be strong network partners my team and I began looking for ways to provide equity investors with quality introductions, speaking opportunities, and of course referrals. Because of the privacy issues, these have been the hardest referrals to make.
To solve this problem, my team and I began researching ways to identify sellers even before the seller knew they wanted to sell.
Talking with investors we have found that some specialize in underperforming businesses and some in buying the top performing industry leaders. We decided to focus on identifying underperformers.
We are not traditional investors. Which means we were bound to look at the problem differently than a traditional investor. I remember something Henry Ford once said.
“I am looking for a lot of people who have an infinite capacity to not know what can’t be done.” —Henry Ford
On this problem, I felt my team have that infinite capacity in this area. We started by assuming business underperformance was caused by:
- Management skills that were not increasing as quickly as the business the business was growing.
- Technology was not being deployed to the detriment of employee productivity.
In finding these companies, the problem we first ran into was in researching the metric to judge those businesses on.
In our research, we learned that no company with 80% of the regional market share (industry leaders) also had an underperforming workforce. Based on this we assumed that underperforming businesses also had underperforming workforces.
"…underperforming businesses have underperforming workforces."
By using public information, we developed an algorithm that could measure hundreds or thousands of businesses for workforce productivity.
Picking underperforming businesses
Here is the first practical process we came up with.
- We used companies in a single zip code
- Then divided the companies by industry
- Ran the Workforce productivity algorithm
- Ran each industry through an 80/20 comparison algorithm
Note: We chose companies with yearly location sales between 5 million and 50 Million.
Technology Industry Base Lines
To help you compare compare, we also include the top and average employee productivity metrics of companies in the industry to compare against. Compare our underperforming businesses with these numbers.
While the average companies employee productivity was $214,285/employee/year, the following is a sample of some of the companies in the bottom 20%.
The D-Multiple tells us how far below average these work forces compared. In this case, the five companies were lower, by a factor of 1.1 to 2.5, than the average company's productivity. The bottom companies on this list would have a potential income increase from 15 million dollars/year to 45 million dollars/year.
Why the investor should care?
For the investor, what this means is being able to more accurately pick underperformers. Plus estimating the potential these companies have to increase their investments. Add this analysis to the EBITDA analysis and you will have a better chance of picking winners from losers.
The goal of this blog is to challenge the way you've always done things. Traditional investors looks at the Accounting records and compare some form of EBITDA.
“If you have always done it that way, it is probably wrong.” —Charles Kettering
In the traditional model you need to look at hundred's of businesses. In this strategy, you can automatically whittle down hundreds of companies down to 1 or 2. All without the need to spend time with hundreds of other businesses.
Your Next Step
We started this to be better networking partners with the equity investors in our network. Most equity investors are fairly conservative and don't change quickly. This may be a radical idea from a technical expert. You might wonder what a technical expert knows about business at all? Still there are some of you that are looking for a competitive edge, and willing to learn more. If that's you, we'd like to talk. Please feel free to contact us to learn more.