What really excites Private Equity? (Part 2) Or how to think like an Investor. — Lionesses of Africa

Sad, but true. As we always say, once we know the rules of the game (even if we don’t agree with them), we can play (do we have a choice?!). Obviously this generalizes terribly and we have a number of excellent forward thinking PE Investors we turn to, so fear ye not, all is not lost. Still, its always better to know how the cards are stacked!

So last week we looked at your raw material supply and your production of Green Widgets, but what about the other end as your production rolls out to your customers? Having decided that a massive automation program is necessary and that you will move your production from 1,000 Green Widgets to 70,000 – do you really have customers waiting to handle such a massive explosive rise in your production? If you have decided that 70X your current production is necessary (note necessary  – always possible – but necessary?), then you clearly believe this, but there must be reasons behind that belief. The Investors will be on these numbers like a rash to check both your conviction and also the data you use to back this up.

Are your current customers able to confirm their needs, how they will increase their orders if you increase your production, will they increase at the same time and same rate as your production or will your warehouse start busting at the seams as you wait for your current customers to catch up or you find new and extra customers? 

Cash Flow Concern – will your current customers insist on credit terms such as 90 days to pay, if they increase their purchasing? Yikes – bet that was not in your plans!

Looking for new customers to take your increased production? How do you acquire new customers and how much does each new customer cost to bring on board. What is your retention rate? No point bringing 100 new customers in through the door each year, if over 80 are leaving through the back…

If driven by social media – how does one engaged user cause another to be more engaged? Post on instagram, one ‘like’ – sorry, but ‘big deal!’, but what about a share or comment – does this then start a conversation and encourage others (potential customers) to join and try out your products?

Ultimately we want our customers to be engaged, then stay and encourage others. This is what an investor will also look for. Even in ‘old’ industries – a long term client is great, but if they recommend you to others and they become a customer, how cool is that. You have just cut dramatically your ‘customer acquisition cost’ to zero. No advertising, no Google or Facebook ad costs, no lengthly expensive meetings, no trips to trade fairs with expensive hotels.

Ever wondered what a Bank is doing asking you to recommend them to friends of yours and ‘awarding’ you with $10 if the friend becomes a customer? The Bank has simply calculated that it costs significantly more (around $40 for most international banks if our reading is correct) to acquire each new customer (their ‘Cost to Acquire new Customers’ or ‘CAC’), so why not pay current customers less to give the same result? Paying you $10, they have just cut their acquisition cost by $30 AND have got a customer who is likely to be more ‘sticky’ because one of their friends recommended. 

CAC is typically calculated as follows:

CAC = Total Marketing + Sales Expenses / # of New Customers Acquired

Please do not forget that Sales Expenses include salaries (when you include salaries this is called ‘fully loaded CAC’), overheads (rent, equipment allocated etc) and any tools they may use, such as ‘Salesforce’, tent and sleeping bag for those hard to reach Trade Fairs (ok – just threw that in to check if you are still with us!) and so on. 

It is also good to show you are aware that this is not a perfect equation. We talk about time value of entrepreneurs’ money as it rushes from production to stock to warehouse to customer to invoice to bank account, and back to production… and especially how you need to make your cash work (keep it fit by exercising it) – not have it stuffed in a product gathering dust in the warehouse, or sitting on your debtors list. The same is true of CAC, if you move your customers quickly from first touch point into a paying customer, celebrate that and therefore mention it. If it takes months to move them from a customer who is trying out your free product before they move onto your fee charging part (as we see in so many tech companies) or your cheaper start-up Green Widget  that attracts and brings customers in, before moving them onto the far more profitable product you produce, then this should increase CAC.

‘Stickiness’ – how long a customer stays, the retention rate, is also important, if not essential. It’s far more expensive to acquire a new customer than to retain a current one—anywhere from 7 – 20 times more expensive! That means your your current customers are more valuable than you think and wake up those old sleepers – at least they know you already and you don’t have to take time explaining!

If you can’t hold onto current customers, marketing and sales become like pushing a bolder up a hill. An Investor is going to want you to be growing customers at a decent rate, not standing still and certainly not losing, so you must expect questions on this.

Ten – Fifteen years ago, Mobile Phone companies had customers that would jump with no hesitation to a competitor with a better deal. They would look at envy at the ‘stickiness’ of banks’ customers that would stay for years even with terrible service – so what was the solution? They moved into mobile banking (we kid you not – this was their central driver). Now they have the best of all worlds, they are nimble, able to move, react and surprise, whilst attacking banks and stealing their customers, with a product that automatically creates ‘stickiness’! 

What if you receive Purchase Orders (‘POs’) from larger customers? Great to get such large orders from which you can plan your year, but what if they don’t want you to deliver immediately, what if they ‘draw down’ subject to their own requirements through the year. This is no doubt how many Lionesses will work with their own suppliers. Brilliant at the back end of your business where you are taking in raw materials to feed your production. You can order 100 tonnes of raw material knowing that if you use 10 tonnes a month you have 10 months of stock available whilst gaining from cheaper pricing from ordering in size, plus your supplier now can only invoice when they deliver to you, so their not your money is in product gathering dust in the warehouse. The same is at the front end of your business. A large customer may order a huge quantity, but only require a small amount per month. Of course this means that you can plan your production around this, but what if you have no planning from your customer and you know that some months they take 10 tonnes, other months significantly more. Your cash is sitting in the warehouse gathering dust whilst waiting to be delivered and invoiced. Not a good position to be in. That is why the breakdown of your customers will also be of interest to investors. Large is great, but what of the speed of production vs speed of invoicing vs warehouse dust collecting!

So ‘Large is Great’ is not necessarily correct. That is again true when reviewing your entire customer base. Investors will be particularly concerned if your 3 largest customers are over 50% of your customer revenue base – even worse if you have one customer over 50%. Lose them or even one of the three and suddenly your revenue stream is meaningless. Cocoa production and have say Nestle as your only customer? Looks great – but you had better be close to their purchasing manager (and not forget their Birthday!) – that would certainly be a bleak end of year if you lost their business.

Once again, this is not an exhaustive list of questions and concerns to expect from investors, but they are often the ones overlooked by all entrepreneurs.

If these start to give you an idea of how to think like an investor and especially one that will naturally and sadly err towards prevention questions rather than promotion ones, as you view your beautiful business, your baby, then it is a start. 

As we said last week, Investors are not there to catch you out (although we would hope for a better balance between promotion and prevention questions of course), but they are certainly there to ensure you have considered all angles, that their risk is mitigated as much as possible and that at the end of the day they are getting into bed with the right partner.

Stay safe.