How can early-stage entrepreneurs differentiate themselves in the long-run?
How can early-stage entrepreneurs differentiate themselves in the long-run?
3 core metrics that early-stage entrepreneurs should learn from public companies.
All entrepreneurs are required to allocate capital, people, time, and resources efficiently and productively to build enduring companies. The better and more efficient you get at allocation, the better the company’s outcomes tend to be. And in the long-run, efficiency in the allocation of capital, people, time and resources can in itself become a company’s moat i.e competitive advantage. Combine an edge in allocation with a high integrity team, and you can repeatedly drive successful outcomes and tap into the Power of Compounding.
Thus, to be an entrepreneur you need to have a deep understanding of how and where to invest your startup’s energy and resources. What’s interesting to me is that most entrepreneurs don’t really think of themselves as investors. Each entrepreneur is either consciously or unconsciously making trade-offs in terms of priorities and focus areas, without realizing that their choice and decision to invest in path A vs path B, will get them to different outcomes.
As the organization grows from a startup to a revenue-generating company, the founder(s) soon realize that their time is not infinitely scalable and they need to start building processes and systems to organize high-functioning teams to be able to deliver successful outcomes, independent of themselves. This is the stage where they truly step into the role of allocation of time, priorities, and capital and it works in the favour of those who understand the art of allocation well. Call it prioritization or efficient allocation, this journey that starts right at the inception, carries on to later stages of the company and holds even truer for public companies.
Let’s look at the 3 metrics that startups can adopt from public companies to shape their business model in a way that truly sets them apart:
Return on Capital Employed (ROCE) is one of the key metrics that an investor should look at when evaluating public companies. ROCE is a metric that measures the efficiency of capital deployment for a company, calculated as a ratio of ‘earnings before interest and tax’ (EBIT) in the numerator and capital employed (sum of debt liabilities and shareholders’ equity) in the denominator. The higher the ROCE, the better is the company’s efficiency of capital deployment.
Now when evaluating companies, you’ll see a wide range of ROCE (negative - even 50-60% sometimes). What is the filter that you should consider?
To be able to build an enduring business, the return on capital employed should at a bare minimum, beat the cost of capital to the company - the second metric that entrepreneurs should pay attention to. If the cost of capital is very high, you have a business that is eating at its own growth to survive. To quote Charlie Munger from Berkshire Hathaway:
"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result.”
So here’s the caveat, you cannot only look at ROCE or cost of capital as independent metrics because ROCE cannot deliver healthy returns without consistent growth in the earnings of a business. Historically, the returns on a stock have mirrored earnings growth over long periods of time. Earnings growth might seem obvious = generating more revenue through sales, more profit which results in the growth of the business. But then, those profits can get eroded really fast if the capital allocators of the business are not making the right bets (leading to not generating healthy returns).
Thus, there you have it: Yearly earnings growth coupled with low cost of capital and healthy Return On Capital Employed, compounded over 20-30 years can deliver massive returns and superior performance. While early-stage founders can get by not thinking about or paying attention to these core metrics of the public markets (thanks to the liquidity in the market with venture capital), those entrepreneurs who do can develop a long-term competitive advantage. These metrics help founders think from a first-principles perspective about which business model to adopt for long-term success. As you go from discovery to product-market fit, aim to think about the business model in a way that can sustain itself through growing earnings, low cost of capital and generate decent ROCE.
To end with, there are 3 categories of businesses based on Return on Capital, that Warren Buffet spoke about in his 2007 letter to shareholders:
High earning businesses with low capital requirements - these businesses can keep growing consistently without needing incremental capital. Examples: See’s Candies & Hindustan Lever
Businesses that require capital to grow and generate ROCE: These businesses need additional working capital as their sales grow, and also have requirements for fixed assets investments. Example: HDFC
Businesses that require capital but generate low returns on capital i.e their business requires significant capital to show growth and then earns little or no money. Example: Indian Telecom sector
Most startups, unfortunately, fall into category 3 of business models, hence end up not being able to sustain themselves and shutting down. As an entrepreneur and investor, our goal should be to find those rare opportunities and business models of category 1 & 2.
As always, look forward to your feedback and comments!
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Until next time!
Hi Shrishti. Those were some insightful words, thanks for sharing. The imminent need for exploring an opportunity where a startup's business model could fall into either category 1 or 2 is an invaluable take on how early-stage startup founders can pave a fruitful path for themselves.
What would you suggest folks who're merely getting off the ground; they think they have a worthy idea but often find themselves thinking about how to go about the business model? They're already in dilemma whether or how would it work for their idea/startup in the initial stages. What'd your recommendation to them for zeroing in on a business model, specially during those early days?
Hi Shrishti. Those were some insightful words, thanks for sharing. The imminent need for exploring an opportunity where a startup's business model could fall into either category 1 or 2 is an invaluable take on how early-stage startup founders can pave a fruitful path for themselves.
What would you suggest folks who're merely getting off the ground; they think they have a worthy idea but often find themselves thinking about how to go about the business model? They're already in dilemma whether or how would it work for their idea/startup in the initial stages. What'd your recommendation to them for zeroing in on a business model, specially during those early days?