Tuesday, 31 October 2006

Venture opportunity screening

Russell Davison

I originally wrote this article, “Venture opportunity screening” in November 2003.

Anopportunity has been screened for the export of handcrafted goods fromSingapore and the venture appears attractive. New technology and newbusiness processes are used by the venture to provide small retailersof antiques clocks, gifts, handicrafts and home décor with handcraftedgoods from Asia by 15 Kg air parcels, delivered in 7 days. The averagevalue of each consignment is S$800 and credit card payment, with order,gives UK retailers 4 weeks to 7 weeks credit with the card company,whilst the venture is assured payment by VISA and Mastercard monthly.Direct mail and telemarketing are used to create and penetrate themarket and bilingual staff are close to Asian suppliers and possesssuperior customer service skills.

A quick screening of the newventure identifies the potential market of small UK retailers and thegross margin is estimated to be 50%.  The competitive advantagesidentified are identified as low fixed costs, control over costs,location and people advantages. The value created is 10% profit aftertax and an IPO exit mechanism is foreseen after 3 years.

Theopportunity concept takes advantage of the recent halving of prices forTranspacific freight and international call costs in the last couple ofyears and new techniques for receiving assured payment frominternational customers. The new venture strategy is to penetrate 10%of the market of UK retailers who sell antiques, clocks, gifts,handicrafts and home décor.

The market profile is of reachablecustomers who seek product variety. The competition is fragmented andmarket sizes are estimated as S$20M, S$80M and S$100M in the UK, US andEurope, respectively. The venture economics profile is of low capitalrequirements and favourable free cash flow characteristics. The time tobreak even is 15 months. The IPO exit mechanism is estimated to harvestS$2M for the founder in three years. The venture provides a good fitwith the goals of the founder and a bilingual team will be createdwithin the first 2 years of operation. Strategic differentiation fromthe competition is by superior customer service, use of technology,pricing and product quality. The market entry strategy is to createcustomer awareness that it is now possible to quickly receive qualityAsian goods in small quantities at a competitive price from the newlyformed company.

The reasonsfor makingthe company believe thatthe idea is an opportunity are concerned with the main components ofcustomer need, premium pricing, underlying value creation proposition,market niche and product mix. Small UK retailers need a variety of highvalue products to differentiate themselves from the larger UK retailersand to compensate for their lower lever of sales activity. They arerequired to purchase goods in modest volumes from wholesalers and UKmanufacturers to realize wholesale discounts and are prepared to pay apremium to reduce their investment in inventory. The new venture has anunderlying value creation proposition of supplying UK retailers directin more frequent, smaller volumes to reduce inventory and to takeadvantage of lower freight costs and international telemarketing callcosts. The marker niche of UK retailers selling antiques, clocks,gifts, handicrafts and home décor is chosen to avoid dealing with theend-user consumer, whose average order value would be unlikely toexceed S$100, unacceptably increasing the administration costs. Theproduct mix is carefully chosen to include only those items whose salesprice to weight ratio is high, to ensure low air parcel distributioncosts (as a percentage of the selling price). There are currently nosubstitutes for the marketing mix of premium priced products promotedby direct sales and telemarketing from Singapore.

The newventure seeks to improve upon the existing value chain by eliminatingthe warehouses of UK wholesalers. This is achieved by employing the‘just in time' distribution technique that has been successfully usedwithin manufacturing industries for the last 20 years to reduceinventory costs. The product strengths are the uniqueness of Asiandesigns, handcrafted features, unfamiliar materials, unusual colours,peculiar symbology and aesthetics. The product weaknesses are unprovendemand, freight costs, fumigation certification for wooden items,humidity control requirements and the non-uniformity of designs.Existing competitors in the industry have been assessed. Direct mailcosts are estimated to be S$1,000 per thousand contacts, telemarketingIDD call costs are S$10 per hour and the web-host charges 1½% pertransaction and S$70 per month. The distribution costs have beenestimated and are 22% of sales. Value chain physical, margin andinformation flows have been mapped and they reveal that the suppliersbenefit from high percentage margins, which are moderate inabsolutedollar terms.

It's estimated that the new venture will capture¼, 1, 2 and 5% of the market in years 1, 2, 3 and 4 of the venture. Thebusiness goal is 10 % of the market, with sales of S$2M, in 5 years.The product cost represents 36% of the sales price, gross margin is 36%of the sales price, fixed costs are 16% of the sales price and profitbefore tax is 12% of the sales price. Resource needs to launch thecompany are modest. The cash flow conversion cycle has been forecastedand a preliminary cash flow analysis has been created. The break-evenchart shows that the venture needs to ship three consignments everycouple of days (or 28 consignments per month) to break even.

Capitalwill be raised for the business in two stages, at launch and afterthree years of operation by way of an IPO. The launch capital ofS$100,000 is to be invested by the company owner. The marketcapitalization for the IPO, after 3 years, is estimated to be S$2M.This is based upon forecasted earnings (net profit after tax) of S$0.1Mfor 2007 and S$0.2M for 2008, giving a P/E ratio of between 10 and 20.The IPO opportunity will attract investors from Singapore governmentagencies, institutions and individuals. The company owner intends toharvest the venture by means of selling the company via the IPO. Thisis estimated to occur in three years time, in January 2007. The harvestprospects are good if the forecasted growth and required margins can beachieved. The company would be source of strategic value to exportersof other products based in Singapore, or to importers based in the UK.As there are no other firms currently delivering this product andservice mix, a company contemplating entry may be a logical buyer. Thebusiness asset requirements are low and, if the owner decided to exit,it would cost less than S$20,000 in lost lease deposits and depreciatedfixtures, fittings, equipment and other venture launch expenditures.This amount seems reasonable, with respect to the venture's potentialand risk. Expenditure after launch can be adjusted to match the levelof sales activity witnessed, so as not to run out of cash beforesecuring enough profitable customers to sustain a positive cash flow.

