What is a Successful Small Business?
Success means different things to different people, but, in small business, success is all about the money.
This isn’t the question I asked at the start of the week. What I really wanted to know was: what percent of small businesses are successful? If you’re thinking of starting a business of your own or if you already own one but you’re not at the milk and honey stage, you’re going to want to know too. What are the odds that this thing that I’m putting all my time, energy, and money into is going to go my way?
Google wasn’t helpful. As I write this post, the first page of results for that query includes lots of links to business failure but not one headline that includes the word success. A person is forced to make inferences. If failure in business is equivalent to closing shop in one, three, five, ten years and so on, then this seems to imply that success in small business means surviving for those same intervals. This seems more a necessary than sufficient condition of success though, like, before you can be in good health, you’ll need a pulse.
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ChatGPT didn’t offer numbers initially. It pointed out how “success varies” based on people and circumstances and then listed some factors that could influence the outcome of an uncertain project like a small business: location, industry, the state of the economy, the money involved, even the definition of success itself. When I asked specifically for a number, ChatGPT cited the same failure rates from Google’s first page. But as though one part of its massive neural network didn’t trust another, it also cautioned me not to read too much into these figures. It suggested I instead consult “government agencies, business research organizations, and reputable industry-specific sources” if I wanted anything more definite. That sounded more like a plan: define the problem, look for data, run the numbers.
Let’s start with definitions in this post. What does success look like in small business? This time, rather than the Internet, I asked my business partners. Each of them is an owner of a small business and, in their roles in Origami, each has talked to and worked with hundreds of other small business owners in the past ten plus years.
The failure state is of course easier to spot, but they’ve seen enough small business success across conditions, industries, and regions to distinguish some of its more salient features. In this post, I’m going to run through some of their perspectives along with my own.
Following the money
Success may mean different things to different people, but my partners and I focused on money as the ultimate success marker for small business. It’s easier to agree on the near universal appeal of a pile of money than it is to reach any kind of consensus on highly personal success measures like autonomy, fulfillment, or the social good. In the follow-up post, I’ll eventually narrow in on one specific dimension: sales. Not because it’s correct or better than the others, but because, by using sales and a small set of defensible assumptions, I can calculate success rates for small businesses in different industries using data from government agencies — just like ChatGPT suggested. I’ll share those calculations in the follow-up post. I think they get us closer to knowing the odds in this game we’re playing.
A successful small business doesn’t lose money
The first and obvious part of this is don’t operate at a loss. The vast majority of small businesses are self-financed or financed through funds personally guaranteed by the owners. Operating losses from an unprofitable business eat away at the relatively small amount of capital that small business owners have available to risk. Owners have to race to get to profitability and stay on the right side of that line if they want to avoid going under and being counted among Google’s casualties.
The second part of not losing money is opportunity cost. If your small business manages to survive and be profitable but your annual compensation is less than what you could earn by doing something else or working for someone else, then you have some thinking to do. Depending on how far you’re along in the business and your feelings on the matter, your business may be a qualified success or a mistake you should’ve never made. Your feelings will tend to change.
It’s one thing to forego compensation when you get something you consider to be important in return: autonomy, control, schedule flexibility, the freedom to pursue a passion or a lifestyle. Or when you see the lost earnings as an investment or sacrifice that’ll eventually pay off. It’s a rite of passage almost, a part of building up a new, untested business into something stable and reliable.
But it’s a different thing altogether when you’re forced to accept relatively poor compensation because your business just can’t afford to pay you more. The lost dollars add up. In the here and now, you have to accept a lower standard of living. Despite working longer and harder than any of your friends, you end up with less stuff, less good stuff, and fewer experiences outside work. The dollars also add up in the future, because you’re not putting away enough funds for your savings and retirement. Compound returns are magical only when time gets to perform the magic. The dollars you put away in your younger years accumulate far more returns than the dollars you put away in your later years.
