Businesses Are Not Always What They Seem
Companies make, distribute, or store a product or provide a service. It’s pretty simple at a high level. Companies and their customers/clients believe they are in the business of selling the thing or service as their primary business, but most of the time, the thing or service is the wrapper for the business they are actually in — financial arbitrage.
Companies that provide experiences are exempt from this. Experiences are purchased for how the product or service makes us feel, sometimes momentarily and sometimes for long periods. Experience businesses such as restaurants, cruises, and luxury brands are about feelings, not financial arbitrage. That said, most companies are in business because of financial arbitrage.
Financial arbitrage refers to an investment strategy of buying something in one market and selling that thing in another market for a higher amount. The age-old premise of buy low and sell high, but buying low in one market and selling high in a different market to a different set of customers is a narrow definition given current nuances. I am broadening this definition to include having an asset created out of another activity in which the asset increases in value over the primary activity, thereby creating value without changing markets or customers.
The most well-known version of this is that most of McDonald’s value is in real estate and not in food service. The same can be said for other companies with large real estate holdings as part of operating their core business. The financial arbitrage business equates to a more valuable asset than the core business will ever be.
Every company has to employ some sort of markup between what it costs them to provide their product or service and what customers pay for it. This is the standard profit margin of most businesses. Still, financial arbitrage happens when a company’s primary business isn’t actually what creates the most economic return and value. A company can sell a low-margin product or service to serve an underlying higher-margin and more lucrative business. In an ideal scenario, the primary and secondary levels are high margin, which is rare.
The selling and services of automobiles, trucks, equipment, RVs, and other machines are a razor-and-blade situation. The companies selling the products spend more on finances, maintenance, insurance, warranty, and other services than they do on selling them. The product is the core activity, but businesses wouldn’t work without the additional offerings that produce the bulk of the financial value.
It is important to note that in most of these cases, financial arbitrage is about profit and asset value, not revenue. Selling the core product generates the bulk of the revenue, but ancillary services or assets create the majority of a company’s overall value.
Homebuilding is another interesting example. Non-custom homebuilders make more money buying and subdividing land into building lots than they do on the actual building of the homes. Building homes requires a lot of time, effort, and products. Subdividing land into lots takes some survey time and cost but is far less complicated, costly, and time-consuming than marketing, selling, and building a house. Many home builders are in the business of land financial arbitrage more than in building homes.
Every services firm is in the financial arbitrage business. Services firms like legal, accounting, and technology advisory (which is what we do at Transform Labs). These firms have expertise their clients don’t, which necessitates the need and purchase of the services; however, financial arbitrage is happening. Clients of service firms could have at least some of the expertise of the service firms. Still, they either don’t have enough ongoing work to substantiate hiring the skill, or having the skills internally isn’t viewed as strategically essential or cost-effective. Sometimes, clients of services firms also don’t have any processes, systems, or knowledge to manage someone doing a particular type of work. Whatever the reason, clients of services firms are entering into a financial arbitrage situation in which a services firm is charging the client a premium over what the firm pays the team members working on behalf of a client. Services firms buy talent lower than clients and resell the talent for a profit. The primary service activity is a means to the people financial arbitrage.
Services firms depend on not making sense for clients to hire the people they provide. The clients of most services firms can’t make the value exchange work to pay their corporate attorney, for example, on an ongoing basis if they don’t have a volume of work for that to make financial sense. The same is true for our clients: it doesn’t make sense to have a full-time CTO, CIO, or other technology leader in addition to scaling up other positions such as engineers, data architects, and designers. For our clients and those of other services firms, the financial arbitrage of paying for expertise on an as-needed basis is worth it for them. There are those cases where a services firm has specialized such knowledge that it takes precedence over the financial implications of the firm-client relationship, but this is the exception, not the norm.
At Transform Labs, we help clients enhance their financial growth levers. Sometimes, the aspects of their business are the core of increasing operational efficiency and productivity to do better, faster, and more accurately. Other times, we help clients maximize their value through more intelligent asset management for increased return. Technology allows organizations to unlock potential across the entirety of their footprint.
The nonprofit sector has struggled to create and leverage financial arbitrage because so much of what nonprofits do is high touch in providing essential human and social services. Not surprisingly, helping people doesn’t create an arbitrage beyond donated goods and services. I have believed for a long time that there could be opportunities for more financial arbitrage in some nonprofits in which the economic value created through skills training, housing security, and more are captured with the value creation created. Someone who goes through a skills training program, for example, and increases their earnings substantially as a result is creating an economic impact that can be generational.
Many of the financial drivers of businesses are not what they appear on the surface, and understanding these drivers is crucial in managing a business, selling to, and servicing successfully. The mechanisms to facilitate the financial arbitrage can’t be undervalued and appreciated because they are the levers that allow the underlying financial arbitrage to happen. In some cases, financial arbitrage is simply buying low and selling high, which isn’t always simple or easy. In others, financial arbitrage is a complex layering of factors to have it work meaningfully over time. But make no mistake; business is a financial engineering game as much as anything else.
