Moving away from hourly billing – jump off the cliff

With the industrial revolution came the need for metrics regarding how much human effort went into producing an item of value. Indeed, the industrial revolution gave rise to modern management science. When machines can suddenly produce way more than human labour could previously, we start to need to have a benchmark on how much labour (and at what price) goes into a product. When we understand the value of the end product, we can start to price the value of the labour used in its production, and so began a line of thinking that started with industrial revolution and mass production then filtered into service industries. It continues today with software able to measure all sorts of inputs in our daily lives in minute detail.

Doctors charge a set fee for consultations, platitudes and procedures that are loosely based on the hours they charge. Dentists have the ability to remove or inflict pain and similarly get away with charging a lot for a relatively short space of time. Other professionals aren’t so lucky. The American Bar Association picked up on this in the 1950’s and encouraged their members to start charging by the hour, instead of a broad fee for types of work. The accounting profession (who by nature are largely a compliance sale) quickly copied the idea of time-based billing. In so many ways it makes sense – a project takes 5 hours, the person doing the work gets paid $100 in salary costs so to make profit, cover marketing etc. and put some dough into partners pockets the client is charged $400 for the same time. Billing by the hour allows practice managers to calculate utilisation just as a production line manager would calculate throughput. Since clients only pay for hours worked directly on their business, it’s got the appearance of a very fair system.

Perhaps so for the very routine types of work: the types of work that will eventually be replaced by software – commodity hours, the kind of labour the singularity will gobble up and spit out permanently. The problem with hourly-based billing is that it treats human input as any other resource and is dehumanising. It’s also very hard to make a profit when you’re effectively a commodity, and it may not be so good for the clients after all: hourly based billing encourages long boring projects rather than quick specialised ones that generate valuable insight that’s worth far more than the hours it takes to produce.

There are alternatives: a recent article in the New York Times discussed a group of Accountants, loosely led by Jason Blumer, who call themselves the ‘Cliff Jumpers’ because they refuse to bill by the hour. They don’t have dress codes, don’t keep time sheets and don’t have billable hours. For Accountants, this is radical stuff. Instead of hours the Cliff Jumpers focus on problems where the pay is higher than the amount of time taken to solve them. For example, they work for creative artists who struggle to make sense of their finances as they become more established, or entrepreneurs who want to sell their businesses. So far it seems to be working although I’m guessing that only a few of the 100K plus accountants in the USA have jumped off the cliff so far.

Taken up to the national policy level the bigger problem with service industry productivity is not one of pricing, but one of metrics. Thanks to the focus on productive output given to us by the industrial revolution, 90% of the metrics used in GDP evaluation and policy setting became about goods production. The problem is that the metrics that work for goods production don’t help us understand the value of ideas or the knowledge economy. The value of services is very hard to measure and policy decisions suffer as a result.

The approach the policy wonks take is to try to break services, like law or accounting down into their component parts. This sort-of works for the more formalised, commodity style work but falls flat in areas like doctors, visual design, advertising or education. Even in the USA, a society which values data analysis and fact-based decision making, productivity measures exist for only about half of the US industries. The industries covered are typically the most the older, more slowly growing ones. So it’s impossible at an industrial policy level to know if policies are working or not, which means a lot of spend is probably wasted and opportunities lost at a national level.

What does this mean for service industry or knowledge economy entrepreneurs? Well if we want to be helped, we need to be able to provide bigger players like government and big business with the right metrics to measure our productivity and impact so that we can demonstrate when/how help will be effective. A core challenge then to entrepreneurs and their advisors in the service industries is to develop the metrics. There’s a great business in there for someone…

The Tac SHAC story

Very few entrepreneurial success stories are of ‘greying entrepreneurs who enter a highly regulated, politicised industry that has shrunk by 95% in the past 10 years and quickly grow a successful business’. So when you find someone who has managed to do just that, you need to tell the story…even more when the story involves lifelong passion, a husband and wife team, and a business that deals in military-style guns and ammo.

