By April 20, 2009 Read More →

The Five Small Business Success Formulas

SteveNelson

Editor’s note: This is a guest post from Stephen L. Nelson on his top 5 small business formulas.  Stephen is the best-selling author of QuickBooks for Dummies (over 400,000 copies sold), of Quicken for Dummies (over 1,000,000 copies sold), and numerous other books about small business accounting, finance, project management, and technology.  He was once called the Louis L’Amour of computer books by the Wall Street Journal because he’s written more computer books (roughly 160 at last count) than any other author.  What I like about Stephen’s insight is that he gets to see what works and what doesn’t for a lot of people.  While I think Stephen’s lessons are timeless, I think they are especially valuable in today’s economic landscape as more people find themselves considering starting a small business for the first time.  

Thinking about starting or buying a small business? As someone who’s worked with and advised small businesses for, gosh, the last twenty-five years, I heartily endorse this idea. You can make great money and enjoy a wonderful time if you own and operate your own small business.

But there’s something weird about successful small businesses–something you should know before you take the leap. Most successful small businesses use one of five, easy-to-describe “formulas” for achieving profitability. And if you’re thinking about starting or buying (or even going to work in) a small business, you want to understand how the formulas produce profits and where the risks reside in a particular formula.

The Five Small Business Success Formulas
Here’s a summary of the five small business success formulas:

  • Formula #1: “It’s Almost Just a Job” Businesses
  • Formula #2: “All Leveraged Up” Businesses
  • Formula #3: “Early Bird” Businesses
  • Formula #4: “External Solution” Businesses
  • Formula #5: “Secret Sauce” Businesses

Formula #1: “It’s Almost Just a Job” Businesses
I want to start by describing the most common and lowest risk small business success formula–the “it’s almost just a job” business. No kidding. I think close to fifty percent of the small businesses that I see in my practice fall into this category.

Job businesses amount to the owner selling his or her time. Someone who’s worked for corporation as a programmer, for example, might become a contract programmer. A former corporate accountant might start selling hourly controllership services. A graphic designer recently laid off might–well, you get the picture, right?

Job businesses work because the owner sells hours of time at reasonable hourly rate. Hopefully some hourly rate several dollars more (maybe many dollars more) than the person’s former hourly wage. Sell enough hours and the job business works pretty darn well.

In my experience–and I think I’ve seen thousands of successful businesses over the last few years–you work hard in a “job” business. But if you can get through the first couple of years and to the point where you’ve built relationships with a handful of decent customers, you’re there. You’ll have a low risk, reasonably profitable venture.

And one note: by “low risk” I don’t only mean relative to other entrepreneurs, I mean relative to anybody who’s working. Someone with a corporate job is very likely to at some point find themselves laid off. With a “job” business, yes, customers come and go. But you would almost never lose all your customers one Friday afternoon.

Formula #2: “All Leveraged Up” Businesses
A powerful but more risky small business success formula rests on financial leverage. And in my experience perhaps twenty percent of small businesses–especially those that employ lots of expensive fixed assets–use this success formula. But let me explain.

On average, small businesses produce profits equal to roughly 40% of the business’s value. In other words, if you buy a small business for, say, $100,000, you would on average expect the business to produce $40,000 of cash profit. And, yes, if you buy a small business for, say, $1,000,000, you would expect the business to produce $400,000 in cash profit. (My source for this generalization about small business profitability is the BizComps database, a listing of several thousand small businesses that have been sold over the last decade or two.)

Now here’s where the return on a small business stuff gets interesting… In many cases, banks and the people selling the small business will finance much or all of the purchase price of the business at low interest rate. Or leasing companies will furnish much or all of the purchase price of the assets used in the business at low interest rates. When this occurs, the business owner makes out like a bandit because of the difference between the cost of borrowing and the return on the business investment.
For example, if you can borrow money at a 10% interest rate and you reinvest those funds in a business or assets earning 40%, you make 30% on whatever money you can borrow.

If all this sounds vaguely familiar to what real estate investors do, you’re right. Leverage is often what makes real estate investments work. But the leveraged small businesses work better than leveraged real estate investments because the interest rate spread is so much bigger with small businesses.

Note again that the example I’ve used here produces a 30% “leverage profit.”

