The one thing companies have in common is that they all sell something, a product or a service. But how important is what you sell to your long-term success?
In some cases, people choose to sell a product or service or to become part of an industry because they have a passion for it. Think of all the geeks who create hi-tech products that they hope will change the way people work or play, or even help solve global issues. Others choose products or services based on what they themselves like to consume, things that excite them. Still others find, or think they have found, a gap in the market and aim to fill an unmet need or demand.
In addition to the actual product or service you sell, it’s important to take notice that there are two types of business formats: recurring and nonrecurring revenue businesses. I am a fan of the former. Let me tell you why.
In the late 1960s and early ʼ70s, I found myself working as a salesman for a payroll processing company, not because I had a passion for the industry, but to earn enough money to support my family. Payroll processing, on the face of it, is not a very exciting business, but I soon learned that it offered the ability to sell a service to a customer and then repeatedly deliver that same service week after week, month after month, year after year to that same customer. That proposition excited me. If you sell a sofa to a customer, it may be decades before they need another one, and by the time they do, they have probably forgotten you exist. Even if they do come back to you, you have to sell them all over again in the face of competition for their dollar.
When Paychex starts handling a company’s payroll, it keeps providing the service until for some reason the customer no longer needs or wants the service. You can count on the revenue; it’s very predictable. Paychex has been handling payroll for some of its customers for several decades. That sort of stability is appreciated by banks and investors and, if you go public, Wall Street.
Not only is the recurring revenue predictable, so is future growth. If you add a hundred new clients, you can easily calculate the revenue they will generate. That level of predictability and consistency is not available to many nonrecurring revenue businesses. I like predictability; it helps me sleep at night.
Another example of a successful recurring revenue business is a sports franchise. When I purchased the Buffalo Sabres in 2003, we had 5,800 season ticket holders. We grew that to over 15,000, and there was a waiting list. Having that predictable revenue helped enormously with stabilizing the franchise.
Recurring revenue businesses don’t have to be service based. There are plenty of examples of businesses that sell products that manage to create recurring revenue streams. Have you ever had drinking water delivered to your house? That’s a recurring revenue business. Even companies selling software have, in recent years, strategically changed the way they do business to encourage recurring revenue by selling monthly subscriptions to their software rather than selling a single download or a disc containing the program. Locking in customers is the genius of this type of business model. As long as your customers remain happy with what you are selling them, they will continue to pay you monthly, quarterly, or annually, and they are sheltered from the attention of your competitors.
Whatever the reason behind your choice of business, you must choose wisely if you expect your company to be successful. Here are six questions I encourage you to ask yourself about the products or services you are either selling now or planning to sell in the future.
Let’s break down each of these questions.
Is there a large enough market for the product or service you are selling? Often entrepreneurs simply assume there is a market large enough to create sufficient revenues and profit to cover a business’s overhead. This overconfidence can be dangerous. I’ve even heard people say things like, “They’ll be lining up to buy this as soon as we open our doors.” I can tell you that in all my years in business I’ve never seen that happen for a new business or a new product. Sure, if you are Apple and you’re launching a new iPhone or iPad there may well be lineups, but Apple has been around for a long time and has built a massively large and loyal consumer base.
My initial goal when I launched Paychex was to sign up three hundred clients. This target was based on the personal revenue I required to maintain a decent lifestyle. I was confident I could achieve this fairly quickly. In reality it took four years.
I remember my first direct mail-out. I sent it to just about every potential prospect in Rochester. I co-opted my nephews and nieces, and they came in to seal envelopes, lick postage stamps, and do whatever else was needed to launch my first marketing venture. We sent out the mailing on December 15, 1970. The end result was that between the direct mail campaign and paying my only employee, I burned through my total investment within the first six weeks of operation. I was hoping to acquire sixty clients from the mail-out—I got six. Three thousand direct mail pieces and all I got was a lousy 0.2 percent return on my investment. Right away I knew I was in trouble.
