Here's Our Criteria for Investing in Companies Ep 406

Alex Hormozi, joined by his wife Layla, delves into the strategies for evaluating and amplifying the value of businesses, particularly in the service, e-learning, and coaching sectors. He presents a three-step checklist focusing on the potential number of units sold, the profit margin achievable, and the competitive dynamics within the market. Alex emphasizes the importance of high gross margins, citing examples from tech giants like Google and Facebook, and discusses how businesses can expand their Total Addressable Market (TAM) over time. He critiques the traditional reliance on TAM as a metric for business potential, advocating for a broader, more dynamic approach to assessing and seizing market opportunities.

• Alex Hormozi introduces the topic of identifying valuable business opportunities.
• The focus is on businesses that sell highly valuable products or services with minimal costs.
• Alex and his wife Layla engage with numerous businesses weekly for potential investment.

"If you look at the biggest companies that exist out there, they sell something that's very valuable that costs them almost nothing. Welcome to the game, where we talk."

This quote serves as an introduction to the business philosophy that the most successful companies sell products or services that have a high perceived value but are inexpensive to produce. It sets the stage for the discussion on identifying and maximizing business opportunities.

• Alex Hormozi is presented as an experienced entrepreneur with a significant business portfolio.
• He shares his motivation for creating content, which is to help others avoid financial struggles.

"My name is Alex Ramosi. I own, it's a portfolio of businesses. It does right now, $110,000,000 a year. All right, so I make this just because I was once broke, and I don't want you to be broke."

Alex Hormozi introduces himself and his business credentials, emphasizing his success and his desire to help others achieve financial stability. This establishes his authority and experience in discussing business opportunities.

• Alex proposes a three-step checklist to evaluate the potential of a business opportunity.
• The goal is to help businesses think about how to transform their current operations into greater opportunities.

"What are the ways that we think through in terms of the value of the business and not from a dollars perspective, but what is the opportunity?"

This quote highlights the importance of assessing a business beyond just its financial value, focusing on the underlying opportunities it presents. It introduces the checklist that will be used to evaluate these opportunities.

• Alex emphasizes the use of frameworks to make quick, informed decisions about potential investments.
• He outlines the importance of determining whether a business opportunity is worth pursuing, altering, or advising on.

"I have to use frameworks in order to make those decisions right, and make snap judgments on, like, do I think this is interesting?"

The quote stresses the necessity of having a systematic approach to decision-making in business. Frameworks allow for efficient and effective evaluation of opportunities, which is crucial in Alex's process of identifying worthwhile investments.

• Alex identifies three primary factors he considers when evaluating a business opportunity: potential units sold, fit for purchase, and longevity of demand.
• He introduces the concept of Total Addressable Market (TAM) and hints at its limitations, which he plans to discuss later.

"There's three things that I've kind of boiled down to an opportunity vehicle. Is this something a business or opportunity that I want to pursue?"

This quote outlines the three main criteria Alex uses to determine the attractiveness of a business opportunity. These criteria serve as a simplified framework for entrepreneurs to assess their own businesses or potential investments.

• Alex discusses the importance of understanding the sustainability of a product or service's demand.
• He uses the example of the weight loss industry to illustrate assumptions about continuous demand based on human behavior and societal trends.

"Is this indefinite. If you're selling weight loss, do I believe that people are going to continue? Is food going to keep tasting better? And are people going to be able to change their genetics in terms of how they rely on it?"

The quote addresses the need to consider whether the demand for a product or service will persist over time. Using weight loss as an example, Alex points out the factors that suggest a lasting demand, which is a critical aspect of evaluating a business opportunity's potential.

• Assessing the potential customer base for a service is crucial.
• Estimating potential profit involves understanding the value delivered and the cost of delivery.
• Profit opportunity is influenced by the value-cost ratio of the service.

"Number one is how many people could potentially buy this service? Number two is going to be, what is the potential profit I can make from the service?"

This quote emphasizes the importance of understanding both the size of the potential market and the possible profitability of the service being considered.

• The value provided to customers and the service delivery cost are key to determining profitability.
• High value but costly services are less attractive due to lower profit margins.
• Services with low value but also low cost can be enticing if there is a significant customer base.

"And that's a function of two things, which is what is the value that people are getting from this outcome? And then how much does it cost us to deliver it?"

Alex Hormozi explains that profitability is determined by the value delivered to the customer and the cost incurred to provide that value.

• Gross profit margin is a critical factor in business model selection.
• Alex Hormozi prefers business models like e-learning and coaching because of their potential for high gross margins and scalability.
• Transitioning to a more valuable enterprise model can make a business more attractive for future sale.

"And the thing is there, the gross profit is actually kind of enticing. And depending on what that first one was, which is how many people are willing to buy this thing, then it's like, this becomes a little bit more interesting, right?"

Alex Hormozi finds businesses with high gross profit margins and large potential customer bases more interesting due to their scalability and profitability.

• Understanding the competitive landscape is essential for business success.
• Competitive dynamics can be a barrier to entry, even with high demand and good profit margins.
• Assessing supply and demand is not enough; one must consider the ability to compete with established players.

"The third piece is the supply, demand, or competitive dynamics of the landscape."

This quote introduces the importance of competitive dynamics as a third critical factor in assessing business opportunities.

• A business idea must be evaluated based on market demand, value proposition, cost structure, and competitive landscape.
• Alex Hormozi provides examples of how to assess opportunities, including entering competitive markets and capitalizing on emerging technologies.
• A business with a large potential market, high value, low cost, and favorable competitive dynamics is an attractive opportunity.