Enter Paul and Lynette Oxley, owners of Tac SHAC – a Johannesburg-based business that has become very successful at selling what are known as ‘tactical’ weapons – typically high-end semi-auto pistols, semi-auto shotguns and semi-auto rifles/carbines that are the civilian versions of military weapons systems.

Guns and the right to bear arms is an issue that divides people; it’s a sharp fence that doesn’t bear sitting on. So while there may be readers who don’t support the legal right of a person to bear arms, I hope to tell you a story of how an entrepreneur enters a really tough industry and succeeds – please take what you can from the Tac SHAC story.

To set the scene, the South African gun industry has changed a lot over the years, with regulation and politics playing a major role. In the apartheid years it was easy to license a gun (for the white population) and all young white males went through intensive firearms training in their 2 years of national service. When apartheid fell and people feared a civil war, the arms industry boomed: guns for self-defence are very much a fear driven purchase and the white-male market had both the training and in many cases, the fear.

Post the countries surprisingly peaceful 1994 elections and the new ANC government gradually got on top of legislation, making drastic moves to regulate the firearms industry through the Firearms control act of 2000. Implementation started in 2004 and not yet been finalised. This new act made it much harder to become a licenses owner of a firearm, requiring all firearms owners to pass a competency test in knowledge of the law and in the application/use of each type of gun they desired (e.g. pistol/shotgun/rifle/self-loading rifle). In addition to this each gun must be individually justified and licensed, your safe physically inspected and background personality checks done. The process takes months even when things run smoothly. The Firearms control act also put far more stringent requirements on gun dealers, firearms instructors, and the industry as a whole. The challenges of implementing the act have been acknowledged by the Police Ministry who admit that no all systems or procedures are yet in place.

Results of the new legislation were disastrous for the industry: around the millennium, it was estimated that there were over 2000 gun dealers in South Africa. By 2004, when all existing gun owners were required to begin re-licensing their weapons, the industry was in tatters and this number was down to ±800. Nearly a decade later, 90% of those are gone too and now only 70-odd gun dealerships survive. For anyone whose industry exists at the whim of government legislation, the speed of this change bears some thinking about.

Estimates suggest that gun owners who simply couldn’t be bothered to go through the new licensing process handed in over 800 Thousand guns to the police for destruction, without financial compensation and to avoid criminal prosecution. The deluge of applications for renewal by existing owners swamped the systems and meant that almost no new licenses were issued for several years. The uncertainty and delays killed the industry. Over 10 Thousand people working in the firearms industry lost their jobs. Local gun manufacturers almost all closed down.

The few gun shops that survived did so by rapidly diversifying away from firearms and into knives, mace, air-rifles, bows and arrows, and into outdoor gear. Speciality shops died – very few businesses have deep enough reserves to survive a few years of almost zero sales, and while hunting has loyal followers it’s already a highly seasonal business with practically zero demand outside of hunting season.

So that’s the scene over the last decade: an industry absolutely destroyed by a change in legislation. Why then, would Paul and Lynette Oxley decide to enter the market, and how have they made such a success?

The Tac SHAC story starts with Paul – whose parents didn’t have guns but he grew fascinated by them, to the degree that he sold his racing bike to buy his first gun while still at high school. Then came military service after which he started studying law and then philosophy at university, and invested some savings into a gun shop. Those savings disappeared when sanctions effectively blocked imports from the USA and the gun-shop closed.

Along the way Paul met Lynette and he sold some guns to pay for her engagement ring. At university Paul started a shooting club and offered training courses to staff and students alike. He got involved in the founding of SAGA (the South African Gun Owners Association) and became active in the administration of sport shooting in SAPSA (The SA Practical Shooting Association). Over the years they both maintained an active interest in sports shooting, but worked in other industries. Skip forward 20 years and Paul and Lynette are still active sports shooters. Paul is now a main mover behind GOSA (the Gun Owners of SA) and following an attempted armed robbery at their home decide to pivot from their African safari tour-operation business into the world of tactical firearms – something that is clearly a lifelong passion for them.