That’s often the way with entrepreneurs. I’ve sat through pitches where a new business owner has a great idea and declares they can capture 10 percent of the market. It’s never that easy. Never. Today, of course, Paychex signs two thousand new clients a week, but that’s the difference between a start-up and a company that’s been around for over forty years.
Overestimating the market is a perennial problem for entrepreneurs; optimism is built into their genes. This, of course, is a double-edged sword. In general terms, optimism is a good trait for an entrepreneur; otherwise, they would never consider starting a business. But overoptimism leads to inflated revenue expectations, which never materialize and subsequently endanger the entire business. I’m certainly not immune to this entrepreneur’s disease. Let me tell you the story of when I jumped into a business without doing enough due diligence and market research.
The business I invested in was a dental imaging clinic. The concept was simple: many dentists at that time didn’t have sophisticated imaging equipment for people requiring complicated dental procedures or cosmetic surgery, so we provided the images to allow them to carry out the work. We were certain they would line up at our door once we opened our clinic. Why wouldn’t they?
Well, it turned out not enough dentists were willing to send their patients to an external service. Bottom line: we couldn’t get enough dentists to send us their patients, to make the company financially viable.
Depending on which report or study you read, approximately 80 percent of consumer products fail. I hope that convinces you not to believe your own press and to carry out sufficient market research. You need to accurately estimate the size of your potential market and the cost of getting a high enough percentage of that market through your door.
Whatever product or service you provide, you have to ensure you can make a profit every time you sell a unit. That sounds obvious, but I’ve come across businesspeople who say they understand this but then can’t tell me off the top of their heads what their gross profit margin is on the items or services they sell.
In its simplest form, your gross profit margin is what you can sell something for minus what it costs you to produce the item. The gross profit on everything you sell has to be sufficient to cover your corporate overhead.
Your variable costs are for raw materials, manufacturing, distribution, license fees, and any direct labor costs (e.g., piecework costs, etc.). Variable costs are costs that you incur when you sell something, unlike fixed costs (e.g., rent), which you incur regardless of whether you sell something.
You need to not only make a profit on each item or service you sell, but that profit when multiplied by the total number of units you sell needs to generate enough revenue to cover all your overhead (i.e., fixed costs).
Making a suitable gross profit margin can be a balancing act between the price you can charge and the cost of delivering the product or service. To obtain a higher profit margin, you have two options: raise your price or reduce your costs. If you find yourself in a position where, because of competitive pressure, you cannot charge more and there is no way to reduce your variable costs, your product or service may not be a viable proposition. Making that discovery before you launch your company will save you a lot of money.
One area some entrepreneurs fail to take full advantage of is negotiating lower prices on raw materials and finding creative ways to reduce manufacturing and production costs. Being resourceful when sourcing raw materials or other variable costs is a key way to increase the profit on each item.
How complicated is it to manufacture your product or deliver your service? Before you commit, ensure you have looked at every step of the production process. Not only do you need to have vendors and key employees lined up, but you also need a backup strategy should a supplier let you down. Carry out a risk analysis by considering everything that could go wrong. What, for instance, will you do if there is a shortage of your primary raw material and not only does it become difficult to obtain but the market price rises to a point where it seriously affects your profit margin? Do you have room to raise your price without it affecting sales? How vulnerable is your profit margin? How can you minimize that vulnerability?
I’ve heard it said that over three-quarters of the products that were around just five years ago no longer exist. Certainly, over the years we have seen technology make obsolete a large number of once-popular products and services. But it’s not only new science that changes what consumers want to buy; new generations have different expectations, and trends such as environmental awareness and an increasing reliance on cellular communication affect what and how people buy. Gluten-free products were all but unheard of a few years ago but today are big sellers. The question is whether this is a fad or a range of products that are here to stay. This applies to a wide range of products and services.
When you look at introducing a new product or service to the market, think ten years into the future and try to figure out whether it could be prone to extinction. For instance, is this a good time to start a newspaper, open a camera retail store, or manufacture e-readers? Probably not. Consumer products and services have a shelf life, some longer than others. Choose one with a longer shelf life.
