Good business, bad business

My coach and I were recently having a conversation around our careers, goals and more broadly what role the businesses we own and work for contribute to our goals. The conversation led us to exploring what makes a good vs a bad business.

In principle a good business is one that creates good returns on capital for its shareholders. The ideal business would be one that generates returns for shareholders with little to no capital (including human capital) investment.

My coach and I are both entrepreneurs. We both work our assess off, focus on satisfying our customers and have managed to create thriving businesses. Our business focuses couldn't be more different though, she's in a people intensive services business and I focus my efforts on high growth technology companies.

Both these categories of business should and must exist to ensure that society functions and I think finding a framework that can help us analyze them can help us allocate capital (including our own efforts) in ways that maximize returns ¹.

A business generates returns from the collection of the activities that it does to turn invested capital into revenues. Not all activities will directly relate to generating revenues (ex. filing your taxes) but the net balance when you sum the returns of all these activities should sum up to more revenue in than capital investments out.

When comparing businesses, one must ask whether the activities of the business create a good return on capital. That means asking ourselves whether the amount of capital needed over time will reduce (scale) and how efficient is the activity at turning investment dollars into revenue (margin).

Both scale and margin should be scrutinized at the aggregate level for investors and for people who are operating the business at the activity level.

A services business can be a good business if the owners can reduce their amount of investment (in the form of better quality of life) while generating the same amount of revenues or by putting in constant effort while growing revenues at a constant or accelerated rate (in the form of hiring more service providers).

You would assess a product business in the same way. The main difference between the types of businesses she operates and mine are that high growth companies have a large number of external shareholders who mainly put in dollars into the business relative to a service business which would have a single or few owners who are contributing both dollars and effort to the business.

Assessing businesses and activities in this way can help generate higher returns. You can take the concept even further and assess the business of you where you apply the framework to your personal life and ask yourself whether the activities you undertake are generating the returns that align to your personal goals.

Asking yourself these questions may feel neurotic to many but it's helped me make sense of the random journey that is life.

Just do it, they day...