Business Angel Blog

I have always been curious and fascinated by Darwin and the theory of evolution. Whilst, not universally accepted as an explanation of where man came from, it has always been the most plausible explanation for me. I feel that as nations, we have evolved distinct patterns of behaviour and taste that have given certain nations an advantage in certain business sectors.

The theory of comparative advantage in Economics (espoused by Adam Smith) holds that if each country simply focuses on what it is best at producing, the whole world will be a better place. This is a much loved theory by those of us who believe globalization to be a good thing (which I think it is!). However, if this theory was to have been put to practice by the whole world, the Japanese would still only be selling rice and silk to the rest of the world as those were the only industries they had a comparative advantage in after the Second World War.

However, with the help of central government direction and massive investment, the Japanese (and other far eastern countries following their example), have developed a population with a real passion for electronic gadgets. It is curious how in Britain we look to the East for our technology and the West for our social, political and cultural influences. The fact that the local population are always on the look out for new gadgets and technology allows Japanese companies to innovate and experiment and maintain their lead as they know the local population will purchase the results of this innovation.

The Italians, who have long been considered ultra fashionable, have for the same reason developed the worlds biggest fashion houses. Having a local discernible consumer base helps these companies try out new fashions knowing that if they succeed in Italy, they are likely to succeed in the rest of the world. And if any of you doubt this proposition, I suggest you take a trip to Milan to see this for real.

Because of the empire, the British have had considerable experience in exporting capital which is one of the reasons why London has developed such a sophisticated financial centre and leads the world in services around capital export such as shipping and insurance.

Finally, the fact that there is no speed limit in Germany, explains, why they have been able to develop such powerful automobile companies. The consumer in Germany will value speed in a car as they will be able to put this technology to good use. In theory, why would anyone in the UK need a car that can do more than 70 mph? (The maximum speed limit)

If you remember that great film, Cool Runnings, you will know that the central joke was that a team from the Caribbean would take part in a winter sport! In the same sense, when you are looking at starting or growing a business, you would do well to explore countries or cultures where your product may have a latent advantage.

I invested in a start up called ICUE, ( www.icue.co.uk ) which allows you to download books on to your mobile phone. It seemed like a risky business proposition, but what persuaded me was seeing the market that existed for this type of service in Japan.

My advice from all of this is to get you to look at markets where your product is most likely to already have evolved or is cutting edge. If you are in renewable energy – find out what is happening in California. If you are developing a fast food proposition, make a trip to New York. If you are starting a new fashion label, see what people are doing in Milan.

I hope this advice proves useful.

Given the massive turmoil in the markets over the last few weeks (and days), I have been amazed at how many people have recently asked me what if any, impact the event of the last few weeks will have on entrepreneurs. Here is my humble opinion.

One of the options I studied when I was reading Economics at the University of Leeds was The British Economy in the 1930s. At the time, it simply felt like one of the easiest subjects to read, but I remember some lessons from that course which is sharply relevant to today’s economic circumstances.

The 1930s started with a bang after the Wall Street Crash of 1929. The world was thrown into economic chaos and this gave birth to the scourge of Fascism and Nazism across Europe. What was interesting about Britain in the 1930s was how there were two economies in operation; the real economy and the financial economy. The real economy actually performed very well during the 1930s and we are at the moment witnessing what I would call a decoupling of the real and financial economy again.

I am bullish about the future. I believe that this current crisis has been more severe and quicker than any of us could have anticipated. However, unlike other economic downturns in the past, I think that we will come out of this one quickly and robustly. This is a great time to start a business, but you have to be careful (as always).

The price of oil has come down sharply in the last two months from $147 a barrel to around $92. The Olympics are over and Chinese factories are producing output at full capacity again. House Prices around the world are coming down sharply and as a result people feel ‘poorer’ and less inclined to spend money on discretionary items. These three factors combined will have a big deflationary effect, which will mean that Central Banks around the world will soon be able to cut interest rates. This will help businesses and consumers alike and I think will help get the economy moving again.

There is also ample evidence that people are spending money on well placed products. Retailers such as Greggs (a mass-market fresh bakery chain) and Thorntons (a middle-market chocolate retailer) are doing very well at the moment. Surprisingly, holiday bookings in the UK are also doing very well at the moment, especially holidays which cost more than £800 ($1500). So the lesson here is that if you have a differentiated offering, you will get the consumers. Know your market and speak to them clearly.

Now is a great time to start a business if you are realistic and start small. If you look at any business cycle, most of the great businesses to emerge have always started when the conditions appear to be adverse! In tomorrow’s  business angel blog, I will give some tips on managing a business through the current turmoil.

 

 

 

 

One of my favourite modules on my MBA course was Financial Engineering. A more accurate name for this module would have been ‘making profits from thin air’. I am convinced that employees from Enron were required to excel on this course! One of the great techniques I learnt about was boot strapping!

For a variety of reasons, different businesses often get rated on different multiples. A mature business with good management which is listed may for example be trading on a multiple of ten of annual profits. A new entrant which is up and coming on the other hand may have a multiple of twenty (as the growth prospects are better). Bootstrapping occurs when a company with a higher multiple takes over a company with a lower multiple and benefits from the entire new company getting re-rated with the higher multiple.

Company A makes profits of £1m and is rated at 10x profits and therefore has a valuation of £10m.

Company B makes a profit of £0.5m but has a multiple of 20x profits and therefore also has a valuation of £10m.

Both companies are worth £10m each and you would therefore think that if they were merged (ignoring any cost savings and other synergies etc) the new company would be worth £20m.

