During his recent interview with Tobias, the man behind the pseudonymous Twitter account, Bluegrass Capital explains the importance of understanding the customer value proposition, when analysing potential investment opportunities. Here’s an excerpt from the interview:
Tobias Carlisle: Okay. So you very kindly sent through a little bit about your investment process beforehand. So the first step in your investment process is to start with a customer value proposition. So can you walk us through how you make that assessment?
Bluegrass: Yeah, absolutely. It’s just on the micro level. Before we even get to unit economics, just think, does this product need to exist? Do customers want this? I mean, does anybody want to watch MTV? No. I mean, so it’s like, I think you can just stop your analysis there for various reasons, if that’s what you decide, but you think of other things it’s like, do people want food delivery? Well, yeah, they really do. People really like having stuff delivered to their house via Amazon, or Dominos pizza, or whatever. So the idea of the value proposition is the customer want this so they better off for it? And if they are and they like it, and it’s something they can buy frequently, repetitively, then you start going further down the list of, does this transaction actually make money for the company?
Bluegrass: For some businesses that are good businesses, it does, they have positive unit economics. For some it’s still debatable. Does Uber have positive unit economics? Does Netflix have positive unit economics? Maybe, maybe not.
Tobias Carlisle: And then, okay, that makes complete sense. So you’re trying to work out, does this product or service help the customer in some way? Does it cut some costs out of what they’re doing? Does it provide a service that they’re prepared to pay for? Then you’re looking at, and this is probably most applicable to software as a service type business, is that fair or is this for any business?
Bluegrass: No, for any business. I mean, like pest control. I don’t want roaches and spiders walking around my house. And my wife if she saw one, she’d be really upset with me. So, it’s a small relative cost, whatever $20 or $30 a month or something for the pest people to come by. It’s non-discretionary basically. They raise the prices 3% or 4% every year and we don’t even think about it. I mean, so that’s the value proposition. I don’t cockroaches in my house, you have the specialty chemicals if you’re Rollins or Service Master to do that, and where to spray and I don’t. And I don’t want to crawl under the house, and I don’t want to get onto the roof and put screens over my gutters to protect squirrels from getting in my attic. I’m sorry, I’m just going on too much of a tangent.
Tobias Carlisle: No, I love it.
Bluegrass: It applies to any business. I mean, it’s like, should this business exist? Do people want it? I mean, do people need this service or product? And a lot of companies you can just look at and it’s like, no, or there’s 100 competitors and … or you can do it yourself, there’s no reason to pay somebody else to do it. So it just fundamentally before you even get to the, does this business make money at the unit economics level? Just think to yourself, do I need this? Do I want this? Is this valuable to anybody? If this business just fell off the face of the earth, would anybody care?
Tobias Carlisle: Right. That makes sense. So then you next look at the unit economics. So for all the star companies, let’s say all the star businesses this was a question of building up the store or whatever the case may be, and then what return can we expect on that, and then if we’re building out X number of stores, we’re going to see, at least up front, there’s going to be some investment, there’s going to be negative cash flow depending on how they depreciate, it could be negative income impact. And then you’re saying that some stage they start overwhelming the growth and the payback starts overwhelming the cost to install it and it becomes profitable and that’s the curve that you’re trying to build. So that’s the unit economics. Is that a fair description of the unit economics?
Bluegrass: Absolutely. Yeah. I was probably long winded on the opener. But my favorite example, as far as the physical tangible model, is Dollar Tree. If you look at Dollar Tree, which is a Dollar store operator, competitor of Dollar General, if you look at Dollar tree’s I think it was 1995 IPO prospectus, I think on the cover page, it just basically identifies, they outline their unit economics on the front page. And it’s basically like it costs us $300,000 to open up a new store. And in the first year we generate … No, it’s $150,000. And in the first year we generate $170,000 of EBIT for that open store. So the payback on that store is six months, or eight months, or something.
Bluegrass: And so the thought there is if being you, if we just had a couple $10 million or something, and we could just spend $300,000 or $200,000 to open Dollar Tree stores, you and I wouldn’t care what the profit and loss of the store was on gap. We just knew that if we open one, it’s going to pay us back in six months, and then the store will still be there, and people will still be going to it, and it’ll still be profitable. We’ll just take any profit comes from that store and open the next door.
Tobias Carlisle: So you’re looking for these companies that can grow very, very rapidly and you’re trying to find them at a fairly early stage in their growth curve where the profitability is somewhat hidden by the fact that they’re still growing and reinvesting at a high rate, is that fair?
Bluegrass: That’s a yes. I’m not intentionally trying to look for companies with those characteristics, but the response I would give you is, I do see a lot of hidden value or a lot of misunderstanding in the current market for businesses with those characteristics. I think it was widely misunderstood seven, or eight, 10 years ago. I think it’s a lot more common and understandable now especially as a lot of funded businesses remain private longer. And as we’ve had the proliferation of Twitter and medium and other blog formats venture capitalists share a lot more information about these companies that are still private. So I think they’re helping educate investors.
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