CHAPTER 10

Enduringly Profitable Small Businesses

Our first and most important recommendation about characteristics you want in your business was that you buy an enduringly profitable business with an established model for success—one that is profitable year after year. In this chapter, we offer some guidance to help you translate that concept into practical diagnostic tools for working through your deeper filters.

Since recurring customers are the foundation of an enduringly profitable small business, we suggest that your first deeper filter be whether its customers buy from your prospect again and again. Usually, you will get detailed qualitative information about the company either in the CIM for a broker-sourced prospect or through a longer conversation with the owner for a directly sourced prospect. This information could include details about the company’s reputation, its business model, and its past history. Look for indications that the business has an outstanding reputation: That is the simplest reason why customers would keep returning. Other reasons should also be readily apparent from business descriptions: Some businesses integrate with their customers’ internal systems in a way that makes it expensive for the customer to shift suppliers, for example. Other companies have an important role in the customers’ businesses but constitute a small expense for customers, so that there is no reason for the customer to seek out a competitor with a lower price. All of these characteristics create a bit of pricing advantage for the business while also reducing risk that competitors could poach customers.

Reputation

A company’s reputation for excellence keeps its customers from eyeing the competition. Take Be Our Guest (BOG), a party equipment rental company located in Boston. BOG rents tables, chairs, linens, plates, glasses, and cutlery to caterers. At first view, BOG could be taken for an undifferentiated commodity business. After all, you’d think caterers would simply rent from whoever had the lowest rental rate on their inventory of party equipment.

And yet, BOG has loyal customers that return year after year. Why? The answer is that failure is extremely expensive for BOG’s caterer customers; far more expensive than the likely price difference between BOG and its lowest-priced competitor. Imagine that it is the wedding day for Mrs. Parkington’s only daughter, and you’re the caterer who has been hired to produce the dinner. You’ve used BOG before, but with 300 guests, you’re considering switching to an unknown competitor with a lower price. But then you start to think. What if something goes wrong at the reception? What happens to your fee if the equipment you need doesn’t show up on schedule? And what about the damage to your future business after Mrs. Parkington tells all her friends what a lousy caterer you are and how you ruined her daughter’s wedding and perhaps her whole life? You know and trust BOG, and you realize that its reliability is worth every penny.

BOG is a business that is small for a good reason: The market it serves needs to stay relatively small. The party equipment rental business is regional because it requires intensive management to constantly solve little service problems (before they become big). This sort of management does not lend itself to a geographically distributed operation. If the business starts serving caterers too far from its warehouse, its ability to respond quickly deteriorates while its transport costs rise and eat into profit. BOG’s scale may be limited, but it has a great reputation. So, despite its small size, it is an enduringly profitable business because of this solid reputation.

No Competitors

While BOG differentiates itself from its competitors with its reliable reputation, Castronics is a wonderful example of a company that has no meaningful competitors simply because of its location. As described in chapter 8, “Sourcing Prospects Using Brokers,” Patrick Dickinson and Michael Weiner used brokers to source their prospects and ultimately acquired Castronics. The company specializes in providing threading, perforating, and refurbishment services for pipe that is used in the oil and natural gas industry. Located in Kimball, Nebraska, the company primarily serves customers in the Rocky Mountain and upper Midwest regions of the United States.

The pipes the company works with are typically 40 feet long; on average, one unthreaded tube costs roughly $1,000 to manufacture and $300 to transport, while threading it costs only $45. As a result, customers care much more about transportation costs than threading costs. What makes Castronics special is that it is located near active drilling regions where there is great demand for threaded pipe; Castronics is the only company providing this service in a 500-mile radius. Its location thus gives Castronics a substantial advantage over its more distant competitors. So customers continue to buy threading services from Castronics, year after year, and the company faces little price pressure from competitors. That is a recipe for a company that will be profitable for the foreseeable future.

What if another threading company enters the geographic market that Castronics serves? Such a move is not impossible, but a new competitor would have to overcome a few hurdles to be successful. First, it would need to obtain the licenses and certifications to cut the different threads required by Castronics customers. Second, it would need to find a location that offers efficient transportation and distribution, preferably near a railroad siding. Third, the competitor would need to attract the appropriate workforce, a task that Castronics devotes significant efforts to accomplish in its rural environment. And perhaps most importantly, the competitor would have to convince potential customers that it can reliably provide the service in a timely manner, because delays and defects are costly and potentially dangerous at the drilling site. While none of this would be easy, a company could overcome these hurdles, and because of this potential for entry, Castronics cannot charge whatever it wants to for its services. Instead, Castronics has to be careful not to encourage competition. Still, because the barriers to entry in its market are so high, Castronics does have comfortable profit margins and recurring customers.

