Economics of a new business

1. Economics of a new business How to evaluate a new venture Buzzwords you will see This is about math, but few people understand math. There are a lot of ways to fiddle numbers, even without going into the Enron/Worldcom illegal ways.

2. Risk v. return You need to get more return if you are making a risky investment. Even straightforward securities investments involve a risk v. reward or a volatility calculation. Market investments are rated by “beta” (β): the expected ratio of the swings in price of this particular investment compared with the general market.

4. Estimating revenue How many can we sell? How much can we get for each one? A note of realism: How much do people spend today on comparable products or activities? What is a credible market share? How quickly can we reach a proposed revenue level?

5. Supply-demand curves

6. Visiting a library

7. Price=incremental cost This is the mantra of traditional economics. (Incremental cost is the cost to produce one more unit of whatever we are selling.) If price is above incremental cost, somebody new will enter the market, increasing supply and pushing down price. If price is below incremental cost, some producer will leave the business, reducing supply and raising the price. For example, airfares go up and new airlines start operating; or airfares go down and some airlines go out of business.

8. Economies of scale In a traditional price-quantity plot, the cost per unit goes up as more units are needed. Think of an 18th-century Cornish tin mine: the most easily accessible tin ore is dug up first. As you need more tin, you must dig deeper, or use ores that are not as rich, or dig in difficult (e.g. wet) places. And thus increasing production involves a higher cost for each new ton of tin produced. Today, in a great many industries, the price per unit goes down as the number of units made increases. Information industries are particularly prone to this: all the cost is in producing the first item, and copying it is often almost free.

9. Silicon chip making A modern fab line (a foundry to make chips) costs $1B. It will only be current for a few years: figure $1M/day. A mask could be $10M. The fab line can produce 50,000 wafers/month, with 100 chips on each wafer. The cost of silicon and labor are insignificant. So: if you can sell ten million of your chip, the cost is $1 for the mask and you need the fab line for 2 months or $6/chip, so your cost is about $7/chip. If you can only sell one million, it will be $16/chip!!

10. Estimating profit What will it cost to make something? Materials, labor, capital investment. (It’s not unusual for the list price of a computer gadget to be 4X the parts list cost.) And also… retail markup (often 40% of a purchase price) marketing costs (often 20%) overhead, interest, …

11. Estimating profit A typical new product plan thus revolves around (a) how long and how much money will it take before we can start delivering; (b) how much can we make as we sell it? The up-front cost is capital investment which is divided over the total number of sales. There are many opportunities to be optimistic about initial costs, sales volume, lack of competition, etc. There is also a lot more to sales than having a better mousetrap: time and chance happen to us all.

12. Don’t use cost-based pricing Suppose you made your $10M mask. Now you find you can not actually sell 10 million of them at $8 each. What now? If you can sell 1 million at $7, you might as well. You’ll clear $1M over the fab cost. You’re not making back your $10M, but that’s spent (“water over the dam”). Would you be better pricing at $15? And selling only 100,000 (but ostensibly “covering your costs” on a forecast of 1M sales?) Clearly no: you’d only make $900K over fab cost. What if the best price you can get is $5? Then shut down (unless the fab line is going to be idle…)

13. Don’t use cost-based pricing (II) • Suppose some TV personality has called your gadget the best thing since canned beer, and people are paying $25 to get it. But you still think you can only move about 10 million of them, max. • Should you (a) keep selling at $8 and sell 10 million or (b) sell at $25 and sell only 5 million? • gives a profit of $10M but • gives a profit of $85M. No contest. • For example, when The Producers on Broadway found people scalping their tickets, they raised the top price to $480 each.

14. Buzzwords on return ROI: Return on investment. This is the goal: how much can you earn on a dollar you spend ahead of time? The project, to go forward, will have to show that it will outperform the S&P 500, and the existing business. ROI: profit/investment. (But usually measured in %). However, it’s easy to distort profit by adjusting some of the non-cash items, e.g. changing your guess on how long the fab line will last. EBIT: Earnings before interest and taxes. EBITDA: earnings before interest, taxes, depreciation, amortization. These last two are a little easier to compare.