Many businesses start out undercapitalized. As I mentioned earlier, I started Paychex with only $3,000 and a credit card, which was soon cut in half by a restaurant owner under the instruction of American Express, so who am I to talk? You can bootstrap a business, but you are reducing your chances of success significantly.
My advice? Do your homework. Get a decent calculator, or these days a decent app on your phone, and do the math. Get help to ensure you have thought of every dime you will need to get you through the first year or more. Figure how much you need to sell and be honest; put your optimism aside for this exercise and keep it real. Then you will need to figure out how you are going to raise the necessary capital. In chapter 3, “Money Matters,” I provided an overview of your options.
The speed of technological change is astounding and accelerating every year. If your product or service is in any way reliant on technology, you need to be aware of the capital costs involved in constantly updating what you sell or what you use to manufacture what you sell. And it’s not only the cost of reinventing the wheel regularly; consider the time, effort, and money required to continually promote and sell new versions of products. Finally, when products become outdated, they clog your warehouse with unsold and potentially unsellable inventory that can be a significant drain on your bottom line.
An important milestone in Paychex’s history was the moment Gene Polisseni, my best friend and HR director, and his associate Tony Tortorella walked into my office and told me we should be selling 401(k) administration. They outlined a well-defined plan and I liked the idea. As was the case with most of our previous entries into new sectors, everything had to be done manually, until we had time to develop the appropriate software programs. It was this development that led us into other products, such as workers’ compensation insurance, employee handbooks, and a menu of other human resource services. Today, Paychex has revenue of over $1.8 billion in payroll services and over $1.5 billion in HR services annually.
These new services were important to our growth in the late ’90s because they were a win-win for Paychex and its clients. We could offer these products at a lower cost than our competitors while still making a good profit. They were profitable because we linked two products together. We could, for example, process 150,000 payroll clients on a Monday, and if 50,000 of them had a 401(k) plan, we had the work and administration done and the money in the investor’s hands by 6:00 a.m. on Tuesday. The other huge benefit was our level of accuracy. Because we processed the payroll, what was on the 401(k) reports reflected exactly what was in the payroll. This gave us a tremendous advantage over our competition. Today, Paychex sells a larger number of new 401(k) plans every year than any other company. The HR Services division is growing in double digits annually.
Always be on the lookout for ways to diversify your product range, especially by using what you already have in different ways or by piggybacking products.
I hope you are beginning to see the challenges you will face when you consider, and ultimately decide on, what you want to sell. But fear not, there’s nothing difficult in increasing the odds that what you sell will make you a profit; you just need to carry out the due diligence outlined above.
I’ll leave you with a final story of a business I invested in that made several product-related mistakes. It ended up in bankruptcy, but it all could have been avoided by keeping to the no-nonsense rules I promote throughout this book.
Bak USA was started as a social enterprise, which in this case meant putting job creation above profitability, a dangerous thing to do. In my opinion, businesses should focus on making a profit first, and once they are successful, then look at social enterprise opportunities. Bak manufactured computer tablets. One was extra tough and rugged for use on construction jobsites and other environments where a normal tablet probably wouldn’t survive its first day; the other was a two-in-one tablet built for classroom and business use. Both were good products, but the profits were never large enough to give the company a sufficient margin to allow it to deal with the constant need for upgrading and technical improvements.
Bak had one other major problem: their biggest customer, Microsoft, accounted for 90 percent of their business. As the company’s largest buyer, it received a discount, which meant Bak’s profit margin fell to only 10 percent of their wholesale price. I talk in more detail about the dangers of relying on one or two major customers for the bulk of your revenue in chapter 5.
It was a perfect storm. They couldn’t raise their price, selling more was not going to help the situation, and not only could they not lower production-related costs, those costs were in fact increasing due to changing technology. All this while trying to operate like a flourishing Silicon Valley company before they were financially stable.
Never let products and services just happen. Think long and hard about all the issues we’ve discussed in this chapter and you will make decisions that will lead your company to a healthy and profitable future.