Archives for September 2016
I believe that you have to understand the microeconomics of a business before you have a strategy, and you have to understand your strategy before you have a structure. If you get these in the wrong order, you will probably fail.
Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different. The essence of strategy is choosing what not to do. Operational effectiveness is about things that you really shouldn’t have to make choices on; it’s about what’s good for everybody and about what every business should be doing.”
From a corporate perspective, the best measure of fitness is return on invested capital (ROIC). This measure matters most because over the long haul, capital flows toward investment opportunities with a high ROIC. Inefficient companies, on the other hand, are eventually starved of the cash they need to survive. To understand just how indispensable technology has become, you have to follow the basic math of return on invested capital. To get ROIC, you divide EBIT, or earnings before interest and taxes, by invested capital. Now let’s divide the numerator and the denominator by annual sales. This restates ROIC as operating margin multiplied by asset turnover. In other words, the two components that define a company’s fitness are the ability to charge a high spread between price and actual cost, and the ability to generate sales from a small base of invested capital.
Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that. So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.vWhat matters always is dollar margins: the actual dollar amount. Companies are valued not on their percentage margins, but on how many dollars they actually make, and a multiple of that. When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows. With free cash flow what counts is when the money actually changes hands. So if you have a business where your customers pay you quickly, you manage your inventory well, and you’re able to take your time in paying your suppliers, your free cash flow can be consistently positive even when your net income is not.
You have to understand what it is that you are better at than anybody else and mercilessly focus your efforts on it.
It’s just as hard to build a large company as it is a small company, so you might as well build a big company. It’s roughly the same effort.
Criteria for assessing the Team: Intelligence, Integrity and Energy. You want someone who is really smart, very hard working and trustworthy. A lot of people forget the integrity part, because if you don’t have that, then you have a really hard working crook and they will find a way to cheat you. Intelligence and energy are easier to measure. Integrity is the most important factor.
Companies only fail for two reasons: The founder gives up or they run out money. Don’t be proud. Get the cash wherever you can. Cash is everything. Raise twice as much and make it last four times as long. Pretend that you don’t have the money in the bank, run lean. Assuming your unit economics are at least breakeven, keep your headcount low, raise money and stay in it for the long haul. It takes a decade to build a great company. There’s no shortcuts.
The only unforgivable sin in business is to run out of cash. What does cash give a business? Options. What do options create? Convexity!
To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.
Try never to be the smartest person in the room. And if you are, I suggest you invite smarter people… or find a different room.
Acknowledging what you don’t know is the dawning of wisdom. I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.
Any return stream can be broken down into its component parts and analyzed more accurately by first examining the drivers of those individual parts.
Learning how to build a sustainable business is the outcome of experiments which follow a three step process. Build, measure, learn.
Why is experimentation so important in an economy? The answer is that experimentation is the best way to deal with one of nature’s solutions to dealing with risk, uncertainty and ignorance: a complex adaptive system. An economy is a complex system in that it is networked and therefore adaptive in ways that a simple formalism, such as used in physics, will fail to predict.
In the case of complex adaptive systems like an economy or a business, the correct approach is to discover solutions via trial and error rather than try to predict.
All a founder or venture capitalist can lose is 100% of what they invest in a startup and yet what they can potentially gain is potentially many multiples of that investment.
Knowing what you can’t predict is one of the most valuable things you can know. Discovery which happens via experimentation via trial and error is a vastly superior way to deal with unpredictability than trying to predict what can’t be predicted.
- Some startups are an attempt to create entirely new categories of businesses at global scale (e.g., Uber, Salesforce, or Airbnb).
- Some startups are about incremental or local innovation, such as a new frozen yogurt shop or sushi restaurant.