Uncertainty and Profit

I spoke with the matriarch of a family business yesterday. She received numerous mailers from Little Engine Ventures over the last couple of years. Eventually, she decided to explore further. She started by holding on to one as a reminder. She then surveyed her husband:

“Dear, how would you rank your job satisfaction?”

To which he replied, “Oh, I would say an 8.5 out of 10.”

This surprised her. And, she confessed it was a peaceful Sunday afternoon with a lot of work orders already booked for the busy summer season. By the next evening he was sprawled on the couch, practically in tears. An employee had quit and they had weather and equipment issues. The stress was almost palpable. She did not have the heart to ask him again. Instead, I assume she emailed me, “How does this work?”

This little story is real and common. We speak with several per week. I am not yet sure whether the business is transferrable. Is it viable without the two of them in the business? What makes it a business and not a job?

According to Frank H. Knight in “Risk, Uncertainty and Profit”, 1921, a businessman assembles people and processes to generate a solution for a paying customer. His profit is determined by the quality of his knowledge, judgement and conduct.

I like this definition of a business. When I evaluate a business I not only look at the financial statements for historical results, I also have to identify the components and their configuration at an appropriate resolution for the given decision. Nearly all business has a technical craft within it. There are skills and tools that make it more productive than the next. What are those key things? Ultimately, this is why any of us buy products and services from others rather than do the work ourselves. We stink at it. They’re good at it. We trade money for the results produced by their skill and material.

Why do I ask these questions? I am trying to build a map of the business. The map is not the business, but it is a lower resolution outline of how it works. Where are the key landmarks? How do they fit together? The slightest differences in their configuration can derive the biggest value.

Sometimes I perceive an ill-fitted piece. What if we moved it? Would the rest of the business look like afterward? There is uncertainty in this imagined state, but this is where the big profits are made. You formulate a believe, implement it, and reap the reward –or loss.

In Little Engine Ventures, most of my effort is spent judging the dependency on the owner-operator, and formulating ways to remove that known risk. As Howard Marks would say, “It’s the most important thing.” What makes it so important? No one else has the absolute power to allocate people and processes like the owner. In my business, I enter this process with an asymmetric knowledge. I have seen many more businesses than the seller. I have seen methods that work, and those which have failed. I also see a much wider swath of employee types, successful and unsuccessful. I see tools used in creative ways and in very standard ways. From this I am able to ascertain an imagined future state. I essentially conduct a thought experiment. What would business look like if the owner and managers were changed?

As a business seller you are not required to underwrite this risk. You already possess it. It is confounded if you work within the business. You retain both the wage as a manager and the investment profit as the owner. How much would it cost to replace you? What would they change to improve the business? What premium or discount do you pay to retain your autonomy?

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