Whilst both Paul and Lynette share an almost evangelical belief that society is best served by a well-armed and trained civilian population, and they live out their belief by drawing ‘non-traditional’ sectors into sport shooting, it is Lynette who is often sought out by would-be gun owners precisely because its so rare to find a lady so immersed in shooting and the gun culture.

Now back to the market: As opposed to the USA market, where there are ±1.5M background checks per month (i.e. roughly 18M new gun licenses being issued each year), the total licensed gun owning population in South Africa is around 2M people, half of whom have 1 gun only and the others on average have 2, giving 3M licensed guns in total. (Recent research suggests another 5-10Million unlicensed guns in SA, which is far more the worry). The type of long guns that Tac SHAC sell are mostly semi-automatic (or self-loading) – each pull of the trigger fires the gun that ejects the spent shell and reloads the weapon by itself. To get a license for these guns is not easy: in addition to the normal competency and license application you must have and maintain what is known as a ‘Dedicated Sports’ or ‘Dedicated Hunter’ status. This means you have to prove regular participation in sports shooting or hunting and be certified as such by an accredited industry body. The process isn’t expensive but it takes many months to get right: if you want a semi-auto rifle or shotgun in South Africa you can get one, but you’ll need to be patient. A rough estimate is that there are less than 5 Thousand dedicated sports shooters in South Africa, most of who will have a pistol, shotgun and rifle. In other words, Tac SHAC entered an industry that had been destroyed by legislation and then, when almost every other gun shop had survived by diversifying into a wide range of outdoor gear, they specifically targeted the smallest, most hard-core section of the industry.

It’s a counter-intuitive strategy that has served them well. Tac SHAC focus on the core, dedicated sport shooting market who can get a licenses for the kind of guns they sell and by the vary nature of their sport and far more frequent buyers of ammunition, which is about half of Tac SHACs business. In other words, each customer is more valuable, by far, than the typical gun owners who will never practice fire his only gun. Sports-shooters will blow through hundreds of rounds in a weekend, (whereas hunters will do less than 10) and will spend R10 Thousand or more on a pistol, and R20 Thousand or more on both a rifle and shotgun. Not as much as a typical cyclist spends, but enough to build a business.

Tac SHACs sniper-like focus on a market segment hasn’t been all they’ve done right. Paul subscribes to the philosophy of being “long-term greedy”. In other words they keep margins down and focus on volume not mark-up, to the degree that other dealers have described them as being the ‘Robin Hoods’ of the industry. They’re able to support the lower margins by operating out of an owned house in a residential suburb, rather than rent expensive retail space. Their active role in promoting the industry means strong industry contacts, good relationships with regulators and suppliers, and this has translated into a strong foundation for Tac SHAC. Marketing is almost entirely word of mouth – Paul and Lynette both spend a lot of time on the shooting range, mixing it up with their customers, drinking coffee with them back at the shop. Their marketing budget is spent by sponsoring shooting competitions and clubs, across different sport-shooting disciplines across the country. Rather than a fancy website they simply have a Facebook page. One with nearly 800 likes…which is probably 15% of their market…which is simply phenomenal.

Tac SHAC also sell to private security companies and anti-poaching units who also need semi-automatic weapons. These B2B sales amount to about half of their firearms business and help them secure the volume that keeps their prices lower in the consumer market, and keep relationships with the importers more exclusive. Lastly, being in a highly regulated industry has some benefits – the requirements to store and sell weapons are tough to comply with and the same legislation that killed the industry for most now acts as a barrier to entry for anyone thinking of rushing in.

So, in summary, the Tac SHAC story is one of a couple who believe in guns and their role in society, who are active in the sport, entering a market that has been destroyed by legislation in the preceding decade and then focusing on a very particular niche. With strong industry relationships to ensure supply and a low cost approach its meant that have the stuff their market wants at an attractive price. On top of this they marketed via direct relationships with a very passionate bunch of dedicated sport-shooters (who are a small but very valuable market segment)…with some fantastic success.