The Importance of Being Unimportant

Customers always want lower prices. But when it comes to demanding lower prices, customers will focus first and hardest on their biggest categories of spending. An automobile manufacturing company is going to focus far more resources on making sure it has the most competitive deal from its steel suppliers than on reworking a deal with the company that provides its postage meters. Thus the importance of being unimportant: If the small business you buy provides something that only makes up a small portion of its customers’ expenses, then those customers are much less likely to switch to other suppliers.

Vector Disease Control International (VDCI) of Little Rock, Arkansas provides insect control programs to municipalities mostly in the southeastern United States. Municipal governments relentlessly try to reduce costs, putting out to public bid most goods and services they buy. But VDCI’s annual client retention rate is outstanding, and almost all of its revenue is recurring. One reason is that its typical municipal government customer pays $250,000 per year for its services—a small amount for most city and county governments. Consequently, the governments often prefer to sign multiyear subscriptions and not deal with the work of an annual renewal process, especially since programs are typically customized and hard to compare, without the promise of substantial savings either way. Of course, for some rural communities, VDCI’s services can be a significant portion of the municipal budget. For them, VDCI’s high level of service and reliability is important, and leads to a high retention rate. VDCI’s service is very specialized and technical. After all, the company is spraying chemicals among voters. You can be sure that the municipal employees who award this contract are very aware that VDCI has done reliable work for their city in prior years.

Being a relatively unimportant part of your customers’ total cost structure won’t eliminate all price pressure, but it will go a long way toward making you less visible when your customers turn their attention to reducing expenses. That’s especially true if you’re also competing on your reputation as a high-quality, reliable provider of services: When your service is a small part of your customers’ costs but is important enough that they want it done right, nobody wants to be the one who picked a lower-cost provider if something goes wrong. This combination again leads to long-term, enduring profitability. As you examine your target, assess what part its services play in the budgets of its customers to gauge how likely those customers would be to bolt.

Integrating with Customers

Have you ever wondered why your bank offers you a free or an inexpensive electronic bill payment service? It’s partly because banks are trying to make it more difficult for you to switch. Before you move to a new bank, you’re going to think about painstakingly reentering the information about each company you now pay with the click of a button. This electronic service is much more useful to you than paper check writing, but it also makes you more “sticky” for the bank.

You want to buy a small business whose customers would have to work hard to switch suppliers. A great example is ADEX Machining Technologies, a specialty machine tool shop in South Carolina. It was founded in 1987 as the M. C. Tool Company and, for many years, produced parts for a variety of manufactured products. This was a difficult, competitive business because customers were skillful at using competing machine shops to bargain down prices and raise quality requirements. The business wasn’t enduringly profitable.

Sean Witty and Jason Premo, who bought the company in 2007, had the idea of gradually shifting to supplying parts for mechanical systems in jet airplanes. This approach was important because in addition to testing and approving the mechanical systems that airplane manufacturers like Boeing buy, the manufacturers also test and approve the parts that their suppliers buy and put into those systems. It is a long, difficult process, and a single component can take a couple of years to get approved. But once an ADEX component is approved by a final assembler like Boeing, it becomes harder for Boeing to switch ADEX out. As a result, ADEX becomes an enduringly profitable business with recurring customers. Sean and Jason took a risk buying a company that was not yet enduringly profitable, but they had a solid plan for moving in that direction after purchase. We’ll talk more about this approach later in the chapter.

Sometimes the switching costs just flow naturally from the business’s activities. Nurse Care of North Carolina (NNC) is an example of a smaller firm with recurring revenues that support sustainable profits. As described earlier, Ari Medoff conducted a self-funded, regional search that primarily relied on direct sourcing. NNC provides home health-care aides to elderly and disabled people in the Greensboro, North Carolina, area. The company serves 120 to 150 clients who have been referred to NNC by their health-care professionals. Clients pay NNC for each week of service, which is typically provided to a client for months or years. As the home care continues, a rhythm develops, and the relationship formed between the provider and the patient would be difficult to upset. A change might occur if the quality of care is unsatisfactory, but NNC makes sure that never happens. The owner of NNC also concentrates on maintaining excellent relationships with patient referrers—doctors, hospitals, and others—and once a patient selects NNC, they contribute a steady, recurring revenue stream.

