The Game with Alex Hormozi - Here's Our Criteria for Investing in Companies | Ep 405

Episode Date: July 7, 2022

They made a list, and they’re checking it THRICE! Today, Alex (@AlexHormozi) shares the 3 criteria he and his wife Leila use when they are looking into investing in companies, how these indicators greatly help their screening processes, and "what is the value of the company based on the potential opportunities?"Welcome to The Game w/Alex Hormozi, hosted by entrepreneur, founder, investor, author, public speaker, and content creator Alex Hormozi. On this podcast you’ll hear how to get more customers, make more profit per customer, how to keep them longer, and the many failures and lessons Alex has learned on his path from $100M to $1B in net worth.Timestamps: (2:29) - 1st criteria: potential units sold, 2nd: potential profit(4:56) - 3rd criterion: supply-demand or competitive dynamics(7:20) - Alex's rule: 80%+ gross margin for service-based business(9:59) - TAM not a good indicator for company sizeFollow Alex Hormozi’s Socials:LinkedIn | Instagram | Facebook | YouTube | Twitter | Acquisition

If you look at the biggest companies that exist out there, they sell something that's very valuable that cost them almost nothing. Welcome to the game where we talk about how to get more customers, how to make more per customer, and how to keep them longer, and the many failures and lessons we have learned along the way. I hope you enjoy and subscribe. My wife and I, Layla, talked to 10 to 20 service, information, e-learning, coaching businesses per week that we're looking to invest in. And that's, you know, after they've gone through, you know, several screening processes. And what I wanted to talk about today is what are the ways that we think through in terms of the value of the business? And not from a dollar's perspective, but like what is the opportunity?

And I want to give you kind of the three-step checklist that I think through and how you can apply it to your own business and think like, how could I take what I'm currently doing and make it more of an opportunity for me, right? And if you don't know who I am, my name is Alex Ramozy, I own Acquisition.com. It's a portfolio of businesses it does right now, $110 million a year. All right. So I make this just because I was once broke and I don't want you to be broke. So that is why we do this.

Anyways, so let's rock and roll. When you've heard people say opportunity or opportunity vehicle, you need to get into a better monetization structure. There's different ways of kind of saying the same thing, which is like how much money can we possibly make from this core thing, right? And so when I'm thinking through this, there are three pieces that I think through. And at the end of the video, I'm going to kind of walk through kind of the downstream impacts of these things and how you can apply them. But this is the big picture.

And you have to make these, I have to make lots of decisions really quickly. so I have to use frameworks in order to make those decisions, right? And make snap judgments on like, do I think this is interesting? Should we pursue this further? Or should we just give some advice and wish them well and maybe see them in the future if they implement it, right? So there's three things that I, that I've kind of boiled down to an opportunity to vehicles. Is this something, is this something, a business or opportunity that I want to pursue?

And so for a lot of you guys who are starting out, this will be very valuable for you because hopefully you can just set this up right. And if you're already in the process of building your business, then maybe you can make alterations to the business and incorporate this. So there's three things that I'm looking at in terms of what I think makes something much more interesting. Number one is the number of potential units sold. So a lot of times people talk about Tam, total adjustable market, and I'll talk about why I think that that the longer I do this is somewhat of a misnomer. So I'll talk about that at the end. But just how many people could potentially buy this thing, right, or buy this service or

whatever this thing is, right? How many people do I think would be a fit to be purchasers of the thing. So that's number one. And that's just going to show me how big, how long we can run this game. Is this indefinite? Is this like, you know, I mean, like, if you're selling weight loss, like, 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, how they rely on it? No, is status associated with being thin? Are men going to be, you know, attracted to women who are in general, like, thinner? I think those things are things that aren't going to change overall. And so those are assumptions that I'm willing to base the fact that there's a lot of people who want to buy

this thing. All right. That's just a simple way of thinking through. Like, what are the assumptions that would continue to make this true? All right. So 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? All right? 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? And so those are two very important components. Is there some elements, right, that are extremely valuable but also very costly to deliver. So that's something that would be less interested. And it might be very valuable, but like there's not a lot of opportunity for profit. Right. On the flip side, sometimes it's a very, very small amount of value, but it costs nothing, right? And the thing is, is there the gross profit is actually kind of enticing. And depending on what the first one was, which is how many people are willing to buy this thing, then it's like, ah, this becomes a little bit more interesting. Right. And so the potential for profit and the gross margin of the unit of thing that we are selling becomes more interesting, which is why Lela and I in general like course, e-learning, you know, guru coaching type businesses to work with because we can transition them from a not valuable model into a more valuable enterprise model that has something that they could sell in the future if they wanted to, right? The third piece is the supply demand or competitive dynamics of the landscape. And so I'll give

you a counter example and a good example, right? So if I wanted to get into, let's say, wireless cell phones, right, like our 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, right because how much does it cost me to add one more user to my phone network pennies right and what do I charge them hundreds of dollars a month right but then the third one is competitive dynamics well I'd have to beat out Verizon and AT&T and all the other big conglomerations of phone service that exist it'd be very difficult for me to break into that right and so that's an example of it checks two of the three boxes but not the third one right and so 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? And let's say that that crypto mining could make people, let's say, $50,000 a year. All right? I'm using an extreme example to illustrate the point. Well, if they had figured that out, then one, just about everybody wants passive or close to passive side income. So total number of people that we could sell this to a lot. Amount of value that someone's getting a lot, $50,000. In this case, it's actually quantifiable. How much does it cost us? In this instance, we'd have to figure out with the cost of the rig would be, but let's say it was, you know, small. Let's say it was $500. Well, then this business becomes incredibly interesting as an opportunity.

