Building a Small Business that Warren Buffett Would Love

Introduction: Painting the Picture of the Ideal Business

Someone is sitting in the shade today because someone planted a tree a long time ago.

—Warren Buffett

Ah, but I was so much older then, I’m younger than that now.

—Bob Dylan

They’re Gr-r-reat!

—Tony the Tiger, mascot of a consumer monopoly company that Warren Buffett loves

A consistent truth exists across all small businesses: Each one is different. A hamburger stand drives down operational costs through inexpensive, rapid-fire delivery; a service business builds sustainability through solid, enduring relationships; a technology firm evolves through bleeding-edge innovation and development. It would be catastrophic for a tax service provider to ram his clients through in 60 seconds just as it would be suicide for a hamburger stand cashier to play a round of golf with customers as the drive-thru line backs up. No matter how disparate the business model universe may be, another consistent truth exists: Every great business is built upon the same core fundamentals.

There Is a Template

The core of a strong business is not a mystery, nor is it a complicated mess. It is found in the wisdom of Warren Buffett, which is a virtual blueprint to create superior business results and build a powerful small business engine. If you follow this blueprint, digest its meaning, and learn its intricacies, you can build an economically superior small business, one that Warren Buffett would love.

You Hold in Your Hands the Blueprint

If you asked Warren Buffett what he looks for in great business, this is what he would say:

• I want to see a consumer monopoly …
• With a strong track record of earnings.
• With a healthy return on equity.
• With the ability to reinvest those earnings at a high rate of return.
• With little or no debt on the balance sheet.
• With the ability to increase prices with inflation.
• With a healthy net and gross margin relative to other businesses and industries.1

These statements embody the principles that Warren Buffett used to turn an initial $105,000 investment into a $40 billion fortune; and if the principles are wielded appropriately, they can be used to transform a small business into an economic powerhouse. This, folks, is our road map.

The Context—Focus on the Fundamentals First

Instead of hacking at the proverbial leaves of a bad business—a missing marketing plan, anemic revenues, low inventory turnover—let us first examine for cancer at the root via the Buffett principles. If a tumor is found, let us determine if intense fundamental therapy as prescribed in the following chapters can save the business, and if not, then it is time to move to higher ground and seek out a better business model. Remember, parameters such as return on equity, and debt to equity allow us to compare across multiple business models. If the current business is terminally ill after delivering year after year of poor returns, then it is time to take a bold step.

Let us first check that we are in the right forest before cutting down the trees.

Who Says? Warren Buffett Does

Don’t take my word for it; take Warren Buffet’s. I could affront you with a spaghetti tapestry of professional credentials but why bother? Warren Buffett is available and his track record is much more stupendous than mine. He grew his initial investment of $105,000 into a $40 billion fortune over 40 years.2 I cut my grass yesterday.

Let us start at the fundamental fountainhead as prescribed by Mr. Buffett before moving onto tactical measures such as forecasting financial statements or business plan development. Let us build a small business that Warren Buffett would love.

It Is Easier Said than Done—A Preview

Regarding Buffett’s second principle, “with a strong track record of earnings”: It is painfully obvious that a healthy business needs a strong track record of earnings in order to be viable. A business without earnings, which represent everything left over on the income statement after all expenses—cost of goods sold, payroll, utilities, taxes, and so on—have taken their bite, is like a lawn mower without a lawn mower blade. It may be fun to circle the yard a few times, but after a while the grass needs cutting. A for-profit business is “in business” to generate earnings, which in turn, when divided by the initial investment or equity, leads to a return. The bottom line on the income statement—earnings—represents the pulse of a business, and Buffett seeks out strong, steady 10-year earnings track records. The entrepreneur should strive to generate strong earnings track records. If this is not a priority, then perhaps your time is better spent circling the yard on a bladeless lawn mower.

Earnings lead to another empirical Buffett fundamental rule, return on equity. Return on equity can be thought of as the common size ratio used to illustrate the productivity of the equity in the business and can be used for comparison purposes. Think of it this way: If you put premium gas (equity) in a jalopy (business), the overall performance of the car will be poor, regardless of the gasoline grade. If on the other hand you put the gas in a new Corvette, all things equal, the car performance should be much better. (You can hug corners, get stuck on speed bumps.) Return on equity is used to distinguish a business jalopy from a Corvette, and is found simply by dividing earnings by the amount of invested equity.

For example, a fourplex generating $10,000 in yearly earnings, with $100,000 of invested equity, is producing a 10 percent return on equity ($10,000/$100,000). This rate of return is superior to a CD at the local bank that is coming in at 4 percent.

In the context of cash flow and financial independence, the smaller the return the greater the capital needed. For example, at a rate of return of 5 percent and monthly expenses of $3,000, it will take $720,000 of investment capital in order to generate $3,000 per month and be financially independent. At a rate of return of 10 percent, the required investment is only $360,000. Quite a difference … like half!

A Business Plan Is Written Once

Remember this also: A business plan is typically written once, but fundamentals are timeless and diamonds are forever. Sure, it is necessary to revise and update the business plan as economic conditions and business strategies dictate, but accurate business coordinates on a compass, as found in the investment principles of Warren Buffett, again are timeless. Let us first build this rock solid framework before adjusting the nuts and bolts.

Bad Pizza Joint … Bad

I have worked with numerous struggling businesses lacking solid underlying fundamentals that could use a healthy dose of Buffett. Case in point: I recently met with the owner of a local pizzeria whose business has very little differentiation from the local mega chains. Net, net, his operation is embroiled in head to head competition with the likes of Domino’s and Pizza Hut. The owner of the small shop works night and day and is very passionate about his business. Still, over the past five years, Domino’s has spent an estimated $1.4 billion in national advertising in the United States.3 Although I am always fond of the underdog and tend to root for him, this is just one battle the small guy cannot win—at least not on this battlefield.

What he can do, in following our plan to build a business that Warren Buffet would love, is create consumer-monopoly differentiation and distinguish his business from the mega chains. Currently his model is very similar to the delivered, standard quality pizza of Domino’s. For our small guy, this results in head-to-head failure. Even loyal fans will eventually capitulate, making the switch based on Domino’s systematized, superior delivery framework with its built-in, machete price slicing offers. As it stands, our pizza guy does not have a chance (Mama Mia!) and must differentiate his model lest he sits stagnant in a slowly spiraling vortex of death. Perhaps he can implement a Hawaiian luau theme complete with a tomato sauce-spewing volcano that erupts every hour on the hour. An Elvis impersonator can perform a couple of numbers (Live! Via Satellite!) before gorging himself on a fried peanut butter and banana pizza just to show the customers how good it is.

I kid a little, of course, but this concept is founded on the same consumer monopoly concept that Warren Buffett loves to see in a business. Coke is Coke because the company has built up an enduring consumer brand over the past 120 years, and if the cans, bottles, and two liters disappeared off the shelves of the local supermarket warehouse tomorrow, most people would take note. The same can be said for the local Hawaiian themed pizza shop that spews pizza sauce every hour while a fat guy in a jumpsuit obliterates a Chicago pan to the tune of See See Rider. If that went away, customers would notice.

How to Paint

We have a road map courtesy of Warren Buffett, but what do we do with it? How can we take the principles of a consumer monopoly, with a strong track record of earnings, a healthy return on equity, with the ability to reinvest the earnings at a high rate of return, with little or no debt on the balance sheet, the ability to increase prices with inflation, and a healthy net and gross margin relative to other businesses and industries, and wire it into a small business in order to build a small business that Warren Buffett would love?

First we take a step forward, and then backward, and now we are...