More things to think about when buying a business

Buying a business can be daunting; especially if you’ve heard even a small fraction of the horror stories that those “experienced in the art” will have to share.

Last week we covered 6 important things to think about when buying a business; this week we continue with a look at how to build confidence in your understanding of any business through more detailed financial analysis and due-diligence.

It’s very important to remember that when buying a business we’re investing, and when investing the most important thing we’re trying to do is protect our capital, and the second most important thing is to grow it. This means that we need to identify all risks and price them into the deal. If the risks are too big then there is no deal, and if the risks are manageable (i.e. the probability of them occurring is low and if it does occur then the impact wont be fatal) then we can build them into the deal terms.

Risks are anything that can impact the future cash-flow generation potential of the business. Understanding them means you need to be able to identify all risks and understand their impact. The only way to really understand the impact of anything is to build a good financial model of the business, that allows you to see how a change affects the cash flows, and hence the valuation of the business.

To help you get started, here are some of the biggest risks you’ll find in the SMB ‘businesses for sale’ market.

Variability/Predictability of cash flows, including seasonal businesses:

To begin, I’m assuming the business you’re buying has full, audited financials for at least the last 3 years and monthly management accounts. If you don’t have this type of information you’re really shooting in the dark and I’d suggest looking elsewhere (or making the entire deal price dependent on future performance). If you have this info then you need to do what is called a ‘horizontal analysis’: this means you compare the same categories from year to year. How much has sales grown or contracted by? Did all expenses stay in proportion? You’ll need to work your way through the financial statements in this manner. What you’re looking for is any year when sales grow faster/slower than the ‘normal rate’ for the business, and also each income statement line (as a percentage of sales). E.g. if Salary expenses go from 15% of sales in 1 year to 25% of sales in the next, you know you need to dig deeper into why this happened. When you get to the Balance sheet, a useful tip is to calculate everything as a % of total assets – this will make it far easier to spot changes from year to year.

Be especially aware of seasonal businesses – they have to generate sufficient cash in the peak season to fund the low season, and you will want to model this carefully. Tourism, agriculture, restaurants and anything in small coastal towns are likely to be very seasonal businesses.

Key staff retention:

The productive capacity of any business depends on its staff, and you’ll always find 20% of staff who account for 80% of the knowledge, client relationships, and whose loss would severely damage the business. You’ll need to identify who these people are beforehand, understand their contractual obligations, and make sure they stay on post your acquisition. Be very aware the key staff are likely to be poached by the seller if he chooses to compete with you, so you’ll need to build your own view as to who is key and who isn’t.

Competitive action by the seller, pre or post sale:

One of the reasons to defer a large part of the payment for any business into the future is to keep the seller motivated to grow the business. In many situations, this means that you want to prevent the seller from competing directly or indirectly with you. It’s crucial to understand who has client relationships and why a particular business buys from you, then you can lock the current owners and employees into a contract that prevents them competing with the business they have just sold. You’ll have to use a carrot and stick approach – a bonus for good behaviour and legal action or damages for poor behaviour.

Concentration of suppliers, customers and product:

A business that has only 1 supplier, a few major customers, and a limited product line is immediately at risk through concentration. Broadly, this means that if one supplier or customer changes their terms with you the business could die. Simiarly to product concentration – a business with only one product can be easily wiped out when the competition change prices, launch a new version, or the Chinese start supplying your customers directly.

Management systems:

A business that is well systemised, that operates as a machine where processes are documented, followed, and improved is far less risky that one where everything is ad-hoc or simply not done at all. The simple reason is that well designed and implemented systems reduce the reliance on key people: a good system means that risk of a key person leaving is reduced because someone else can quickly pick up where they left off. It also means that new staff (yourself included) can quickly get up to speed on the business.