Thestrategic analysis of the competitive landscape estimates that the fourcompetitor categories are large UK importers with warehousing,specialist UK manufacturers, UK manufacturer's brokers and internethobbyists with no marketing who have market shares of 50%, 25%, 20% and5%, respectively. Marketing tactics for each competitor vary. Profilesof the competition in year 2003, for price/quality and marketshare/profitability have been created.  The main manufacture ofthe handcrafted products, by definition, is not subject totechnological change. However, the required quality assurance,fumigation and humidity control processes involve technology that willtake six months to two years to develop, implement, install andmaintain. The new venture has the competitive advantage of being inclose proximity to the suppliers of the goods and an additionaladvantage can be gained by hiring staff who speak Mandarin andIndonesia Bahasa.  The new venture is also able to work with itssuppliers to assure quality and meet fumigation and humidity controlrequirements. The new venture can be price competitive if theadvantages of low fixed costs, zero/low inventory costs, low suppliercosts and higher customer value (through increasing their inventoryturnover) more than compensate for the new venture’s higherdistribution costs of delivery by air parcel. The new venture’smarketing positioning, relative to the competition, has been chosen. UKspecialist manufacturers and manufacturer's brokers are vulnerable tocompetitors, like the new venture, being able to offer good qualitysubstitute handcrafted product designs from Asia. Once penetrated, thissection of the market will always remain vulnerable to the newventure’s competitors and they will lose market share if the quality ofthe new venture’s products can be maintained. Another vulnerability ofthe new venture’s competitors is in the creation of awareness in UKretailers that handcrafted Asian goods can be procured direct from thenew venture.

The founder's vision is to change the way manygoods are exported from Singapore, by offering superior customerservice and good quality products, using staff skilled in CRM and byusing new business processes. The company aims to inspire its staffthrough leading by example, on the job training and by continualemployee attendance at CRM business management training seminars andcourses. The founder has many years of international businessmanagement experience with a large MNC throughout America, Asia andEurope and many years of experience in project management andengineering in Europe with various companies.    He isvery knowledgeable about logistics, procurement and sales andpossessesthe skills required for the venture's success. Additional bilingualpersonnel are required in Mandarin, Bahasa and English.  These newstaff members will be attracted to the venture after the first sixmonths of launching the company. The founder has previously managedprocurement and export of industrial products from America, Asia andEurope.

Significant assumptions are made in the screening of thenew venture. It’s assumed that the sales projections are realistic andthat customers will purchase the goods without first being able totouch and see them, apart from the photographs and specifications inthe new venture’s catalogue. The ability to recruit local staff withgood customer service skills and understanding of UK dialects, namesand customs is assumed. It’s also assumed that the implementation ofsupplier quality assurance will be successful and that customers acceptthe new venture’s terms of payment. The downside consequences ofinvalidity to these assumptions are lost growth opportunities if salesprojections prove to be unrealistic and the company could be forced tocease trading if it is found not to be possible to recruit local staffwith good customer service skills and UK knowledge. If product qualitycannot be controlled then customer returns and lost trade could costseveral tens of thousands of dollars in refunds to the credit cardcompanies, who demand 100% customer refund guarantees. The maximum costof liquidation, to the founder, is less than S$80,000 and is tolerable.Bankruptcy is not tolerable by the founder for participation in thisventure.

The risk of the venture is rated as medium as it ismanaged by financial bootstrapping and with the use of milestones.Before the IPO in three years time, the business is initially funded bythe founder. The founder's investment is moderate and break even isestimated to occur in the 15th month of trading.Bootstrapping is used between break even and the IPO listing tominimize the company's exposure to financial risk. Borrowing could beused to promote growth, but this would increase the risk. Milestonesare placed along the venture's path to the IPO, as checkpoints, beforefurther resource commitments are made. The first milestone is placedafter the first six months of operations. This marks the transition ofthe company into leased premises with a shop front and a commitment toengage two staff before the end of the first year. The precondition forpassingthis milestone is that the direct mail and telemarketingcampaign have generated more than one hundred positive responses orenquiries and that the receipt of the first few purchase orders isimminent. Similar milestones are placed every six months to matchadditional resource commitments with previous, current and future salesactivities.  A schedule for week-by-week action steps, during thefirst six months, has been created.

The value proposition can beenhanced by communicating to retailers the true cost, to them, of theircurrently low inventory turnovers and how the new venture company couldassist them to increase their inventory turnovers, thereby reducing theamount of their capital tied up in stock. The new venture could improvetheir value proposition by appointing agents or distributors in the UKto penetrate the 90% of the target market that they don't envisageinfiltrating by direct mail and telemarketing alone.   The sequence of customer database generation, direct mailing andtelemarketing batch sizes could be changed to improve the fit byfocusing on a pilot study. The sequence could be changed so that 500targeted customers are contacted four months ahead of the plan tostatistically infer the likely response from 5000. Staff could be addedearlier than planned to divide the tasks of CRM database creation,direct mail and telemarketing between staff and the founder. The fitcould also be improved by eliminating the need for premises with a shopfront for local sales. Local sales are expected to be low, so moreeconomic business premises could be used in an out of town industrialarea. The free cash flow characteristics are at their optimum withadvanced payment commitment and retarded payment for logistics andresources. However, the value chain could be extended to manufacturethe products ourselves. The major risk, after venture launch costs, isthat the initial marketing investment of S$10,000 does not createcustomer awareness, enquiries and orders at the magnitude planned bythe new venture. The risk/reward balance could be adjusted byincreasing or decreasing the marketing investment.


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