Here are five criteria I use to evaluate a business. I have used these criteria for over 20 years and are based on sound economic principles. 50% of businesses fail within the first 2 years. Only 5% of businesses survive for 10 years or more. The criteria listed address the main reasons why businesses fail to make sufficient cash flow and profits. They may seem like common sense, but most start ups fail because they do not realistically appraise their chances of success.
1. How Much Bargaining Power Do Customers Have?
The more options and bargaining power your customers have, the less profitable your business will be. This is because if your customers are in a strong bargaining position, they will be able to take their business to someone else or require a price reduction to make a sale.
2. How Much Bargaining Power Do Suppliers Have?
The more bargaining power employees, contractors, and suppliers have, the less profitable a business will be. This is because suppliers will be able to increase their prices, increasing business costs. If a business cannot pass increased costs to its customers via higher prices profits will decline.
3. What is The Nature and Degree of Competition?
The more the competition, the lower the profits. If competition is in the form of price competition this is the worse case senario.
If you can differentiate your product offering and add value in a way that customers will pay a premium, this is a better senario.
The best senario is to create a virtual monopoly by creating products and services that lead the industry in terms of value for money and innovative benefits to customers. Examples include the apple ipad, the apple ipod, the windows operating system, & google search engine, google adwords and adsense.
4. What Are The Industry Barriers To Entry and Exit ?
How easy is it for others to start up and compete with the business. How easy is it for customers to switch to another supplier. What are the costs customers must pay if they switch to another supplier. Can the business create a sustainable competitive advantage that deters competition form start ups and deters customers from switching to another supplier?
5. Does The Business Generate Predictable Positive Cash flow and Profits?
Does the business generate regular repeat sales and cash flow? Are systems in place to generate cash flow and profits without the intervention of the business owner.
Does the business have a pathway to its customers to make sales?
Can be business generate sufficient positive cash flow and profits to provide a competitive rate of return to the investors?
Is the rate of return sufficient to compensate for the risk incurred and resources invested.
Is the cash flow and profits predictable and stable. Is the business a saleable asset with a value that can be objectively determined. The greater the profits and cash flow the greater the selling price, The greater the stability of cash flows and profits, the less risk which increases the selling price.