Comparing Business Opportunities
Business owners who have capital to invest will be inundated with ideas for spending it: run a new advertising campaign, buy new tools which will improve operational efficiency, hire a new salesperson… The list goes on and on. Many of these proposals, when examined in a vacuum, will sound like great ideas, but how can we compare them in an apples-to-apples way in order to make decisions?
At Setaris, we take the standard “business school” approach and modify it in light of the particular circumstances that face small businesses. This lets us make sure we’re working on our best opportunities without requiring too much overhead.
The Standard Approach
You may be familiar with Return on Investment (ROI) and Net Present Value (NPV), which are two of the standard tools used to financially analyze and compare business opportunities. The problem is, for many of the opportunities, it is difficult to quantify what kind of return you’re going to get. If you run an advertising campaign, how many leads will you generate, and how many of those will convert to sales? How much will gross margins actually improve if you retool your assembly line? Depending on which estimate you use for these numbers you may find that your calculated ROI varies from a large, exciting number all the way down to a negative value.
Larger businesses address this challenge by hiring consulting firms, performing market research, and studying previous projects that were similar in nature. Small firms often go in the opposite direction and give up on the process entirely. In this case, capital budgeting becomes an ad hoc process: Sales have been slow for several weeks, therefore we need to update our marketing material! Investment decisions often end up being made without considering the opportunity cost of foregone alternatives. Decisions are made on an emotional rather than rational basis, and the business owner loses the significant advantages and insights that can come from using quantitative tools like ROI and NPV.
The Middle Ground
At Setaris, we’re strong believers in the importance of adhering to a formalized capital budgeting process, but we want to avoid confusing ourselves with the false precision of detailed ROI calculations. We achieve this by using ROI and NPV analyses as heuristics, mental models that guide us in the right direction. After all, the underlying logic of these tools is completely sound; the problem is just that it’s very difficult to quantify the inputs with precision.
We hold a weekly capital budgeting meeting to discuss any available investment opportunities. We briefly review all the opportunities we have on the queue, let each opportunity’s advocate explain their thoughts on what kind return we can expect from the investment, and then weigh that against returns that are available from other projects. Again, we avoid trying to calculate precise ROI numbers. Instead, we focus on what we can say with confidence. For example, are there two projects that require similar investments? If so, can we say for sure that one will provide a bigger pay off than the other? If you repeat this process you can filter out opportunities that are clearly inferior and get down to a list of your best choices. Here are some of the principles we use to compare investments while avoiding, or limiting, the use of NPV calculations:
- Round uncertain benefits down to zero. If you can’t comfortably put a floor (i.e. a minimum value) on a benefit you’re going to get from an investment, then round it down to zero. We generally don’t take equity from our clients because we can’t, with certainty, put a minimum value on a start-up venture.
- Ignore benefits you expect to receive far in the future. It’s very hard to say with certainty that a benefit will accrue after 3, 5, or 10 years have passed. It’s better to focus on investments that pay off in short-order. With this in mind, when we make marketing investments we don’t assume that we’ll have a perpetual relationship with the client. We want the relationship to be profitable, when marketing costs are factored in, even if it only lasts for a short time.
- Compare rather than calculate. When it’s hard to quantify multiple numbers (e.g. the goodwill you engender with clients for taking certain actions versus the cost of those actions), focus on whether you can say with confidence that one is at least bigger than the other. We often choose which marketing channels we want to target by comparing them. It’s hard to know how much we’ll be able to sell through any channel, but we can often be pretty confident that one channel will outperform another.
- Focus on your best opportunities. Small businesses should avoid investments that aren’t overwhelmingly compelling. Opportunities that have the potential to be home runs will provide a much higher likelihood of rapid growth. We’re frugal by nature but we avoid spending too much time on squeezing costs because the upside is limited.
- Keep your investments small. We find it helpful to think of each opportunity as an experiment or bet. There’s always a chance that something will go wrong. If each project only requires a small percentage of your business’ equity then it’s much easier to recover from mistakes. At Setaris, we apply a percentage-of-equity limit to our investments.
That should give you a sense of how we make budgeting decisions here at Setaris. Next time you’re considering several opportunities for your business run through the list above and see how those guidelines can help you come to a decision.