INDUSTRY AND MARKET ISSUES (PART 2)
Profits after Tax
High and durable gross margins usually translate into strong and durable after-tax profits. Attractive opportunities have potential for durable profits of at least 10 percent to 15 percent and often 20 percent or more. Those generating after-tax of less than 5 percent are quite fragile.
Time to breakeven and positive cash flow
As mentioned above, breakeven and positive cash flow for attractive companies are possible within two years. Once the time to breakeven and positive is greater than three years, the attractiveness of the opportunity diminishes accordingly.
ROI Potential
An important corollary to forgiving economics is reward. Very attractive opportunities have the potential to yield a return on investment of 25 percent or more per year. About 35 years ago, many venture capital funds achieved only single-digit returns on investment. High and durable gross margins and high and durable after-tax profits usually yield high earnings per share and high return on stockholders’ equity, thus generating a satisfactory “harvest” price for a company. This is most likely true whether the company is sold through an initial public offering or privately, or whether it is acquired. Given the risk typically involved, a return on investment potential of less than 15 percent to 20 percent per year is unattractive.
Capital Requirements
Ventures that can be funded and have capital requirements that are low to moderate are attractive. Realistically, most high potential businesses need significant amounts of cash – several million naira and up – to get started. Business that be started with little or no capital are rare, but they do exist. One of such venture was launched in Lagos with N200, 000 of the founder’s capital and grew over N300 million in sales by 2003. In today’s venture capital market, the first round of financing is typically N20million to N50 million or more for a startup. Some higher potential venture such as those in the service sector or “cash sales” businesses have lower capital requirements than do high-technology manufacturing firms with large research and development expenditures.
If the venture need too much money or cannot be funded, it is unattractive.
Internal Rate of Return Potential
Is the risk-reward relationship attractive enough? The response to this question can be quite personal, but the most attractive opportunities often have the promise of – and deliver on – a very substantial upside of 5 to 10 times the original investment in 5 to 10 years. Of course, the extraordinary successes can yield 50 to 100 times or more, but these are exceptions. A 25 percent or more annual compound rate of return is considered very healthy. About 30 years ago, those investments considered basically risk free had yields of 3 percent to 8 percent.
Gross Margins
The potential for high and durable gross margins (.e. the unit selling price less all direct and variable costs) is important. Gross margins exceeding 40 percent to 50 percent provide a tremendous built-in cushion that allows for more error and more flexibility to learn from mistakes than do gross margins of 20 percent or less.
High and durable gross margins, in turn, mean that a venture can reach breakeven earlier, preferably within the first two years. Thus, for example, if gross margin is just 20 percent, for every N1 increase in fixed costs (e.g. insurance, salaries, rent, and utilities), sales need to increase N5 just to stay even. If gross margins are 75 percent, however, a N1 increase in fixed costs requires a sales increase of just N1.33.
One entrepreneur, who built the international division of an emerging software company to N650 million in highly profitable sales in just five years (when he was 28 years old), offers an example of the cushion provided by high and durable gross margins. He stresses there is simply no substitute for outrageous gross margins by saying, “It allows you to make all kinds of mistakes that would kill a normal company. And we made them all. But our high gross margins covered all the learning tuition and still left a good profit.” Gross margins of less than 20 percent, particularly if they are fragile, are unattractive.
(Part 3 continues in the next article)
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