As a comparison, real estate investments often produce returns of 10% (including appreciation). If you borrow money for 6% and reinvest those funds in something earning 10%, you pick up 4% of profit through leverage. That’s great. But 4% is nowhere near 30%.

One caution about leverage: The “all leveraged up” formula only works most of the time. Perhaps (and here I’m generalizing based on what I see in my practice) a “leveraged” business works great four out of five years. Or maybe a “leveraged” business works nine out of ten years.

Eventually, however, some internal shock (like the departure of your key employee) or an external shock (like a recession) means you’re not getting positive leverage. You may be paying more for the money you’re using in your business than you can make on that money. When these sorts of shocks to the system occur, the business that uses too much leverage fails.

Formula #3: “Early Bird” Businesses
The business formula that many people think of first is the idea of getting to some new or fast-growing market early. I guess that makes sense. The popular monthly business magazines tell one or two of these entrepreneurial success stories in every issue.

But here’s why these ventures make such good stories: If you start an early bird business in a market without strong established competitors, you may enjoy fast-growing revenues and profits for years or even decades. Not to be vulgar or anything, but if you succeed in an early bird business, you may find yourself shopping for a private jet.

The reason that early bird businesses work so well is maybe obvious. If you enter a market growing at, say, 100% each year, you have a great shot at growing your business by 100% a year. Grow your business at, for example, 100% a year for five years and you’ll go from $1,000,000 to $30,000,000 in sales. Yikes.

The “early bird” formula, unfortunately, suffers from a weakness–at least from the individual entrepreneur’s point of view: Potentially fast-growing markets are often well-known, highly-anticipated, and over-crowded with veteran entrepreneurs and venture capitalists. Furthermore, you get many “false positives”… opportunities that start out looking terribly promising but later fail to deliver.

Peter Drucker discusses these points at some length in his seminal work, “Innovation and Entrepreneurship.” But to sum up Drucker, early bird opportunities probably aren’t that practical for individual entrepreneurs to pursue. The odds for individual success are too low. Nevertheless, if you find and pursue one of these opportunities and you succeed, well, expect to see your picture on some magazine covers.

A final comment: While many people and perhaps especially refugees from super-successful entrepreneurial ventures like Microsoft and Google try the early bird formula, I really don’t see very entrepreneurs succeed in small business settings using this formula. In fact, I would guess less than five percent of my business clients successfully use this tactical approach.

Formula #4: “External Solution” Businesses
The “external solution” business formula may be the most surprising small business opportunity–at least to new entrepreneurs. But I’ll bet ten to twenty percent of the successful small businesses I see fall into this category. So let me explain.

Very regularly, a large organization like a corporation or a government agency has a problem that it needs to solve. But the organization doesn’t have the right person to deliver the solution. In these cases, the big organization commonly says to an individual, “Listen, we’ve got s problem we need solved. We don’t have anybody internally on staff who can deal with this. So, how about we pay you, like, $500,000 a year in consulting fees for the next couple of years? Sure, it’s a lot of money. But we need this problem solved.”

That sounds sort of crazy. But a significant number of small businesses amount to such external solutions the entrepreneur creates for a single large customer or client. These businesses represent wonderful opportunities for the entrepreneur. For one thing, the “external solution” business can be immediately profitable–and often highly profitable. Furthermore, the business’s lifecycle can often be planned with a huge degree of certainly because the business probably ends when the “solution” is delivered.

If there’s a mistake that people make with “external solution” ventures, it’s this: Sometimes the entrepreneur doesn’t recognize that this success formula typically provides a very short-term opportunity. Eventually, for example, the bridge gets built or the oil refinery gets upgraded. As long as the entrepreneur expects and is ready for the business to “finish,” nothing bad happens. But the “external solution” small business gets into trouble if the entrepreneur implicitly expects there’s another bridge somewhere that needs to be built or oil refinery that needs to be upgraded.

Formula #5: “Secret Sauce” Businesses
Not every successful small business uses one of the preceding four success formulas. In fact, there’s at least one other terribly common success formula that small businesses use: the secret sauce formula.

Probably the best way to begin thinking about the secret sauce formula is by looking at a successful franchise operation–something like McDonalds Corporation.

