When he was 17 years old, Warren Buffett struck upon a business idea that would one day lead him to be the best investor in the world.
The business idea:
Set up a used pinball machine in the local barber's shop.
The insight:
Bored customers will play games on it while waiting for their haircut.
The setup:
Buffett got along with his friend Don Danley who fixed up the old pinball machines while Buffett handled negotiations with the barber, Frank Erico.
Their pitch to the barber:
“We represent Wilson’s Coin-Operated Machine Company, and we have a proposition from Mr. Wilson. It’s at no risk to you. Let’s put this nickel machine in the back, Mr. Erico, and your customers can play while they wait. And we’ll split the money.”
The business model:
Buffett has called it, "the best business I was ever in."
Let's understand why.
Buffett and Danly bought their first pinball machine for $25. The biographies on Warren Buffett state that subsequent machines cost $25–$75. Let's say, it cost $50 on average to acquire a pinball machine and fix it if it's broken.
This $50 is an upfront cash outflow or investment in the business. Once this $50 is invested, the pinball machine generates cash for its owners every week.
The first machine had $14 in it at the end of the first week. Out of which, the barber took a 50% cut, leaving Buffett and Danley with $7.
Also, let's say repairing the machine cost $2, i.e., maintenance CAPEX. So, that leaves $5 as earnings/week.
So, to start off with, we have a $50 cash outflow to acquire the machine. This is followed by a series of $5 cash inflows every week, as the machine generates cash for its owners.
Essentially, the machine pays for itself in just 10 weeks! Whatever cash it generates post that is pure income.
And being the smart-aleck he was, Buffett reinvested his weekly earnings into setting up another pinball machine, and then another one, quickly having pinball machines operating in barbershops all over Washington, D.C.!
Once there were 2 pinball machines running, each generated $5/week. That's $10/week.
This means that there was enough cash in just 5 weeks to buy and set up Pinball Machine 3.
Pinball Machine 2 arrived in 10 weeks.
Machine 3 arrived in 5 weeks after that.
4 would arrive in 3.33 weeks after 3.
5 would arrive just 2.5 weeks after 4.
See the pattern? Each successive pinball machine took less and less time!
This is the essence of compounding in business. Great businesses are able to RE-INVEST their profits back into themselves to grow these profits at increasingly faster rates over time.
Via this business, Warren had "discovered the miracle of capital: money that works for its owner, as if it had a job of its own."
Takeaways:
1. Understand customer behaviour
2. Offer risk-free propositions to partners
3. Have manageable CAPEX and great unit economics
4. Reinvest in growth
That’s it.
