A framework to analyse, understand and invest in businesses (Part 1 of 3)
What analysis would you do before deciding to invest in a company?
Here’s a framework drawn from a compilation of ideas from different sources like investment notes, Twitter threads, podcasts, blog posts, and my experiences.
Not all steps are necessary for all businesses, but going through this checklist will generally ensure you are well placed to make the investment decision.
In Part 1 of this post, I will try to unravel the first two steps of the checklist…
1. Understanding the business
Part A: ADEPT method
Everyone knows what Domino’s does - sell pizzas.
But for some businesses, this basic premise may not be as easy to intuitively grasp.
For e.g. what the hell does Appen do? You know it’s something to do with technology definitely. Machine learning or AI (artificial intelligence) maybe, but what exactly?
I found that using the ADEPT Method (or any variation of it) to be a useful starting point. (The original post uses the method to explain concepts in math)
Let’s try to untangle Appen using the method.
So what does Appen do?
Analogy: It’s like an adult teaching a child how to identify things.
Diagram:
Source: Appen investor presentation
Example: A group of people name/label things (car, lampost, dog etc.), the data set is then fed to AI computer models. The models are then fed real-world photos of things and tested if they can identify correctly. The process is repeated till models improve
Plain English: Appen collects and labels images, text, speech, audio, video, and other data used to build and continuously improve AI systems
Technical: Appen is a provider of training data/ labeled data used to teach AI models or machine learning algorithms to make proper decisions
The broad idea with this method is to start with a simple analogy and slowly progress to the technical terms.
As you may have guessed, this step is not appropriate nor needed for simple to understand businesses, but can be super useful for complex businesses.
Having understood what the business does. The next step is to understand if it does it well enough.
Part B: Product-Market Fit
The three components for a successful business have been reasoned to be
an innovative product
supportive markets
and really good people (management)
So why focus only on the first two aspects, you ask?
Here’s Andy Rachleff (co-founder of Benchmark Capital) to whom the ubiquitous term ‘product-market fit’ is attributed
You want products that are bought not sold. When people want to pull it out of your hands that's product market fit
A product’s value hypothesis needs to be driven by what markets desire about a product and what other products don’t have.
Andy continues
When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens.” “If you address a market that really wants your product — if the dogs are eating the dog food — then you can screw up almost everything in the company and you will succeed. Conversely, if you’re really good at execution but the dogs don’t want to eat the dog food, you have no chance of winning.
A ‘great’ market can be seen as a market that is desperate for the product. This ensures a pull effect on demand instead of a push.
And while it would be amazing to have a ‘great’ team it is more important to have a ‘great’ market.
Probabilistically, backing a company with a ‘great’ market gives you a better shot at picking a valuable company than backing a company with a ‘great’ team
Unfortunately, there is no formula to check if a company has achieved product-market fit. However, there are many anecdotal markers which include
Growth achieved primarily through organic word of mouth (meaning very low or negligible customer acquisition spend - think Atlassian)
High growth in average revenue per retained customer
High Net Promoter Scores (NPS) of at least 40 or higher
A good example of the above is Brisbane-based Octopus Deploy, which recently raised US$170m from US-based Insight Partners. This was the second biggest ever venture capital investment in an Australian tech company.
Founded in 2011, Octopus bootstrapped for the best part of the last decade before finally taking outside investment. This signifies organic word-of-mouth-led growth. Not surprisingly, they also reported an NPS of 65+
Here’s Insight Partners describing Octopus’ market’s desperate need for their product
As the software ecosystem continues to grow, the market demands better, faster, and more frequent software releases. Once code is written, compiled, and tested, it then has to get deployed into production. This is where things typically break down – traditionally, deployment has been a manual and complex process, and oftentimes the most challenging and fragile part of the software development pipeline.
And Octopus’ great product value hypothesis
Octopus first enables developers to easily and automatically deploy to target machines both on-prem and in the cloud, and ensures that all deployments are correct and consistent between environments. From there, Octopus closes the gap between deployments and operations with runbook automation, enabling teams to define, manage, and execute runbooks in a productized way to keep software running smoothly
Having understood ‘what is the company doing’ with Part A and the ‘who is it doing it for’ in Part B, it’s time to move on to ‘how is it going to make money?’
Part C: Business model
The next step is to understand how the business makes money?
This thread does an excellent job of summarising the most common business models
It also notes the KPI that needs to be optimised under different models.
Another good way to unravel this is by getting your hands on the income statement and review the key revenue lines.
Here’s a summary of operating revenues for Pushpay Holdings
Source: Pushpay Annual report
This makes it clear that Pushpay makes its money from subscription revenues and processing revenues. If you dig a bit further, the companies will also elaborate further
Subscription revenue comprises recurring monthly and annual fees for donor management and church management systems provided to Customers
Processing revenue consists of volume fees that are primarily based on a percentage of the total dollar value of payments processed.
In other words, Pushpay’s business model is two-fold, i.e. #3 Take a cut and #4 Charge a subscription.
Having fully understood the business, it’s time to understand the ecosystem and the opportunity.
2. Understanding the opportunity
Part A: Key insight and sizing (Total Addressable Market)
This part is perhaps one of the most critical parts of the investment decision.
Essentially, this is the thesis or the belief you have about the company based on multiple factors such as the company’s strategy, global trends, and your views about the future.
For example here is the core insight driving Octahedron Capital’s investment in Peloton
Once you have the core thesis - you can then go and find evidence to support the thesis. This will be done through all the other steps in this framework.
Conventional wisdom from big hitters like Sequoia Capital has always been “target big markets” - mainly because companies that have a large market to capture
Below is an example from Peloton’s investor deck deriving the total addressable market of users
Typically, such calculations start from the overall demographic and work their way down to the potential market size of users
Source: Peloton investor presentation
However, as you can imagine - calculating TAM is more art than a science.
Thus unsurprisingly, there are a few who feel it’s an exercise in futility. Airtree’s John Henderson asked Does market size even matter?
He concurred with Reed Hastings (CEO of Netflix) who said this
“Typically, venture capitalists say that you want to go after the largest market possible. I’ve always thought that’s crazy because you can’t defend it …. I have always thought you want to go after the smallest market possible that can hold your 5- to 10-year growth ambitions.”
In other words, what is key to understand is not that the addressable market is super large BUT is large enough to accommodate the company’s growth plans over the next 5-10 years.
Part B: Overview of the ecosystem, who are the competitors?
Under this step, the aim is to understand the different players influencing the ecosystem in which the company operates such as the suppliers, regulators (if any), and competitors.
For example, let’s say you’re buying your morning coffee. You take out your phone, with Apple Pay installed and linked to a debit card, and tap it against the terminal.
Here’s an overview of the entities involved in making the transaction happen
If you planning to invest in a fintech company providing services to the merchant - it makes sense to first understand the chain of events and all the parties involved.
On the other hand, if you fancy a BNPL player, would be useful to first review this summary of global providers …
and then understand the differences in their distribution models
This will help in getting a strong understanding of the industry dynamics and the competitors facing a particular business.
I will wrap up part 1 of this post series here. More to come in parts 2 and 3.
It’s been a while folks! The last couple of months have been eventful on a personal front (having moved from Auckland to Sydney)
Here’s to being more consistent.
Cheers!