Whatever you think about the eating at the “Golden Arches,” you probably agree that McDonalds Corporation supplies its franchisees with lots of expertise about how to locate, setup and operate a fast food hamburger restaurant. Probably every element of the operation from French fry cooking times to bathroom cleaning procedures has been carefully thought out and is regularly re-assessed. In combination, this collective knowledge amounts to a secret sauce that McDonalds’ franchisees use to jack up their profitability relative to competitors that lack this information.

Good franchisers supply a secret sauce formula to their franchisees. (For a franchise royalty, of course.) But some entrepreneurs have developed the same sort of secret sauce. For example, a restaurateur may have learned where to locate, how to setup and how to profitably operate Chinese food restaurants, fish-and-chips shops, or hotdog stands.

Secret sauce businesses won’t look like other businesses. Even a bit of due diligence or research will indicate that such a business isn’t a job business, that it isn’t all leveraged up, that it isn’t based on a single customer or client, and that the business works for a reason other than fast growth in the market it serves.

In fact, if you do look at (or build!) a secret sauce business, you’ll realize that the business success flows from dozens or maybe even hundreds of smart decisions and clever improvements. This collection of decisions and improvements probably means the risks of a business using this formula are fairly low. But of course the secret sauce formula needs to be continually refined and improved. Otherwise the sauce will lose its zest and grow stale.

Additional Resources

Some of Stephen L. Nelson’s Small Business Do-it-yourself Resources

Posted in: Finance, Guest Posts

18 Comments on "The Five Small Business Success Formulas"

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  1. Don Willits says:

    The failure of our local Dream Dinners (and other similar “you come in and assemble your meals for the month in our kitchen using our recipie” franchises in the area) stems from a series of poor business decisions. Not the least of which was the owners loosing themselves in the cult of personality (look at us! we’re on a magazine cover!) and failing to look out for the individual franchise holders (each month had new recipies, requiring nearly new sets of ingrediants for the franchise holders to purchase, resulting in continous spending and little opportunity to leverage left-over supplies bought for the march menu in april. During a good economy, these poor decisions did not hit critical mass. Which is to say, that secret sauce without business wisdom ends up going to waste.

  2. Praveen Rangarajan says:

    Formula #1, yeah, me too !!

    Formula #2 is a very interesting read. It feels all too comfortable. But my catch is this. When there is a fall, there is a greater risk of the business collapsing altogether.

    I had this colleague, a Business Development Manager, who would swear by formula #3. He used to tell me, start this business, make money, and switch over. For the most part he was successful (not huge profits, but profits nonetheless). I find this synonymous to the short term traders in the stock market. Risky yes; but good returns if you strike it right.

    wrt Formula #4, Aren’t all the Service and Solution providers, “External Solution” businesses? Also, could it be that the corporation finds it cheaper to get stuff done outside than inside (even with a good resource pool)?

    My favorite in this Formula #5. Its good in two ways. One, you are forced to redefine your position every once in a while, and two, there’s a healthy competition between competitors.

  3. Rick Samona says:

    Great job of “demystefying” owning a small business. I like your points since they combine the art with science. The challenge I see is less with the business idea and more with “taking it to market.” Everyone has a great idea but taking it to market is the tough thing.

    Thanks for the insight!

  4. Giovanna says:

    I enjoyed reading this post. I agree with you that the early bird gets the worm. :) Thank you for sharing.
    Giovanna Garcia
    ImperfectAction.com

  5. J.D., thanks for bringing Stephen’s insights to us.

    Stephen, congratulations on your incredible success & thank you for explaining the Five Small Business Success Formulas. Entrepreneurs used to be one of the significant contributors to America’s success. I remain optimistic enough to believe that this is still true.

    Your clear, common sense characterizations are timely. My lovely bride are weighing our options & seeking appropriate an appropriate opportunity. We will remain mindful of your insights. Thank you for the guidance. Best wishes for continued success!

  6. #4 is my favorite w/o hesitation. ;)
    The risk associated with this is obvious to me either. Until now i would call my self as an intrapreneur – sort for entrepreneur but working inside the company. That is the reason I am constantly on the hunt for new bridges and new oil upgrades ;)

  7. Great advice overall, especially for this entrepeneur. I especially like the point about having to go back and re-assess, modify your secret sauce (Formula #5) — otherwise it loses zest and grows stale <– love it!