NNC’s recurring revenue stream contributes to the sustainability of the company’s profits in several ways. First, because NNC can project its revenues several months ahead, it can accurately adjust its operating expenses according to this demand. Second, it’s tough for competitors to poach clients. Once NNC begins to work with clients, they just aren’t in the market for other health-care providers. Finally, NNC’s sources of new patients are recurring sources. For example, the geriatric care manager at a local hospital refers patients to NNC month after month because, over the years, patients have reported back that they are well taken care of by the company. Referrers like this aren’t interested in experimenting with other services, because satisfied outpatients help their business. Nor is a competitor that offers a price cut likely to win away these referrals—the hospital and its geriatric care manager don’t pay for NNC’s service; their outpatients do. The referrers are focused on excellent service with no mistakes.

Businesses Without Enduring Profitability

Companies whose profits are less likely to endure also share some common traits:

• Technology-driven companies: As the technology changes, so will your customers. You’ll need to reinvent their products and find new customers frequently. If you like recurring revenue as we do, you’ll steer clear of these companies.
• Cyclical businesses: If your customers are able to defer purchasing from you when their business gets soft, your revenues will drop like a stone. Because you will be responsible for regular payments on your acquisition debt, this volatility creates a big problem.
• Huge competitors: Avoid any business that a large national chain could compete with. Dance with a giant, and you’ll get crushed.
• Specialized assets: Avoid any business that requires you to buy specialized equipment that can only be used by one customer. Once you acquire the equipment and the debt that goes with it, the customer can use your weak position to drive prices down.

While we strongly recommend that you focus on enduringly profitable prospects, some searchers have had great success deliberately buying businesses that are initially not enduringly profitable. For example, Sean Witty and Jason Premo bought the manufacturer ADEX before it became enduringly profitable. Another example is Greg Mazur, who purchased a pet food distributor after graduating from Harvard Business School. The company had no exclusive distributorships, and manufacturers and customers could easily switch from one distributor to another, squeezing margins from both directions. He took a business that wasn’t enduringly profitable and transformed it into one that was by shifting product lines and growing it into a very successful company selling exclusive, specialty products to the same retailers year after year. Just like start-ups and turnarounds, we believe businesses that are not enduringly profitable are riskier for the buyer and more difficult to manage and require transformation to be successful. That doesn’t mean it isn’t possible, but we prefer safe and easy to risky and difficult.

Filtering for Enduringly Profitable Prospects

In this chapter, we’ve focused on the traits we often see in a prospect that has enduring profitability. Ask these important questions about your prospect:

• Does it have a strong reputation?
• Does it lack competitors?
• Is it a small part of its customers’ costs and an essential input to the customers’ success?
• Is it integrated with its customers?

You might have noticed that almost every example we discussed in this chapter had more than one trait that kept its customers buying year after year. Castronics had a transportation cost advantage, but also had licenses and certification for the products its customers wanted. Vector Disease Control was an unimportant part of the total costs, but also had a reputation for safe and reliable service. ADEX and Nurse Care became enmeshed with their customers and had strong reputations. We think these traits are typical. They are something you should look for in prospects, and the traits should be relatively easy to see early in your filtering. We believe that especially in combination, these traits will lead to enduring profitability with long-lasting, higher margins.

Let’s turn back to Randy Shayler to see how these filters applied to the business he was evaluating, Zeswitz Music. Using the information in the CIM to assess the enduring profitability of Zeswitz, Randy found that the company had several of the traits highlighted in this chapter. Zeswitz had a great reputation with the schools it worked with, and its brand name was well established. Indeed, of the 48 school districts that the company did business with, 38 had been with Zeswitz for 20 years or more and were responsible for about 95% of the company’s instrumental rentals. Furthermore, the company maintained close ties with the music programs of its schools, handling repairs and replacements of broken instruments quickly and providing other services that integrated Zeswitz with those programs. Instrument rental was also generally a small part of the commitment a parent would make to a child’s education so that once a student began renting from Zeswitz, there was little incentive to switch rental companies as long as parents were satisfied with the service they received. While the CIM did not provide specific information a bout the recurrence of customers, there were strong reasons to conclude that Zeswitz would be an enduringly profitable business.

Next Steps

The initial filters and your qualitative assessment of enduring profitability should enable you to quickly eliminate many business prospects. For those that survive your scrutiny, the next deeper filter is some simple quantitative assessment of enduring profitability, as we describe in the next chapter.