We are a part, albeit a small part, of the angel community in Richmond, Virginia, where we live. Over the past several years, various entrepreneurs have approached us to invest. We have listened to dozens of pitches and invested in a few. How do we decide which business we will sink our hard-earned cash into?
We have a slightly different model than most investors. We aren’t necessarily looking for the “new, trendy or sexy” business. No, instead, we often invest in those in a favorable industry.
How do we define this? A favorable industry is growing, is profitable and is low risk. The reason for a “favorable” rating is straightforward: The value of your business will increase only if it grows and/or profitability increases.
As for risk, lower risk is better, of course, because you want the growth and profitability to continue. Here is more detail about these attributes:
No industry can grow at a rate that exceeds the GDP growth rate forever — say 2 to 3 percent in the United States. However, as the National Federation of Independent Businesses has said, many industries will exceed this growth rate in the short term. That’s why we look for an industry that is growing. A rising tide raises all boats.
For instance, in the past five years we have invested in, among others, a construction firm, two property-management companies (commercial and residential) and, in a move that somewhat broke our pattern, a startup technology that serves the property-management industry.
We avoid industries, on the other hand, that are being or are likely to be overtaken by new technologies. For example, we wouldn’t want to invest in a business that manufactures CDs. CDs are quickly going the way of vinyl records.
This is self-explanatory: industries likely to be profitable in the end share several characteristics:
3. High barriers to entry by others
Profitable industries tend to attract new entrants. And those entrants will compete for profits right away. As a recent post on Cleverism.com explained, existing players in these industries will strive to create and/or maintain barriers to entry, because high barriers to entry protect industries from new entrants.
What do high barriers mean? They might mean that the industry is costly to enter, because it requires rare, specialized skills or is one with protected intellectual property. For example, three entrepreneurs with a medical device needing funding recently approached us. The consideration before us was that the hurdles for bringing a new medical technology to market are high. But, if the technology succeeds, those same barriers to entry will help protect the product’s profitability.
4. Low barriers to exit
If the time comes when there is excess capacity in the industry, companies need to be able to leave. If they can’t leave, they will compete away all of their profit — a result when too many businesses chase too little volume. Low-exit barriers allow marginal operators to leave a business rather than make the industry unprofitable for everyone.
5. Ability to differentiate your product or service
In a true commodity business, where no one company can differentiate its product or service, the winner will be the competitor with the lowest cost. The problem is that small, growing businesses can rarely maintain a low-cost position.
That’s why we look for industries where the product or service can be differentiated. Then the business can focus on the market segment that values the things that make its offering different. We also want to make sure that competitors can’t easily copy whatever it is that makes the product or service different.
6. A position of strength vis-à-vis suppliers and customers
Suppliers will want to charge as much as they can. Customers will want to pay as little as they can. Obviously, if suppliers and customers are successful, profit will evaporate. Instead, we look for a situation where suppliers compete away the profit in their industry by selling to us at low prices and where customers are willing to pay a premium for our offering. We look for an industry where the participants are in a position of strength so that they can maintain good profit margins.
7. Low risk/low volatility
Businesses that are currently profitable and growing can become a nightmare if the situation changes quickly. We look for industries that are stable and low risk. Examples of risks to avoid are:
Regulatory risk. Many industries are heavily regulated. A 2014 study by George Mason University listed various manufacturing, financial services and health sciences among the most regulated industries. New regulation can destroy an industry’s profitability overnight. For example, the Affordable Care Act threatened to put independent health insurance brokers out of business. This hasn’t happened, but many in this industry remain fearful. Avoid industries likely to face new regulation.
Spoilage risk. If unsold product becomes worthless, competitors may cut prices significantly to sell the product rather than lose it. Airline seats are a good example. Once the plane’s door closes, unsold seats are worthless. Airlines have a significant incentive to cut price rather than fly with empty seats. As a result, profits in the airline industry are notoriously volatile.
Overall, it’s hard to find the perfect situation. We always have to accept some compromise. However, if you are looking to buy or invest in a business, we suggest that you try to find an industry that meets as many of the above criteria as possible. They will improve your chances of success.