Legal action:

Almost every business faces legal actions at some stage of its life. Sometimes these can be crippling. Pending legal action is easy to hide from a buyer, so you need to consider an independent legal review and also making sure the seller indemnifies you from legal action relating to the business before the sell it to you.

There are many more areas of risk, which we’ll cover later. Hopefully these tips will prevent you making some of the bigger mistakes.

Things to think about when buying a business #1

Buying a business is a potentially great way to become an entrepreneur. With a bit of luck the business you want to buy has got through the first couple of years and a lot of the early-stage risk is gone. Hopefully there are customers who love the product, suppliers who want nothing more than for you to succeed, loyal staff that want to work for a new owner, and the premises is locked into a nice long-term lease with very low escalation clauses, and of course we also hope you have a very motivated and honest seller who doesn’t have any unreasonable expectations of value or deal structure.

Have all that? Congratulations! You are one in a million!

For the rest of us, most times buying a business isn’t a smooth process nor is it cheap. In the next 2 articles we’ll cover some tips to help you buy the business of your dreams, without losing sleep in the process:

1. Keep emotion out of it:

Unlike buying a house where emotion often comes into play, you should buy a business because it represents a solid investment opportunity where the returns far outweigh the risks to your capital. A great tip I learned from a friend is to look at any opportunity three times: your initial assessment, then two more. One as if you are wearing an optimistic hat and another, on a separate day where you wear your pessimistic hat – the results are very different. Listen far more to your pessimistic voice – it’s going to be more accurate 90% of the time.

2. Don’t bet the farm:

We all love a rousing war-story by an entrepreneur who risked it all and made millions, but in truth most times when people risk it all they lose it all. You have to appreciate that no matter how much homework you’ve done and how certain you are when signing the purchase agreement, chances are something will go wrong or you’ll screw up in some unimaginable way and you’ll lose most, if not all the capital you’ve invested. Give yourself a fighting chance by not investing all your capital. Even better, put the rest of your capital into a very low risk investment that offers 100% guaranteed returns and lock it in there for a long time.

3. Have choices:

Make sure you consider where else you can put your money. Consider many different businesses before you choose where to invest. Seriously – unless you really know the industry you’re looking at and have also run your own business before, you want to get to see several different businesses in different locations and of different types before you make such a long-term decision. Take the time. Keep options open so you’re not forced into a deal.

4. Don’t buy a job:

There are many people who fall into the trap of paying a few million for a business where they then work 12 hour days only to earn what they could as a salaried employee elsewhere. Make sure the business you want to buy will pay you a market related salary (i.e. that it will pay you the same as what you’d pay someone else to run it for you) and make sure that it is profitable enough to make an investment return above that. If you are really just buying yourself a job then rather take your capital, invest in a financial product and get yourself a job.

5. Live the life & get advice from people in the business:

If you’re going to be hands-on in a business you need to know what the day-to-day demands are like long before you sign anything. People in corporates often complain about boredom or ‘chores’ but the entrepreneurial grass isn’t much greener – we still do boring stuff each day. We still talk to difficult customers, make coffee, clean up and do stuff that isn’t sexy. Don’t expect different. Speak to people in the industry about what life’s really like, and if you can, spend a week working in a friends business during their peak times to know what kind of hell you are about to pay good money to live in.

6. Do a deal that is almost certain to make you money: 

You make money by buying now and paying later, and by buying low and selling high. You also make money by taking steps to reduce risk. For this reason, most of the deals I’ve worked on involve the buyer paying only a small part of the agreed price as cash upfront, with the balance paid based on performance of the business over time. I’ve covered this in previous articles, but in essence the typical upfront amount is around 20-30% of the deal and the repayment term around 5 years. Bear in mind throughout that unless you are earning healthy dividends, the only time you’ll really make money when buying a business is when you’ll sell it to someone else. So you’re really looking for a business that you can grow at around 30-40% per year before you’ll make any kind of return…and only then if you can find a buyer in the market at that time.

We’ll cover the financial analysis side of buying a business in next weeks article.