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By Sean Wise

Globe and Mail Update - December 2007

A few years ago, when I was a director in Ernst & Young's Venture Capital Advisory Group, one of my goals was to build relationships with fast growing companies. The firm wanted to expand its share of the accounting pie, and believed one of the best ways to do that was to focus on those companies currently below the radar of the other global audit firms. It is a good strategy; young ventures are desperate for support from service providers be they law, accounting, marketing or public relations. The problem, however, is: how does one decide which ones (of the thousands of small companies starting out) will become big companies - big enough to justify the cost of investing in them now?

Knowing which "horse" to back - is half the battle. As a result, and in an effort to ensure a shared nomenclature, I started to develop a communal taxonomy to help classify the various types of ventures that my team and I encountered on a daily basis. Our goal was simple — identify which companies should be "hunted", and which should be allowed to "roam free". I'd like to share with you now, my taxonomy for referencing ventures. It is a jungle out there after all, and you need to hunt efficiently in order to stay alive.

The Four Types of Business Animals You can Hunt

For the most part, I classify companies as one of four types: Mice, Dogs, Elephants and Gazelles.

• - Mice are small companies that are likely to stay small. Think "Bob's Pizza"- they can serve a great slice of 'za but it is unlikely they will double in size annually.
• - Elephants are large companies whose growth is constant, but at a low level. Think Royal Bank. Its revenues grow annually, but it is so large that the growth is negligible over the short term, yet noticeable over the long term. Unfortunately, these companies have a high client acquisition cost.
• - Dogs are medium to large companies that are experiencing low or negative growth. Think "AOL". A great company, but its revenue is shrinking. In the venture capital business, I often refer to these companies as kennel capital, i.e., companies that should be put to sleep.
• - Gazelles are young companies that are experiencing extreme, massive growth. For those that pitch them early, the CAC is low and carries with it a high return on investment. Think "Facebook".

From a cash flow perspective, all four business animals start at similar points, however, they diverge rather quickly. The green Mouse stays fairly consistent, growing and shrinking its cash flow over time - possibly as a result of seasonal conditions. Never is it losing money, but it's never really hitting it big, either. The yellow Elephant starts in the best cash flow position and grows consistently at a relatively reasonable CAGR (Compounded Annual Growth Rate - a common business term used to represent the annualized growth of the business). Backing an elephant is never a bad idea, it is in fact, the safest bet (no one ever got fired from trying to land an Elephant). Unfortunately, Elephants are hunted by all, and this in turn, drives up the CAC.

Elephants also tend to be more bureaucratic and the sales cycle, too. Landing Elephants can also be extremel long sales cycle (months not weeks). The blue Dog starts with decent enough cash flows, but any effort to win them as clients is wasted, since their growth is negative and these Dogs may soon need to be put to sleep. This results in high CAC for Dogs, and since many of the Dogs your try to do business with won't survive, the average CAC is raised.

The Gazelles are where it's at from a business development (aka hunting) perspective. Gazelles tend to have the highest CAGR. They're also non-bureaucratic, and are flat in their organizational chart, which contributes to shorter sales cycles and lower CAC.

Two other Animals that roam the landscape

In my travels, I've run across two other types of animals that business development officers need to be wary of. First, there are the Blowfish, named by my good friend Joe Timlin of Growthworks, one of Canada's leading venture capital funds. Joe describes Blowfish as self-aggrandizing entrepreneurs who "inflate" themselves moments before presentations. These entrepreneurs are often witnessed claiming to know software better than Microsoft, search better than Google, and know mobile better than Nokia. Their goal is display a blind faith / confidence, which they hope will be infectious. Unfortunately it seldom is, and often Blowfish undermine their creditability with their posturing.

Giraffes are similar to Blowfish in that they aren't ideal targets for business development. Giraffes are similar looking to Gazelles from the neck down, but from the neck up, a firaffe's head is squarely in the clouds. The company has the potential to run fast like a Gazelle, but it's weighed down by senior management's unrealistic views. Unlike Blowfish, Giraffes tend to do well, but their growth often plateaus due to management's internal limitations. For instance, Giraffes tend to claim that they will hit $50M in revenue within five years. Hearing this is supposedly every potential investors dream come true. But the truth is, very few companies succeed in achieving it.

Companies doing $50M (Gazelles) do exist; they are just a lot more rare than the Giraffes and Blowfish would have us believe. Take, for example, the top 10 companies on the 2006 Profit 100 list, prepared by Profit Magazine. Of the top ten on that list, only four companies are doing more than $50M in revenue, and of those four, only two are making money.

How to pick a Gazelle

Imagine getting in on the ground floor of Google, Facebook, Workbrain, Salesforce.com, or even Holey Soles. Each were (and continue to be) global Gazelles. The problem is, it is difficult to weigh the claims of future clients. In the ten years I've been listening to pitches, I've only once heard a company say: "We have a so-so chance at growth". Every company to grace my boardroom is "the greatest company since Google". So how does one tell which are Blowfish, which are Giraffes, and which are Gazelles?

I can share with you some signs I use to spot a potential Gazelle, but I would be mendacious if I claimed that I could always tell the Gazelles from the Giraffes, and in fact, anyone who claims that is lying. If we could spot Gazelles perfectly, we'd be rich and on a beach in the Cayman Islands. What I can share are some tips for spotting a potential Gazelle. In truth, only time will tell which companies go on to become a Facebook and which go on to become a Friendster (never heard of Friendster? That's because it became a Dog long before the market it had first-mover advantage in grew large enough).

Look for the following to spot a Gazelle:

1. Focus on those in industries with CAGR > 25%. If an industry is growing annually by 25% or more, then even those companies who finish second or third in their niche will do well. After all, a rising tide floats all boats. Backing companies in mature markets is like hunting for Gazelles on barren fields. Companies can't grow exponentially unless their industry grows exponentially.

2. Look for Scalability. If a company can scale, it means they can produce their products for ever-increasing margins (i.e., the 1000th widget costs less to make than the 10th). Always a necessity if you are looking to sustain double digit growth.

3. Focus on Sustainable Competitive Advantage. If the company you are reviewing lacks any sort of proprietary intellectual property (i.e., patents), or has no barrier to entry, how will they stop others from flooding the market and eating their lunch? Gazelles continue to grow faster than their competitors by being able to differentiate their offerings to their clients. I argue that the iPod isn't the best mp3 player in the world. It lacks a radio, doesn't handle all file formats, and doesn't allow for upgrading. Yet is the ipod has more than 80%+ of the MP3 player market. Why? Because of its form factor (which has been copied) and because of itunes. itunes creates a barrier to entry for others, and helps sustain Apple's massive growth.

4. Look for the 10x rule. Being a little better, a little faster; or a little cheaper isn't enough to turn a startup into a Gazelle. For that to happen, a company has to offer a solution that is 10x faster, 10x better, 10x more secure, 10x cheaper, etc. To sustain double digit growth over the long term, and/or to obtain dominant market position, you will need a 10x solution, a solution that is exponentially better.

The Bottom Line

Whether you are a startup, an angel investor looking to back the best startups, or a service provider looking to serve either, you need to be able to spot high growth companies earlier than others. You need to be able to separate the wheat from the chaff - the potential world leaders from those that will become kennel capital.

If you are looking to find the next Google, Facebook, or Workbrain, you need to strap on your pith helmet and start tracking the Gazelles. Doing so will most likely ensure the greatest returns on your efforts, after all, have you ever tried to wrestle an Elephant?