Have a Good Business Model? Take This Test

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Do you have a great business? One thing I’ve learned from coaching hundreds of entrepreneurs is that just about every one of them thinks they have a “great” business model. Do you? If you want to test how great your business really is, ask yourself how it rates on the following four factors:

Lots of Demand–Book to Bill Ratio

While it’s nice to build a business around a niche that your competitors have overlooked, a great business has significant demand for whatever it sells. One way to gauge that is to look at your book-to-bill rate, which you can calculate by dividing how many orders you’ve taken in by the orders you have shipped. If you have strong demand, you should score a ratio of 1.2 or higher, which means you’re booking more than you’re shipping and growing. Think about how good boutique wineries operate. They always sell out their entire inventory each season–which means their demand is always higher than their supply. Why is that a good thing? Because it keeps their prices high.

You Have a “Mafia Offer”

A Mafia Offer is where you can offer your customer such a good deal, they would be crazy to turn it down. Just think about the history of the video rental industry to see how powerful this can be. Remember when you used to have to go to the video store to pick up your movies? That was fine until Netflix came along and made their first Mafia Offer, which said, why go to the store when you can just order your movie online and we’ll ship it to you? Even better, we won’t charge you a late fee and we’ll give you the envelope to mail it back to us. You’d be crazy to turn that down, right? Of course, Netflix did it all over again when it introduced its streaming movie plan. Now, you can do everything with your remote control in just seconds. Oh, and they’ll charge you less to do it. You can tell a good Mafia Offer whenever you see an existing business model folding under the pressure created by a new one.

Strong Gross Margin

Your gross margin is the amount of profit your business has earned before paying overhead and after you’ve paid for the cost of making your product or delivering your service. Great businesses have gross margins of 50% or higher and net margins, which account for general overhead, in excess of 20%. Think software companies, professional service firms, and pharmaceutical manufacturers. When you have margins like these, you don’t need to tap external financing to keep growing and you’ll net sky-high valuations if you want to sell your business.

Your Assets Work Hard

To calculate your return on assets, add up all the assets in your business–including your cash, equipment, and working capital–and then compare that to your profits. If your profits don’t represent at least 20% of that figure, then you don’t have a great business. Why? Because that means you’re not generating a high enough rate of return to justify the risk of operating your business. You could put that money into the market and return a similar rate without the risk of, say an employee lawsuit, your building burning down, or even running out of cash. You need to generate a return that’s materially better than anything you could get from the market to make it worthwhile. In fact, if you have a 20% return on your assets, you have a really good business. But of you earning a 50% return on assets, that you truly have a great business on your hands, usually because you’re not burdened with a lot of inventory, equipment, or working capital.

Use these four factors to take a hard look at your business. Give yourself a score on each and see how you rank. That’s how you’ll know how great your business really is.

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