The three traits of elite business models that every founder must know
Some business models are simply better than others. That statement may sound obvious, but it’s all too often softened or avoided in discussions about entrepreneurship. The harsh reality is the businesses behind the Forbes 400 list of richest Americans prove this fact beyond a doubt:
Extraordinary wealth tends to originate from a relatively small subset of business models.
The companies that generate the most wealth are not just well run, they’re structurally set up to have an advantage. The good news is that you can replicate that advantage once you know the 3 traits elite business models all share.
The Forbes 400 business model filter
It’s no secret that the businesses behind the Forbes 400 list have historically processed some of the finest business models going.
Not only do their Value Equation variables work in concert to deliver high equity rates of return, but these businesses are also:
- Highly scalable
- Capable of operating leverage
- And able to address extremely large market opportunities
In many cases, the required business investment was low to begin with and the equity investment even lower. That’s a huge part of what makes it easier for founding teams to retain meaningful ownership as their businesses scale. Ownership retention is a powerful, and often overlooked, contributor to personal wealth creation.
Scalability alone is not enough
Plenty of businesses scale. But what separates elite business models from the rest is that they can scale efficiently. High levels of operating leverage allow these companies to grow sales without a commensurate increase in business investment.
Technology and investment management firms exemplify this trait. Once core infrastructure is in place, additional revenue often requires minimal incremental capital. However, even in these businesses, growth is not free.
Working capital requirements still tend to rise with sales. Inventory, receivables, and cash balances often increase as revenue expands, which means growth can consume cash that might otherwise be used for reinvestment or investor distributions. This is why even excellent business models face a sustainable growth constraint.
The speed at which elite business models can grow
How fast can great businesses grow? A useful rule of thumb is that a company can grow at approximately the same rate as its after-tax equity returns without requiring additional equity capital. Grow faster than that, and new funding becomes necessary, whether through equity dilution, additional borrowings, or reduced cash distributions.
This constraint applies even to businesses with strong operating leverage. And it helps explain why some high-growth companies repeatedly raise capital despite impressive revenue expansion. Inflation complicates this further.
Rising prices increase nominal sales, but they also inflate inventory and receivables draining liquidity without improving real profitability. This is one reason inflation can be so destructive, even to well-designed business models.
A practical way to look at elite business models
Let’s look at a practical way you can think of elite business models and the characteristics they all share:
1. Capital stack
The best business models generate high current equity returns with minimal reliance on Other People’s Money (OPM).
A useful way to initially look at this is to:
- Set OPM to zero
- Assume the business is funded with 100% equity
This creates the most conservative capital stack and allows you to compare raw business model potency without the benefit of leverage. OPM adds risk because it has payment priority over equity. Removing it clarifies whether returns are coming from the business model itself or from financial engineering.
2. Equity efficiency
Elite business models generate the highest ratio of operating profitability to business investment. In other words, they are efficient users of equity. The more equity-efficient a business is, the less dilution founders face when raising capital for growth, which is why many Forbes 400 members retain high ownership percentages in the businesses at the root of their wealth.
Equity efficiency is not just about returns, it’s also about control and compounding.
3. Growth in a proven model
The best business models combine growth potential with proven economic potency. From a value investor’s perspective, growth introduces risk. That risk is far easier to manage when growth occurs within a business model that already produces strong cash returns. History offers plenty of warnings, from the dot-com boom to more recent public companies with limited earnings and unproven models, that growth alone does not create wealth.
Growing into a potent business model is far safer than hoping growth will eventually make a weak one work.
The Reality for Most Businesses
You should now have a clear picture of what collectively characterizes the finest business models:
- High equity returns
- Low reliance on OPM
- Scalability with operating leverage
- Asset efficiency
- Large market potential
Businesses capable of producing high returns on equity with limited use of OPM are among the most powerful wealth-creation vehicles available. If such a business can also assume a leadership position in a large global market (and if founders can retain meaningful ownership), the potential for extraordinary outcomes exists. Most businesses, however, don’t meet these criteria. The markets they serve are too narrow, they require business investment to grow in proportion to revenue, and/or they rely heavily on OPM and new equity.
These things make it difficult for founders to retain large ownership stakes as they scale. And it’s not necessarily that these are “bad businesses.” They’re simply built differently.
But what happens when growth arrives before a business model is ready? And why does growth so often expose weaknesses rather than fixing them?
Follow along with future articles here, or explore my YouTube channel as I continue to reveal the principles you need to know to truly become business rich.
