I’m sitting in my investing office, looking over the river behind the property, figuring out what I’m going to do for the day. I’ve got a cup of coffee in my Seattle’s Best mug from Border’s and am listening to Roosterspur Bridge by Tori Amos. The ideal would be to plow into a giant pile of stock reports but that isn’t going to be possible for a few days because the operating businesses need my attention. We have so many opportunities over the next twelve months to explode in revenues and profits by taking business from weakened competitors that I’m driving everyone pretty hard. Aaron, as always, has been patient, long-suffering, and wonderful.
One of the questions I often get asked is how, exactly, we make money. Moreover, most people want to know why we’ve succeeded when others have failed. To explain how easy it really is to create a large amount of wealth, I wanted to go through and work the problem backward (as Charlie Munger would say, follow the mathematician Jacobi to solve all of life’s problems: “Invert! Always invert!”). By seeing how we think about these things at our company, you can gain insight into whatever it is you are involved in yourself.
Let’s begin with a simple premise: You want to make $10,000,000 after taxes by selling your business and walking away when the deal closes. You own an online retail site. How do you do it?
The Three Metrics that Matter
In online e-commerce, there are three metrics that matter. Any good analytics program can provide this data by putting a bit of code on your pages – Google Analytics, which is free, is one of the best. These three metrics are:
- Monthly Visits: This is the number of times a person comes to your site each month. It is not page views. It is not hits. If the same person comes to your site every week for four weeks, that would count as four visits. For a traditional retailer such as Wal-Mart or Target, it would be the number of times someone walks through the doors.
- Conversion Rate: The conversion rate is the percentage of visits that result in a sale. If you have 100 visits and 2 orders, your conversion rate is 2% (2 ÷ 100 = .02, or 2%). The higher the conversion rate, the more likely you are meeting your customer’s needs. A “good” conversion rate is usually between 1% and 3% but it depends upon the nature of the ecommerce site. The easier it is to checkout, the more attractive your prices, the lower your shipping rates, the better your search engine optimization, the higher quality your product images, the more professional and informative your descriptions, the higher your conversion rate.
- Average Basket Price: This is the average sales ticket for orders placed on your site. For a baby gift site, an $80 average order may be good. For a furniture site, $700 may be acceptable. If you try to increase the average basket price by increasing product prices, you could lower your conversion rate. Thus, the conversion rate and average basket price have a powerful, inter-connected relationship. Just realize that if you are targeting an average basket price of $150, you aren’t likely to get there if you only sell $19.95 products.
Those three metrics – monthly visits, conversion rate, and average basket price – determine the success of an online business. Going back to our earlier problem, let’s answer the question: How could I make $10,000,000 after taxes by selling the business?
The Math of Working Backwards
Working backwards, it becomes evident that you’d need to sell the company for $14,000,000 to end up with $10,000,000 after taxes. Once you’ve reached that size, most good businesses will sell for about 10x EBIT, which means earnings before interest and taxes. This would not be the case if you were a traditional retailer because you’d have fixed expenses, real estate, capital-intensive inventory requirements, and much lower profit margins due to the business model. For a successful, growing company with high margins, it’s reasonable. You may have to wait for a better economy, but it’s reasonable, especially if you can find a competitor that has a strategic reason for acquiring your business.
That means that you would need to make $1,400,000 in pre-tax income ($14,000,000 sales price ÷ 10x EBIT = $1,400,000 operating income). If your cost structure is right, you should be able to generate 28% operating margins with a successful e-commerce business. If you can’t do that, you’re doing something wrong. My guess is, you’ve become intoxicated with sales and forgotten that profits are what matter. Thus, to generate $1,400,000 in pre-tax profits would require sales of $5,000,000 per year ($1,400,000 ÷ .28 = $5,000,000).
If $5,000,000 in online sales sounds daunting to you, remember to go back to our three metrics. Monthly Visits. Conversion Rate. Average Basket Price. Once you play with those numbers, you realize just how do-able it is. To hit that sales level, it would require only 1,000,000 visits per year, a 2% conversion rate, and a $250 average basket price. To put it another way, you only need to build your site so that it’s large enough that 2,740 people visit you from search engines or shopping portal search day (1,000,000 annual visits ÷ 365 days = 2,740 visits per day). At a 2% conversion rate, you could expect this to yield 55 orders each day. At $250 per order, that’s $13,750 in daily sales, or $3,850 in daily pre-tax profit at 28% operating margins. That gets you to your goal of $1,400,000 in pre-tax profit in a year. Find the right buyer, and you can sell for $14,000,000, pay your $4,000,000 in taxes, and walk away with $10,000,000.
Change How You Think About the Problem
Thus, the problem is not, “How do I make $10,000,000?” so much as it is, “How do I get 2,740 to visit my site each day, convert 2% of them, and have an average basket price of $250?” You can change the numbers around depending on your product mix. If you only have an average basket price of $125, for instance, you would need to get 5,480 daily visitors. It is entirely your choice how you construct your business. The point is, that thinking of the problem like that makes it far easier. Almost anyone, with enough work and dedication, can create that kind of search engine traffic. This is the reason I moved from Princeton, NJ back to the Midwest to launch our Internet companies in 2009 following the success of the first in 2007. It’s a better business model.
In my case, we aren’t really interested in selling the companies. Instead, I want the businesses to pay their income taxes and then pay up the net profits to headquarters where I can use them to invest in stocks, bonds, mutual funds, real estate, options, acquisitions, startups, or whatever else I think offers us good value for our money. That is why I call my businesses the “cash generators”. They provide me with the funds necessary to compound. Someday, our objective is to take the company public so friends, family, and colleagues can own shares and grow wealthy along with us.