But if company B was to buy company A, the new company may get rated on the same multiple as company B before the merger. Therefore the new company B will be rated at 20x profits of £1.5m which is £30m.

Bootstrapping has thus ‘created’ £10m of additional value simply through re-rating the prospects. Some of you will no doubt argue that I have simplified this very complicated area. Of course, it is a bit more complicated than this, but the end result is the same.

In the 1980s companies like Hanson trust were able to build themselves into huge empires by acquiring companies which had lowly rated earnings, but then apply a higher multiple. This made Hanson shares expensive – which allowed them to continue to buy other companies. Tomkins also did the same thing before it suffered a severe bout of indigestion having bought RHM (incidentally, my first employer). RHM was simply too big for them to manage effectively.

Start ups are often valued at a multiple of turnover. Hence many start ups do try to buy other companies with turnover. This is especially true in cases where you can buy a company for cheap because it has run into trouble.

This is a brave strategy. The key thing to bear in mind is management ‘bandwidth’ Many companies, especially start ups simply do not have the room to manage another business.

Given the climate we are in though. I would not be surprised if someone did come along to buy many businesses on the cheap with a view to bolting them all on to get a higher multiple.

You heard it here first!

In a recent blog, I talked about elasticity of demand and hopefully demonstrated why it is such an important concept for entrepreneurs to understand and appreciate when it comes to their own business. 

The key conclusions from that business angel blog were

 1) Understand the nature of the demand you are facing.

2) If it is elastic, you need to develop a very low cost business model as the lower you can make your price, the better for your demand – and profit

3) If it is inelastic, try to put up your prices as demand will remain at the same level

4) Don’t take the above for granted!

Of course, if your demand is elastic there are things you can do to make your demand less elastic – ie less sensitive to price.

 The most effective way of making demand inelastic is through branding and strong marketing. Before you start advertising, try to really understand what is important to your customers.

 1) Is it customer service?

2) Is it being associated with a good brand?

3) What can you do to make your product more important to your customer? (Typically a product which has elastic demand is not that important to a customer)

4) How can you make your product or service vital to the success of your customer?

5) What account management can you offer? Remember though that you have to remain a low cost business

6) Can you develop a menu of products so that you can bring the core price down even further? Think of the airlines and Dell breaking down the service into a very basic proposition and then having lots of add-on’s which can be charged for separately. Ryanair’s stated aim is to be able to offer flights for free and then make money from all the other bits and pieces that passengers may need to make a journey

7) Can you imbed your product or service as part of something bigger for a trial period? To make consumers realize how valuable the service you provide is? Think of how Anti-Virus software typically comes embedded or free for 90 days. Not only do you get used to using it – but it also means that you do not have to pay for this when you may be hard up having just bought a laptop!

The above is not an exhaustive list – but hopefully gives you some food for thought on making your demand inelastic.

I would really welcome your feedback on this. It would be great to hear of some cases where the advice from this blog does prove useful!

Here’s to being inelastic!

Readers of my blog on percentages may recall that the key message was that Entrepreneurs should be acutely aware how sensitive the bottom line of their business is to changes in demand and changes in prices.

I made the case that wherever possible; you should look to increase prices. This though depends on a very important concept called elasticity of demand. This is basically a measure of how responsive consumers are to changes in prices.

A good is said to have inelastic price demand if it does not respond to price increases or decreases. Cigarettes are a great example of this. And this is precisely why they are taxed so heavily. A 10% increase in the price of cigarettes may result in only a 1% fall in demand – as such it is inelastic and you will always increase your total revenue by putting up prices. Same also applies to oil (at least in the short term) – hence again why taxes represent a significant proportion of the total cost in the UK (just over 50%).

If the government tried the same thing with say cakes or fast food (and there is an argument that they should to encourage healthy eating) they would find that total tax received would be less. Demand here is said to be elastic as a 1% price increase may result in a 5% fall in demand (I am guessing here!). I do know from my experience at Mr. Kipling cakes that whenever we ran price promotions, sales went up significantly. A 25% drop in price would sometimes result in sales doubling.

Where demand is elastic the best pricing strategy is to go as low as you can as the resulting increase in sales will more than compensate for lower margins.

The lesson from the above is you need to find out whether the demand for your products is elastic or inelastic and then adopt a strategy that fits with that.

These things do not remain static though. Low cost airlines discovered that demand for air travel was very elastic and then adopted a business model where they would have the lowest possible cost base. The problems for the established carriers is that they are stuck in a high cost operation model and therefore have to focus on the business end of the market where demand is inelastic (hence low cost operators do not go for that market). Again, in an economic downturn, the demand for international business travel slows dramatically. (Not a good time to have shares in established airlines!)

Another good case study is to do with quality newspapers. There was an assumption that demand for each brand was inelastic and therefore no point in running price promotions. Under Rupert Murdoch, The Times challenged this and ran a very famous (and aggressive) price campaign reducing the price of The Times to just 10p. The Telegraph believed this was folly as they were in an inelastic market. They were wrong. Sales of The Times grew significantly and The Telegraph dropped.

There are some important lessons here. One of the main objectives of branding and advertising spend is to try and make the demand for your individual product more inelastic. That is how the marketing expenditure is justified.

In another blog, I will talk about what you can do to increase the inelasticity of demand for your product or service.

The main lessons from this blog are though that you should be aware of the nature of the demand you have and your pricing strategy and business model need to reflect it.

Happy Pricing!