In The Great Game of Business, Jack Stack wrote: “There are only two ways to make money in business. One is to be the least-cost producer; the other is to have something nobody else has. Unless you have a proprietary product or service, you have to be prepared to compete on price, and you can do that best if you’re the low-cost provider… On the other hand, it’s always nice to be in a position to charge a little more. To do that, you have to come up with an edge that customers can’t get anywhere else. Maybe it’s quality, maybe it’s a particular service, maybe it’s a brand name. As long as you’re the only one who has it — and customers want it — you can charge a premium for it.”
It’s almost impossible to become a successful small business by trying to be the least-cost producer of something a lot of competitors have or do. Small businesses typically set up in fragmented industries with low entry barriers; industries that don’t require a lot of upfront capital; industries in which prices and competitors aren’t always well-known. It’s difficult and expensive to set up the controls and hit the volume needed to keep unit costs down. Even then, the reward for earning your scars and figuring out how to eke out a living in such an industry is that someone can always come along and undercut you on price. Because it’s the easiest way for the new guys to get started and win business. Because the new guys don’t know what they’re doing or they’re willing to accept less than what you’ve calculated to be a fair return. It’s an unrelenting grind. It’s certainly not a path to success.
What does lead to success is differentiation: as Stack says, having something nobody else has. Something tangible or something in the mind of the customer. It could be technology related, but it doesn’t have to be. You could combine the common ingredients of your industry to create a different product or service. Or discover an unmet need or an underserved market. Giving customers the feeling that your business is well-run goes a long way. Whatever its nature, this difference pays off with pricing power: the ability to set prices high enough to earn a comfortable margin. This is a characteristic that, in my experience, every successful small business has.
Warren Buffett’s perspective here is helpful as always: “The single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I've been in both, and I know the difference.”
Decreasing direct work for the owner
We have clients that do very well but their business is basically them. They may have employees, but they’re the star, they’re who the customer wants. It’s a celebrity kind of success: when the celebrity fades, so does the success. We have other clients that get good results but they still play the critical management or sales role in their company. They have a business in which they’re not the product, but they haven’t yet put the necessary operational, marketing, and financial systems in place to safely leave the day-to-day in the hands of capable enough staff. The owners are still around and still critical for making the whole thing go.
At some point, most successful small businesses manage to separate the business from the owner. It’s a sign that the business and the owner have both matured. The business because it has the resources to support the new layers of control and management. And the owner because he or she has finally committed to taking that step. This is a good place to end up. The business runs itself. The owner just has to set the objectives and monitor the results. The business becomes an asset the owner can grow, sell, or use to pursue other interests in the next stage of life: another business, an affluent lifestyle, politics.
Owner income of $300K or more
This is always going to be a subjective number. Different people see themselves as well off at vastly different income levels. Age and work experience play a part too. Darren picked $300K now, but, earlier in life, he would’ve picked a fraction of that number. When I looked into it though, $300K made sense.
The threshold for the top 1 percent of income tax filers in Canada in 2020 was $254K. So, unless inflation has caused incomes at the top end to skyrocket, $300K in income should put you in the top 1 percent in 2023. The top 1 percent gets a bad rap, but, for me, I always think of the bridge verse from the Wham! song: “Cuddle up, baby, move in tight; We'll go dancing tomorrow night; It's cold out there, but it's warm in bed; They can dance, we'll stay home instead; Jitterbug.” What he’s singing about there is options. In a cold world, the 1 percent have more options. Who doesn’t want that?
When it comes to big bucks, $300K is an appropriately modest Canadian goal by the way. To be in the top 1 percent of income earners in the United States in 2023, Forbes claims you need a salary of $598K.
I’ve written about the 4 essential small business numbers, the key financial metrics I believe small business owners need to track and understand to manage their businesses. From reviewing years of data for hundreds of small business clients, I’ve found that if all of these numbers are meeting targets and moving in the right direction, then the business is almost certainly doing well in terms of its finances.