"So if I wanted to get into, let's say, wireless cell phones or cell phone service, well, lots of people need it. Okay, that's good supply. The value versus what it cost me to add an additional user in, the gross margins are really good."

Alex Hormozi uses the cell phone service industry as an example of a market with high demand and good profit margins but difficult competitive dynamics.

"And so a different example of that, I'll tell you like a hypothetical crazy good example would be if someone had figured out a way to create hardware that does crypto mining, right?"

This quote introduces a hypothetical example of a business opportunity with a large market, high value, and potentially low costs, highlighting the importance of assessing all factors when considering a business venture.

• Alex Hormozi challenges the traditional emphasis on TAM for business valuation.
• The suggestion is to use alternative lenses to evaluate a business's potential.
• One should consider ways to expand the audience or customer base.
• Another aspect is reconfiguring the business to enhance customer outcomes or reduce fulfillment costs.
• The goal is to increase gross profit per unit sold.

"If you're thinking through these lenses, and I'll talk about the tam thing in a second about why I don't think it's necessarily as good as people used to think in terms of assessing the value of the business."

This quote indicates that Alex Hormozi will explain why the traditional focus on TAM may not be as effective in assessing business value.

• Alex Hormozi recommends aiming for 80% or higher gross margins in service businesses.
• Gross margin is crucial for covering business expenses beyond the direct cost of goods sold.
• Profit is essential for business sustainability and scaling.
• There's a misconception among smaller businesses that higher charges are negative.
• High gross margins are characteristic of successful large companies.

"And I'll give you a couple of rules of thumb here that I like, which is, if I'm doing any kind of service business, I like to have 80% or higher gross margins, all right?"

This quote provides a specific rule of thumb from Alex Hormozi for service businesses, emphasizing the importance of maintaining high gross margins.

• Businesses, especially smaller ones, often mistakenly believe that charging more is unfavorable.
• Higher prices are necessary for gross profit, which enables business growth.
• Gross profit is not solely for the owner but is used to cover various operational costs.

"And the thing is, especially smaller businesses think for some reason that charging more is bad, right? And you got to get out of that, because if you want to help more people, you need to have gross profit in order to scale."

This quote addresses the common misconception about pricing and underscores the importance of gross profit for scaling and helping more customers.

• Alex Hormozi identifies business models with nearly 100% gross margins, such as software and information/education businesses.
• These businesses have low incremental costs after initial development.
• High-margin businesses can charge significantly while maintaining low additional user costs.
• Information and education businesses have similar margins to software but with less development cost.
• However, information and education businesses may face higher churn rates.

"You look at the biggest companies that exist out there, they sell something that's very valuable, that costs them almost nothing."

This quote highlights the business strategy of successful companies that offer high-value products or services at minimal incremental costs, leading to high gross margins.

"The only other type of business that's like this with a close to 100% gross margin is information and education businesses, which is why Leila and I like these types of businesses, because they have the same margin as software businesses, except you don't have the cost of development."

Alex Hormozi explains his preference for information and education businesses due to their high gross margins and low development costs compared to software businesses.

• Skill-based businesses face the challenge of providing value that may diminish over time as clients learn the skill.
• There are strategies to reconfigure such businesses to retain clients by distinguishing between consumable and one-time consumable aspects.
• By focusing on consumable elements, businesses can increase the "stick" of the client, meaning the likelihood of them staying.

And I'm going into the weeds here, but hopefully you'll enjoy it.

This quote shows Alex Hormozi delving into the specifics of how businesses can maintain client retention despite the inherent value decline in skill-based services.

• TAM (Total Addressable Market) is not always indicative of a company's potential size or growth trajectory.
• Founders and businesses often expand their vision over time, which can lead to the exploration of adjacent markets or silos.
• TAM should be considered more flexibly, with the understanding that businesses can grow by expanding their market through various strategies, including mergers and acquisitions.

The reason that I think it's interesting is that businesses and founders expand in vision over time.

Alex Hormozi emphasizes that a founder's vision can evolve, which in turn can expand the business's market beyond the initial TAM.

• Businesses can grow by scaling one avatar (customer profile) significantly before considering market expansion.
• Long-term growth may involve entering new or adjacent markets, which can be achieved organically or through mergers and acquisitions.
• A short-term focus on TAM is practical, but long-term growth potential should consider the possibility of expanding the market served.

You could just scale one avatar to probably 100 million a year before doing that.

Alex Hormozi advises that focusing on scaling a single customer profile can lead to substantial growth before needing to branch out into new markets.

• The original or current TAM may not reflect future growth potential if a business is capable of expanding its market.
• Considering the long-term horizon, businesses should evaluate whether they can capture a larger share of the market over time.
• This approach requires thinking beyond the immediate TAM to envision future opportunities.

If the answer is yes, then the original TAM or the current TAM is not necessarily what the future TAM is going to be.

Alex Hormozi suggests that the future TAM may be larger than the current one if the business can expand who it serves over time.

• To increase opportunity size, businesses should consider how to appeal to more customers, enhance value relative to cost, and enter unique or new spaces.
• These strategies can lead to increased revenue and a larger market presence.
• When investing time and money into companies, these factors should be considered to maximize potential returns.

And if we can do those things, then we increase what I would consider the opportunity size of what we are pursuing and then ultimately make more money.

Alex Hormozi concludes that by employing these strategies, businesses can increase their opportunity size and profitability, which is a key consideration in his investment decisions.