We get approached by ~1200 companies per year and spend some time with about 400 of them. One of the key filters for us to identify opportunities we may be interested in is how quickly we can grasp the basics of the business’s economics; i.e. how value gets created.
In most cases, the best way to observe this is the income statement. That is why it’ s important to show some granularity primary line items in the income statement. Viewing the income statement across a meaningful time span, you can start connecting the dots and get a feel of how the business creates value.
However, in some cases, we look at income statements in which the value chain is not obvious. We view this as a bit of a red flag. We try to work with the founders to dig and understand the value drivers, but experience shows that if a founder is having difficulty explaining the fundamental economics and the way value is created within a few lines on her business plan, it’s likely that their model is flawed, or worse, they don’t fully understand it themselves.
Warren Buffett warns that a business you invest in should be simple and understandable. We agree.