I’ve also written about the first and most important of the 4 numbers: sales. A successful small business is (almost always) going to have sales growth; it’s offering a distinct something that customers want (a precondition of success) and it’s offering it to more and more customers over time (another precondition of success). The sales growth brings in the money needed to hire people into specific roles as opposed to having a few people take on multiple roles. Increasing specialization makes the company more productive and efficient which, in turn, creates the capacity for more sales growth. As well, fixed costs get spread over the increasing sales. This leads to increasing profits. And increasing profits increase the resources available to fuel additional sales growth. The fuel that keeps this engine going is growing sales.
Whether that growth is measured over months, quarters, or years, the sales chart is going to show an upward trend as we move to the right. The annual rate of growth should also be well above 2.2%, the average growth rate for Canadian small businesses, but likely below 20%, the threshold rate used by Innovation, Science and Economic Development Canada for high growth small businesses.
I added an “almost always” clause to my earlier statement that successful small businesses will show sales growth. That’s because consistent sales growth is harder to sustain at higher sales levels; small businesses run into capacity issues with staff, with facilities, with capital, with management, with the market. It’s a ceiling that appears out of nowhere. Things that worked to reach one level of sales stop working when the business targets a higher level. The business may still be profitable and generating cash; it may still be successful. But new managers or management approaches are needed to avoid stagnation or falling back.
Increasing or acceptably high profit margin
Successful businesses are profitable businesses, but they don’t start off as profitable. It takes time to generate sales and then to generate a break-even level of sales. That’s the level at which the gross margin just covers the company’s operating expenses. Below that break-even level, the business will be operating at a loss — unless it takes steps to increase its gross margin or reduce its operating expenses. Because small businesses have a limited amount of capital to absorb losses, the amount of time they spend under the break-even level must be kept to a minimum.
At the other side of break-even, successful businesses will show an increasing trend in their net profit margin as long as sales continue to increase. The increasing sales dollars result in increasing gross margin dollars. But, with good management, the fixed expenses should remain constant up to some higher threshold for sales. Up to that threshold, more gross margin dollars flow to the bottom line, leading to an increasing net margin. At or around that higher sales threshold, the business will have to take on additional fixed expenses to support the new sales level. This will temporarily cut into the net margin but, if the anticipated sales increases occur, the previous pattern will just repeat. Gross margin dollars increase in line with sales but fixed expenses move in less frequent, well-planned jumps. That’s what leads to the increase in net margin past the break-even sales level.
Net margin can’t increase indefinitely. Each industry has its ranges. And those ranges have to be adjusted for the small business space. Our heuristic in Origami is to set 10% as a target if the small business hasn’t been able to consistently achieve that result. And this is a 10% net margin after the owner has been paid a market wage for the work he or she does in the business. If the company is consistently operating above a 10% net margin, that’s usually a sign that the owner understands the need to monitor and manage that number.
Strong operating cash flow
Some small businesses are profitable but they don’t generate cash. This is because the cash from profits gets tied up in their working capital: inventory, accounts receivable, or accounts payable. Successful small businesses do a good job of quickly converting operating profits to operating cash flow. They’re also disciplined in their use of cash to purchase inventory or pay suppliers; and highly disciplined in extending credit and collecting on accounts receivable.
Strong cash position
A business that generate more cash than its owner knows what to do with is a very happy problem and a very strong sign of success. If the business already has more cash in the bank than what’s needed to cover 2-3 months of its operating expenses —what we call a margin of safety — then the owner can choose to retain the extra cash flow to fuel further expansion or move those profits into a holding company to pursue other investment opportunities outside the business.
But owners can also be too quick to move cash out of a growing business. A business usually needs to increase its asset base to generate higher levels of sales. The increase in assets is usually supported by an increase in retained earnings, that is, the growth is self-financed. But if the owner keeps stripping the business of cash, then either it won’t have the funds it needs to grow or the owner will have to seek debt financing. This is less than ideal because, while the debt may increase returns due to leverage, it’s also going to increase risk because of interest and covenants.
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