And then the third is, what are the competitive dynamics? Well, if there's no one else who can offer this, then we're off the races, right? But on top of that, how new is the space? Are there a lot of new people coming into it? Are there established people who are killing it that would try and price us out, et cetera? And in this space, for example, everything's brand new and said the competitive dynamics are great and it's massive, you know, it's very quickly growing and will continue to grow probably for the foreseeable. So in this instance, it'd be like, wow, this is a very interesting business that I would want to participate in or learn more about.

And so 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 use to think in terms of assessing the value of the business. I'll talk about that in a second. Hey, Mosin, a quick break just to let you know that we've been starting to post on LinkedIn and want to connect with you. All right, so send me a connection request and note letting me know that you listen to the show and I will accept it.

There's anyone you think that we should be connected with, tag them in one of my or laylist posts, and I will give you all the love in the world. All right. So let's get back to the show. If you're using these three lenses to think about your own business, you can ask yourself, okay, is there a way that I could make this, you know, applicable to potentially more people, right? So that I could have a total higher number of units or bigger audience that I could sell to, number one.

Number two is, is there a way that I can reconfigure this thing so that it either makes the customer a more valuable outcome, right? and or it costs us less to fulfill that outcome. So we increase the gross profit per unit sold. Is there a way that I can reconfigure what I'm doing? And I'll give you a couple 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. So what that means is if I'm selling something for $1,000 a month,

it has to cost me less than $200 a month. And for those of you who are new to making money, people will get their panties in a watt about that. But like profit is what drives business. All right. And it's not that all of that gross profit that's before cost of doing business goes to the owner. That's just everything that you have to chip down away from. So you're starting at 80. And let's say you want to run a business that runs 50% margins, right? Well, then that means you've got 30% there. Right. In that $1,000 month example, I got $300 a month to cover everything else that I do in the business that covers that covers marketing, that covers admin costs, it covers payroll, that covers HR, finance, all of these other, legal, whatever, all the other functions. the business. So the thinking is 80% is minimum. And the thing is especially smaller businesses

think for some reason that that's like 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. If you look at the biggest companies that exist out there, they sell something that's very valuable that costs them almost nothing. All right? So think about Google, right? They sell ad space. It costs them almost nothing besides the actual, like their incremental cost of running an ad is virtually zero. Right. And they charge a King's Ransom for it. Facebook, same thing, right? They charge for eyeballs that cost that,

like they've one time cost to building, then after that the incremental cost of showing adds to more eyeballs is almost nothing. So it's all margin, right? You look at the phone company that I was explaining earlier. Like they have their one time cost of building the thing, but then the additional cost of adding one more user is almost insignificant, right?

But they can still charge a great amount of money for it. This is the recent software is something that people find incredibly valuable. It costs one time to build it. And then after that, each incremental user is almost all profit. Now 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 Layla 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. The downside is that those types of businesses tend to have higher churn because the increased value or the value declines over time when someone learns a skill from this type of business. That being said, there are ways of reconfiguring the business to increase the stick of the client by pulling out the things that are consumable versus not versus one-times consumable. And I'm going into the weeds here, but hopefully you'll enjoy it. All right. So something that is a one-time consumption is like, okay, I've gotten this value that I now understand a new business

model that I could potentially be using, you know, or an improved version of the business model that I have. And so finally, I want to talk about why I think Tam is not as good of a, you know, indicator for the potential size of a company. Well, look at some of these original companies. So look at Facebook. When they started out, it was like supposed to just be a college, you know, network thing, right? It was supposed to be, you know, Facebook, I think is what the actual term was way back in the day for like a yearbook, right? And so that's literally what the name of the thing was, right? And so somebody might look at that initially. Obviously, people could see where it potentially go, but they saw that and be like, well, maybe the TAM, the total judgment market is just college students. The reason

that I think it's interesting is that businesses and founders expand in vision over time. And the, the, the when a vision is a visionary or a founder has run out of vision or run out of future is the moment that the business dies or they sell it because they just don't know what else to do to grow up, right? And so what happens a lot of times is that if we can continue to increase and eat up the total adjustment market that we have defined for ourselves in our business, a lot of times adjacent, you know, our adjacent markets or silos all of a sudden become more and more attractive. We find out that there's a lot of similarities or that we find out there's another need and then we can branch into yet another silo. Now, if you're like,

Like, that's the exact decision I did. And I went from 100,000 to 200,000 a year. No, that was dumb. Like, that's not the point of this. Like, you could just scale one avatar to probably, you know, 100 million a year before doing that. That's not the point. The point is that you, you know, on a long enough time rise in businesses also through

mergers and acquisition, things like that, they can buy up other companies that are adjacent close to them, et cetera, and expand the total interest market they have, which is why I don't necessarily think of it on a long-term time horizon, but I do think about it on a short-term time horizon. So if I'm looking at like the next three to five years, then I'm going to be like, okay, we're not going to change advertisers in the next three to five years, but do I think that this thing over the next 20 years could eat up more and more of the pie by expanding who were potentially serving? If the answer is yes, then the original Tam or their current Tam is not necessarily the future Tam is going to be. All right. And so that's why I don't see Tam as as valuable as I think

it, you know, it is purported to be. All right. So you hopefully can think through those three different opportunity kind of vehicle frames in terms of like, how can I, how can I look at my TAM in a way that potentially could sell more customers? How can I increase the value versus the cost of what it is that I am delivering? And is there a way that I can enter a space that is more unique or newer, which I can either do by going into the clearly new spaces or by trying to redefine what I'm doing in a new way, right? And if we can do those things, then we increase the, what I would consider the opportunity size of what we are pursuing and then ultimately make more money. All right. And so that's what I'm thinking about when I'm looking at these companies that we're, you know, potentially investing time and money into.

And otherwise, hope you have an amazing day. Bye.