Daryl’s “Rule of 30”

Some blog posts are silly. Have you seen our post about buying a stapler?

Some blog posts are very serious. We post details about our Annual Meetings.

This post is somewhere between silly and very serious. I’ll let you decide which way you want to read it.

Today, I was updating my OKR’s and made a note to explain the difference between a well-run business, a good business and a

good investment to my team. A novice would hear me say one or more of those phrases and miss the subtle differences. At Little Engine Ventures I’m looking for the intersection of these three aspects… and I want it close to home. It’s rare, but not so rare that

you cannot ever find them. You have to look hard and deserve it. To simplify communications, I started using short hand rules of thumb. They’re not comprehensive. We do perform more complex analysis on our investments. But they are guide posts to be aware of at a high level. Combined they function a bit like gravity, centrifugal forces and photosynthesis around here. This post official dubs this grouping as “Daryl’s Rule of 30.”

  1. A well run business sends 30% of gross profit to the bottom line (or more)
    • Every business is different, but all businesses depend on gross profit. A steel frame company may generate single digit gross profits. A software company can generate 90% gross profit. The real question is what you do with the gross profit. If you cannot generate a gross profit you should stop immediately. (Ironically, we have purchased businesses that had product lines that generated negative gross margins. We shut down that product on the first day…particularly if it provided no marketing value. That negative gross profit should be called an expense!)
    • A sustainable business generates profit and cash flow. It takes discipline to refrain from spending all your gross profit. A well run business retains a large portion as profit. I like 30% as a rule of thumb because in a 50% gross margin company that’s 15% net income. That’s humming. In a 15% gross margin business that’s 4.5% to bottom line. While I like this business less, I respect the manager and consider it well run.
  2. A good business generates a 30% gross profit on revenue (or more)
    • The reason gross profit is so important to me is that I’m bent toward growth. With a thin gross profit I cannot finance growth with internal resources. Growth causes me to run out of cash. I dislike that.
    • I also believe gross margin is a sign of a sustainable moat. You don’t have to lever it up or run a ton of volume to make it work. The business probably has some sort of force that prevents competitors from eroding your margin. But, is it well-run? That is on the manager.
  3. A good investment has a 30% margin of safety (or more)
    • A good business that is well run is exciting to be part of. I love starting business like that. I like being around them and learning from them. However, I’m unlikely to become an owner unless the price offered is at a discount to the intrinsic value. I like to play it safe and make sure I’m not cutting things too close. I like a 30% discount on the price versus the value to me as an owner.
    • The funny thing about intrinsic values is they differ depending on the owner. A strategic buyer can have a value to them that is far, far above the value to the current owner. Thus, a strategic can pay a high price and still have safety. LEV is a rare breed in that we move around. I say we are professionals at comparing apples to oranges. We rank-sort based on safety… and chose the safest option first.

Combined these three “rules” capture my quick screens. Bonus comments: 30% for 30 years is a big hairy goal.

 

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