15. More on return Remember, however, that the other expenses are real. Taxes have to be paid. This is not optional (except in some acquisition scenarios about tax losses). Depreciation and amortization are real if you are going to stay in business. So is interest. So a lot of people would prefer simple, “cash flow” (but for a capital-intensive operation, this leaves out a lot). And so you have “free cash flow” (cash flow – investment). Sounds great, right? But Wal-Mart had negative free cash flow during most of its growth (they spent a lot building stores but each earned enough to pay its mortgage). “There are three kinds of lies: lies, damn lies, and statistics” (Benjamin Disraeli and then Mark Twain)

16. Recorded music The $15.99 you might pay for a music CD goes to:

17. Time matters “Burn rate”: how fast is the new operation or company going through its start-up funding? “Break-even”: when does it stop requiring new funding? These apply mostly in the venture capital scenario: a group of investors offers money to some entrepreneurs in return for some stock and a business plan. Typically a new startup promises break-even in 12 months, needs new capital then, fails again to break even in 24 months, the venture capitalists throw out the original founders, and after 36 months the place is closed down. Venture companies are however unusual: the goal is typically to sell the company, not the product.

18. Network effects Some products require many people to have them. It’s no use being the only person in town with a tennis racket. Communications technologies are particularly prone to network effects, also called network externalities. Perhaps the most important example right now is eBay. Everyone wants to sell and buy in the market that offers the most choice and eBay has managed to dominate. Another example is the successful effort of Microsoft to get people to send email in Word rather than Ascii, so that the recipients will have to buy Word* *(If this bugs you, see the freeware antiword).

19. Blades v. razors John D. Rockefeller (the first) gave away kerosene lamps. Traditionally, razor blade companies sold the razors very cheaply, to make money on the blades. Similarly, Kodak used to sell very cheap cameras as a way of encouraging the use of film. Today, cellphone companies provide the handset cheap to get the contract. It works if you can guarantee the consumer will use your product for the “refills”: you might be a monopoly (Standard Oil, Kodak) or you might use a proprietary format (razor blades, toner cartridges, cellphones). Once in a long while, you give away razors to sell blades: e.g. public domain ebooks to sell the hardware, iTunes for the iPod, and the early RCA radio network.

20. Profit v. market share There is a Japanese marketing style of “get market share first and profit will follow”. It works in industries with large economies of scale, in a country where many companies are parts of large groups. (For example, Mitsubishi makes not only cars and heavy machinery but also Nikon cameras). This has also worked for Amazon; it lost money for years but now it’s cashing in, and “Borders.com” is no more.

21. Amazon, operating income Millions of dollars, year ending.

22. How sell the new plan? Inside a company, people are likely to want lots of detail. Plans will have numbers, charts, projections, and so on; hundreds of pages are not unusual. Venture capitalists don’t have time to read plans. They get oral presentations, with a couple of sketch pages, and make a personal reaction to the people doing the presentation. Of course, inside a company, the plans may exist, but the decision is likely to be based on personal experience anyway. With luck, the purpose of the plan is to guide the new operation, at least in initial stages.

23. SWOT analysis Good Bad Inside Outside

24. Strengths Exclusivity: patents, trademarks Complementing: familiar customers, channels Resources: investment, staff, location And, of course, a presumably superior product/idea. Investors tend to like exclusivity. Thus, lots of patents. Patents also boost resume of engineers, and roughly you get 4 patents per patent lawyer you employ.

25. Weaknesses Staff, locations, equipment not up to the new challenge. High costs Technology not the best. Marketing weaker, or brands not as well known. Difficulty raising capital. Labor problems. Poor history doing similar things. Note that weaknesses may mean “we might fail” or “we might not even get started”.

26. Opportunities New technology. Demographic trends. Fashion or taste. New locations (including internationally) Re-use of existing facilities.

27. Threats Competition, especially price competition Nowadays, particularly global competition. Substitute products. Bigger competitors. Also, large suppliers or customers. Threats can be unusual: in early 1990s heard a military contractor talk about the “problem of peace in Europe”.

28. Example: i-Pod Strengths: built on Apple reputation & abilities in music Opportunity: new technology for digital music Able to gain exclusivity via proprietary audio format. On the other hand… Lots of other people could make & sell similar devices Recording industry might have made trouble. So as usual, it’s only easy in hindsight.

29. STEP analysis Social, technical, economic, political. Also known as PEST. Most usual for international businesses: which countries are appropriate for investment. For example, in the 1960s and 1970s, mining companies switched their investment from Africa to Australia, accepting lower quality ores and higher wages in exchange for political stability.

30. Sample financials OPERATING EARNINGS From a Texas “moot corp” business plan contest; this is for distributing health care information to Hispanics and selling advertising on the way.

31. Summary A credible business plan involves a proposed product or service, a schedule for going to market, financial projections and a broader discussion. Many of the numbers are doubtful. Nevertheless, it’s useful to try to understand what might happen; there are some businesses that start with what seem unbelievable plans (e.g. selling cat litter online) and in most cases they go bust.