    –Kevin

  8. Thanks for comments and constructive criticisms everybody. Your feedback truly “tempers” the material and provides me with fuel for thought…

    Let me also specifically respond to a couple of things that Praveen shared… Apologies to you, Praveen, if I’ve been corrupted your points in any way through my editing (see italics below) of your words…

    …Formula #2 is interesting [but] feels all too comfortable.

    For the record, I agree. I sometimes tell people that making “leverage” your secret formula is a bit like saving time by skipping the work of fastening up your car seat belt. Most days, of course, not “buckling up” has no downside. At some point, however, you’re likely to experience catastrophic consequences from your decision to save time by not using a seat belt when you drive.

    All that said, however, and this sort of bugs me in a way, leverage does work most years. And if you’re not over-leveraged, you may even survive a serious internal or external shock.

    Formula #4, Aren’t all Service and Solution providers “External”

    Yeah, good point. Perhaps what I should call Formula #4 is the “single customer” or “single vendor” business. Or maybe the “dominated by a single customer” business.

    I was just trying to find a “handle” to use to refer to these small businesses you commonly see that are really all about solving, e.g., one customer’s problem. I am amazed at how many small businesses look this way once you see “inside” the business.

  9. Per says:

    Stephen, in this period of economic changes, sharing your wealth of information about startups is helpful.

    I assume that #1 may grow into include additional people and develop into a consultancy co in the IT space; or as a contractor in the building industry.

    Which brings me to what are the transitions or hybrids you see that works well? What are the risks?

    In general are there books – “dummies” are ok – or other sources you would recommend on how to be successful? My son is looking into either #1 or #2.

  10. Every business is risky as pointed out here. I think it comes down to doing what you love and finding the best way to bring it to market. #4 is probably my favorite, but not everyone can put themselves in this type of position.

  11. Gennaro says:

    The “Early Bird” business approach seems to apply to websites too. Being first to a particular niche or creating something new will often make a person an instant expert with lots of traffic and references going there way.

  12. To respond to Per’s comment, “Which brings me to what are the transitions or hybrids you see that works well? What are the risks?”…

    I think this is a really good question. But let me break my response into two chunks…

    TRANSITIONS: I think, ideally, one should transition from formulas 1 thorugh 4 to formula 5. In other words, ideally, you maybe start off as a job or leverage or early bird or external solution business… but at some point, when you get into competition with large, well-run competitors, you probably HAVE to use the “secret sauce” approach. At some point, your business model has to stand on a firm foundation of proprietary knowledge, well-engineered business practices, unique insights about your industry, etc. All this said, however, in my experience people don’t regularly transition from to formula #5. Maybe partly the lack of transition probably stems from fact they don’t feel any immediate need to transition when the “leverage” formula, say, or the “early bird” formula is working well? And maybe partly the lack of transition stems from fact that if you’re making a “job” business work or an “external solution” work you don’t have much time? (In a “job” business, you’re probably selling all your hours to maximize your profits. In an “external solution” business, the short lifecycle of the business doesn’t give you much opportunity to accumulate a bunch of specalized knowledge.

    HYBRIDS: This is an interesting idea. In my practice, as odd as this may seem, I really pretty easily classify most small businesses using the classifications provided above. But there probably are people combining “formulas”… Also, I would wonder if a “hybrid” approach probably (using my very simple taxonomy) almost automatically and very quickly looks like a “secret sauce” formula. E.g., a wee bit of financial leverage might be one of the tools you use in a secret sauce business to jack profitability.

    Good questions, Per.

  13. Salwa says:

    Great article. Have really enjoyed reading it!

    I so agree with you on the “Early Bird” business approach. In any type of business, let it be online or offline. Being first will often make a person an instant expert.

  14. JD,

    Once again you have done a great job by getting Stephen L. Nelson to post on the blog. The post does a great job of of explaining and guidance for owning a small business.

    The biggest challenge is not striking a good buisness idea, but how to go about executing it and make it viable in a competitive market.

    I like the early bird formula, makes lot of sense, and guess applicable universally.

    Thanks for great insights.

    Regards,
    prashant

  15. offshore ibc says:

    The early bird gets the worm. I love that one.
    Good read.

    Daniel
    Pibc