What is the difference between a trade and a business?
A trade is a once-off exchange of goods or services for value between two parties. Each side parts with something of perceived value in exchange for something they value slightly more – otherwise the trade would not have happened. If any one side does not give up value, it’s not a trade; it’s a gift or an expropriation!
A business is an organisation that has arranged itself to solve a problem or a need for many other parties on a continuous basis over time. It delivers the product or service at a lower cost than the value of that product/service has to its customers. That literally is THE definition of gross margin!
Sometimes, this ability to deliver a product or service at lower cost than the client’s willingness to pay is due to a brilliant idea, an improved manufacturing process, marketing-genius founder, or a super invention, while other times a licence or a patent bestows this right on a business. For most businesses, the fundamental reason to deliver its service or product is just that it is ‘organised’ in the right way. All parts need to be MANAGED appropriately for it to be sustainable.
But not all businesses are created equal.
Great businesses do not have to spend any of that gross margin to tell potential clients about their service or products – clients just flock to them and stay with them. Lesser quality businesses have to spend some of their gross margin on marketing – to inform or convince potential customers of their existence or to convince existing clients to stay.
Great businesses spend little to nothing on product development, while lesser businesses have to continuously spend some of their gross margin on maintaining or improving their products/services.
Great businesses have competent, hardworking, honest and engaged employees that deliver their products/service to customers. This normally shows up in higher productivity of employees. Basically, fewer people are doing more work, which lower overall costs and allow for employees to have a larger share of the gross margin per person – in short: better salaries. Lesser businesses have to try and exploit their workforce in order to be able to deliver their products/services while protecting what is left of that precious gross margin.
Great businesses can carry on delivering a product/service even if they lose some of their employees unexpectedly. Lesser businesses are dependent on specific groups or individuals to serve customers. A loss of these vital people removes their ability to serve their clients.
Great businesses do not have to spend a lot of money on maintaining their existing assets, while lesser businesses continuously have to spend some of their gross margin on maintaining or replacing their assets.
After all of this, the tax man normally takes a share of what is left of the gross margin. This leaves the net profit, which belongs to the owners of the business.
Everything else is balance sheet management: how much of the business’s capital should be allocated to building/buying new product/service lines, how much should be invested in new productive assets as part of that new business, how much of that should be funded by outside debt etc. Finally, there is the decision on how much of this year’s profit should be re-invested in the business, and how much should be returned to the owners of the business.
Great businesses have the ability to re-invest very little of their net profits to maintain or expand their operations in order to service more clients, while lesser businesses have to re-invest substantial parts of their net profits.
Which leads to the final point: great businesses are managed by leaders that have the ability to understand both the income statement part of their business and the balance sheet part of their business. The super-class of leaders also gets the link between the two. They can sustain their operation by balancing marketing, product development, pricing, employee management and maintenance capex appropriately over time, while also having the ability to determine where to apply the business’s capital in order to expand their operations.
The true value of a business is determined by its ability to sustain a relationship with its clients over a period of time in such a way that it gets rewarded for the service or product. The more certain that gross margin and its sustainability, the more valuable the business.
Once we look at the world through this lens, it is obvious that many so-called businesses are actually only engaged in a series of once-off trades, gifts or expropriations – mostly based on the ability of an individual or special group that has the ability to convince potential customers of the next transaction. Without these people, there is probably no business left after some time. These “businesses” generally have no value to outside parties; only to the special group on the inside.
There is nothing wrong with a trade though. Life is full of trades, and they can be beneficial. Just don’t confuse a string of trades for a business.
This is a framework we use at RECM when we consider investing in any opportunity – whether it is in private companies, public companies, debt instruments, commodities, derivatives or currencies.