Tuesday, September 18, 2007

Six Filters for Business Evaluation

I am currently reading, Seeking Wisdom: From Darwin to Munger. The book seeks to provide guidelines for better thinking, explain what influences our thinking, and delves into the psychology of misjudgments. All topics of real interest to investors.

The book leans heavily on the writing and speeches of Warren Buffet and Charlie Munger. It reads like a reference book - with each chapter full of terrific nuggets of wisdom and quotes to remember.

The book includes a useful checklist for business evaluation. All investors, like pilots, need to have a checklist to ensure consistent best practices in decision making. At Hummer Winblad, we put together a checklist for every deal.

The book's checklist follows. While perhaps the book's list is not perfectly suited for early stage investing....like many frameworks, the real value lies not in the specific framework itself, but in the consistent application of a mental model that ensures diligent analysis and carefully weighed decision making.

Filter 1: Can I understand the business - predictability?
Reasons for demand - how certain am I that people are likely to buy this type of product or service? why will they buy? what are the benefits?
Return characteristics - Industry and company return characteristics and change over the last five years? Is there a business model comparable that has made real money for its investors and management team and proven the operating model's economic value?
Industry structure - (a la Michael Porter), no of competitors and size? Who dictates terms in this industry? Do I know who is going to make the money in this market and why?
Real customer - who decides what to buy and what are his decision criteria?

Filter 2: Does it look the business has some kind of sustainable competitive advantage?
Competitive advantage - can I explain why the customer is likely to buy from this company as opposed to others in the market? what is the basis of the advantage - market knowledge, execution strength, or technology?
Value - how strong is this advantage, does the advantage benefit from network effects or scale that will make it stronger and more durable over the years?
Profitability - can the advantage be translated into profitability and why?

Filter 3: Able and honest management?
Is the team competent and honest? Do they understand the market and are they focused on value creation for the owners of the business?

Filter 4: Is the price right?
Can I buy at a price that provides a good rate of return with an adequate margin of safety?

Filter 5: Disprove
How can the business get killed?
Who could kill it?
If it failed, what are the likely internal and external causes?

Filter 6: What are the consequences if I am wrong?

At Hummer Winblad, we add:
Filter 7 - what disruption will aid the company is driving growth?
What wave will the company ride that rewrites the operating dynamics of the industry and drives the reallocation of capital away from old models and technologies to new players in the market?

The book is a fun read and one to have on your desk.

4 comments:

  1. I have to admit the book is great and a personal favorite of mine, but hunting down a copy was a bit difficult (have to call a bookstore in Omaha and order it over the phone). It's one of the few books that can have relevance to just about everything you do.

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  2. What would be really interesting is to take those 7 filters and apply them individually to the Techcrunch 40 going on right now.

    I suspect that few would make it all the way through.

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  3. Thanks for the detailed review! Very informative and useful.

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  4. I have enjoyed the renewed discussions on business models. This critical area has been ignored for too long. Many times, competitive advantage and business model are used interchangeably. While vitally important, competitive advantage is only one of the eight components of a business model (see Business Model Institute).

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