CDs and Sunglasses – Not all $ are created equal

One afternoon, a long time ago, I was taking a stroll on Times Square and made a snap decision to buy a digital camera to bring as a gift to my parents on my next visit. I walked into one of the touristy electronic stores.

The owner, some enthusiastic chap, thought it worthwhile to rehearse his cross-selling skills on me. He offered some CDs at a discount, which I refused, then tried to hustle me into buying sunglasses, which I needed since my “future was so bright”. I laughed. I walked out when he began peddling a suitcase to use on the trip.

Fast forward a few years, I was looking at a business that had high revenue growth, good gross margin and a clearly defined path to profitability. I asked the owner to send product samples to my office. His response raised a red flag – the company had about 500 SKUs. I backtracked and asked him for the revenue breakdown of his products. Suddenly, the growth rates for most were no longer as impressive. I dug a bit deeper and the gross margin didn’t look so fat after untangling all the “adjustments”. The entrepreneur had an explanation. The company had started off selling fried plantains and when those didn’t seem to stick, it launched popped potato chips, but then decided to just extend the product range to air-dried and then freeze-dried fruit and eventually… candy, to fully attack the snacking category. I took the opportunity to share the CD and Sunglasses lesson.

For companies that are having difficulty cracking a desired core market or finding product-market fit, the path of least resistance is to start selling something else, kind of related, but fundamentally different. All products above are snacks, but plantains and potatoes are sourced from different places. And, though they sound very similar, air-drying and freeze-drying are totally different manufacturing processes.

For entrepreneurs with a mission to build a brand, launching multiple products is often poor strategy because of the inefficiencies and high cost of working with small batches. Also, an eclectic product mix makes it challenging to build a coherent story that justifies putting everything under one brand umbrella. Brand building requires patience and rigorous testing in order to establish a match between product and market. Rather than launch a new product, investigate who likes / hates your product and why. Rather than add a new feature, consult your customers on adjustments that could improve the utility of existing functions.

As an investor, I spend time identifying the core revenue of a business and analyzing its: Characteristics – distribution methods, elasticity, psychographics etc.; Scalability; and Economic expected value. I avoid assigning credit to CDs and Sunglasses.

I will cut my entrepreneur friend in New York some slack. He probably wasn’t trying to build the next biggest brand in electronic products. He was just an opportunistic middle-man in retail, searching everywhere for a decent mark-up to cover his hefty New York rent.

The fundamental unit – Lesson from a botched interview

When I was in business school, a close friend made a referral for a potentially prestigious role with one of the leading private equity firms investing in Africa. This was an opportunity I was desperate for. One of the partners at the firm invited me for a coffee chat in San Francisco.

When we met, I was relieved to see that he hadn’t brought a computer with him. I had purposefully left mine at home to avoid being ambushed with an on-site modeling exercise. After we ordered our drinks, we had a small chat and I was doing really well showing off my knowledge on different industries and business models.

The partner then pulled out a piece of paper and sketched out a short five-year financial summary for a “hypothetical” company. He then asked me to model a “quick” leveraged buyout analysis by hand. I got all the mechanics right, double checked my mental math and handed it back to him with that “nailed it!” grin. The exchange that followed was one of the most important lessons of my life and one of the reasons I decided to write this blog.

In my cash flow statement, I assumed no changes in working capital; no investment in capital expenditure and made silly assumptions on other fundamentals that were meant to make the arithmetic easier to perform. After reviewing the model and obviously in a state of total flux, the partner asked what type of company I was presenting and in what industry it was? I briefly tried to get the focus back to my mechanical prowess, but he became so infuriated that I ended up apologizing for wasting his time. 

The partner told me that he gives the same test to everyone who applies for a job at his firm (Analyst to Principal) because the fundamental unit of investing and entrepreneurship is the same. However, the depth of analysis and debate that is expected changes dramatically for every role. As a Senior Associate candidate, I was expected to ask relevant questions and make credible assumptions about all operational aspects of the business – Growth stage of company; Unit economics; Capital structure; Working capital requirements, Investment in capital expenditure. I was also expected to debate other investment considerations – Effect of investment cycle; Exit considerations and multiples etc. The work I had submitted was only good enough for a summer analyst.