Entering the world of direct investment can be both exciting and intimidating. This change is especially challenging when your background includes operating and managing businesses.
One of the hardest aspects of this transition to the Direct Investing world is transforming your mindset.
You see, to be successful as an investor, you first have to start thinking like an investor.
Start thinking like an investor, stop thinking like a manager
If you have been a manager or a business owner, you are likely coming from a mindset of acting, doing, and creating, with the goal of making money.
However, at its core, direct investing is not about making money. Direct investing is the art of avoiding loss.
Adopting this mindset is the first step in your transition.
The next step is looking for investment opportunities that fit for you. This is where the real work happens.
On the investment side, there are some specific things that you can do to make investment decisions more quickly and with greater confidence.
Define targets and criteria for yourself around the kind of investments are the best fit for you. Base this on questions that examine your experience.
- What is your background?
- What industry knowledge or expertise do you have?
- What perspective did your position(s) give you to answer complex questions?
Answering these questions unleashes your personal unfair advantage when investing in that industry, business, or market.
This creates your first filter, providing you with some guidance on where to look for investment opportunities. However, to fully evaluate investment deals, you need to examine these 4 attributes:
Attribute 1: A business model you understand in an industry where you have experience
Look for companies that operate using a business model you understand in an industry where you have experience. All businesses operate in one of two business models, both of which are perfectly viable approaches to any industry. They’re either
- Differentiated, meaning they provide a better product or service at a higher price, or
- they’re Cost Competitive, meaning they compete by providing a product or service at the lowest cost to customers.
Both business models are viable and definitely work.
As a side note, at Transfigure we prefer businesses that operate using a differentiated model. Under this approach, margins are typically higher and more consistent.
The important thing to evaluate is that the managers and operators understand the model that they’re using for their business. Are they applying strategies that are consistent with that business model?
If the business has a strong brand and focuses on providing a superior product using a differentiated model, they should not have to rely on substantial discounting to grow their business. If they are applying a cost-competitive strategy, it is not consistent with their model, it might be a warning sign.
So make sure you understand the strategies they are using and ensure they align with the business model.
The other factor here is leveraging your industry knowledge and experience. This allows you to have more insights into trends, the future of the industry, or the market.
Focus on understanding or applying your knowledge and expertise to determine where the industry is heading.
- What disruptive changes are likely on the horizon?
- What opportunities does this create?
- How can you partner with operators to recognize value from these changes?
Now, investing in businesses or industries you are very familiar with is a balancing act.
You need to be careful because familiarity can create blind spots. This is especially true when it comes to identifying disruptive changes – the kind that create explosive or transformative growth.
Attribute 2: A sustainable competitive advantage
Look for businesses that possess a sustainable competitive advantage.
These are businesses that have the ability to change prices with minimal impact to sales or revenue.
An easy example would be looking at brands like Coke or Nike. Each of these companies have a loyal customer base. They can charge a premium for their products or change prices relatively easily.
So you’re looking for advantages that help your target business reinforce their position within an industry or market.
Of course, they do not have to be the same size as Coke or Nike – those companies are well established. However, you can look for and find smaller businesses within certain markets that operate with similar competitive advantages.
The point is to look for businesses that are considered best-in-class within the markets you’re exploring.
It’s actually fairly common for small businesses to possess that kind of advantage when it comes to customer service and attention. This is because the owners are involved on a day-to-day basis.
This brings up a related point. With small and growing businesses, it is critical to examine closely whether the market or competitive advantage is driven by the work of just one person at the company.
If it is, that’s not necessarily bad or a deal breaker. However, you need to identify a clear path for them to expand this advantage beyond just that one person.
Attribute 3: A competent and honest management team
As an investor, it is crucial that you look for competent and honest management teams at the companies where you plan to invest.
You want a management team that genuinely has a partnership view with investors. This ensures that interests are aligned on all levels
Here are some proven indicators of an honest and competent management team:
- Clear and accurate communication,
- Exhibited partnership mindset,
- Solid understanding of where value is created and captured,
- Managers who are respected by their employees.
To explain #3 above, you want your management team to have a firm grasp on the unit economic staff, team dynamics and skills, competitive differentiation, and the strategies that pull everything together.
For #4, managers and operators should have an accurate understanding of many aspects of the work. They should know
- the market landscape,
- the competitors,
- market influences and drivers,
- client and customer demands and needs, and
- shifts in the industry.
At the end of the day you want to look for knowledgeable people you want to work with because they understand the industry.
After all, you will potentially be stuck with them for quite some time.
Attribute 4: A fair price
Finally, you want to find businesses that are available at a fair price.
The deal needs to make sense financially. Make sure to look at all these factors:
- Return structure: is there alignment between investor and operator interests, or does the structure itself create a conflict?
- Operating financial needs: are the projections realistic and achievable? How do you know?
- Investment strategy: is this a hold for cash flow? Or are you investing and counting on some kind of increase in value to sell later so you will recognize your returns off the back end?
- Shifts or risks: What potential shifts or risks could limit or reduce this strategy?
- Appropriate valuation, actual vs projections: Make sure the valuation is within a normal range. Does the valuation align with typical market expectations? Is the valuation based on previous performance or unrealized opportunity? If it is based on projection, they may be overly optimistic, especially as pitched to a potential investor.
- Exceptions to valuation: what exceptions to valuation and the baselines around that can be justified? Does the financial history or projections actually make sense?
Understand how the value of the specific business is created in order to understand the whole value of the business. Consider the history and prospects.
Trust your instincts – Especially when they suggest caution
In conclusion, at Transfigure, we find it very important to remember to trust your instincts.
Even after you consider all the factors we’ve just covered, if the deal does not feel right, trust that your instincts are correct.
If you can’t explain it, trust your gut and err on the side of caution.
On the other side, be careful justifying investments that do not pass some of these tests. Even if they do give you a strong gut feeling, the red flags should overrule you instincts. Remember, direct investing is first the art of avoiding loss.
Running through warning signs to follow your gut can be dangerous territory for investors.
Finally if you’re looking for direct investment opportunities or partners, we would love to connect with you.
At Transfigure, we’re looking for investment opportunities and evaluating deals all the time.
Connect with us right now to learn about some of the investment opportunities that we are excited about. Learn about how to partner with us on an opportunity so you can be confident in your decision.
We would love to hear from you.
