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So should you buy your business or build it from scratch?

By : Ziad Abdelnour| 10 June 2010
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We at Blackhawk receive and review over 2,000 business plans a year; and the question that keeps recurring at all times by every one of our entrepreneurs seeking funding is:

Should I buy a business or rather build one from scratch?

Here’s a few pointers you should consider before heading down either path.

Deciding whether to expand your business organically or through acquisitions is the ultimate “build or buy” decision. It’s similar to the choice between buying an existing home or building your own, but we’re talking about your livelihood here—not to mention your employees’ well being and your investors’ returns.

Mind you, for businesses, the buy and build paths aren’t mutually exclusive. You can certainly grow your business in hopes of adding more operations down the road and you can buy new businesses with the intent of growing them organically.

But for a business of limited size that doesn’t have the benefit of a full corporate development arm, pulling both off simultaneous is likely impossible.

Still, both strategies have a lot in common. They require similar disciplines in terms of cost-benefit analysis and careful execution. And the hazards along each path often pop up to varying degrees in similar areas.

The Basic Benefits and Costs

On the surface, expansion through acquisition makes a lot of sense if you’re looking to enter a new product line or a new market. Setting up shop in a new location and building from scratch is costly and time consuming. Finding acceptance for a new product can be a slog.

Take a look at it this way. The time that you want to buy a business is if you really want to get into a market fast. That your go-to-market timing is of paramount importance. What you get is an instant infrastructure, customer base, cash flow, inventory, physical plant, distribution network and supply chain – all the vital ingredients for a functioning business. But remember that you’re inheriting a process. Someone else’s process. And that process may not be what you want.

By buying instead of building, you’re sacrificing the ability to tailor the business to all of your specifications. Building can allow you to move at your own pace, pull back if circumstances change quickly on you and guard your business culture. However, the pace of execution could cause you to miss a market opportunity.

Know Your Own Business First

Whether you’re embarking on a buy or a build strategy, you want to make sure that your existing business is on solid ground. In particular, you want to have real outstanding and stable management team already assembled and one with enough depth that it can focus its attention on an acquisition or a build-out without harming the business you already have.

You also have to determine if you even have the account management team to support the growth. The success of your current business is based on your ability to offer your existing clients top-notch service. Any growth strategy could put that at risk, and render any possible benefits moot.

Then there’s the matter of your financial infrastructure. How strong are your financial controls? How well do you measure your cash? If you’re getting ready to grow, there’s going to be a lot of stress on your working capital and your ability to measure your financial health.

Those three things – the strength of your team, infrastructure to support new customers, and solid financial controls and metrics – are essential to any building strategy, as well as an acquisition strategy. But if you’re seriously looking at pursuing acquisitions, there is another critical element and that is experience at deal-making.

In an ideal world, your whole top management team would have some expertise in closing and integrating an acquisition, but that’s seldom the case. Hopefully someone in your top ranks has solid experience in the area. But failing that, you’re going to have to bring in a corporate development person or top notch advisors, which can be a considerable cost depending on how long the integration takes.

Such advisors carry their own risks if their goals aren’t aligned with yours. One way to match up objectives is to offer a success fee, where the advisor is paid for results achieved over the first few years and not just for closing a deal though if acquisitions aren’t already a core capability of yours, expect the advisory fees to mount.

Developing a Business Growth Strategy

There are many ways to guide a business through a period of expansion, including geographic growth, growth through acquisition, and franchising.

Turning a small business into a big one is never easy. The statistics are grim. Research suggests that only one-tenth of 1 percent of companies will ever reach $250 million in annual revenue. An even more microscopic group, just 0.036 percent, will reach $1 billion in annual sales. In other words, most businesses start small and stay there.

Know Your Industry and Market

Now that you’ve sized up your staff’s strengths and weaknesses, it’s time to assess your industry and market. If you’re growing organically, you need to figure out how much growth your market can actually support.

Usually in industries that are very fast growing, you don’t see acquisitions for a while. The reason is that the companies have a much better return on their capital by just plowing it back into their growth versus buying other businesses.

Conversely, if your market is mature, you need to figure out how much return you can reasonably expect from your investment. The simple truth is that it’s hard to create private equity-like returns in industries growing 5 to 10 percent.

By expanding in your existing market, you might risk cannibalizing your existing business, so you need to closely examine where you fit in with the marketplace.

Strategies for Growing Market Share Via Acquisitions

Today’s unprecedented market climate presents a daunting mixture—tight credit, negative growth, great uncertainty, and severe stock market volatility. With consumers weighed down by debt and with businesses seeking to cut expenditures, companies are finding it harder to grow organically.

For some companies, growing via acquisition may be an especially attractive option in such environment. In many industries, the same forces that are restricting organic growth—the credit crunch and the recession—have also separated the strong from the weak. While companies with high cost structures or heavy debt loads are struggling, leaner and better capitalized companies are positioned to take the lead in growing through consolidation.

Since it has become nearly impossible today to unlock value via an IPO, acquisition may be attractive to privately-held target companies, as well.

At Blackhawk, we are working closely with the management of a number of our portfolio companies on acquisition strategies; and we have found that strong businesses can take advantage of lower multiples to eliminate competitors and to increase market share. If your company is considering growth through acquisition, we would offer six essential principles to consider.

#1: Be prepared to pay with cash: Acquisition financing has become a critical challenge, especially with bank debt now much harder to obtain. Publicly traded companies have lost one-third or more of their market capitalization, thereby reducing the value of stock as a currency for acquisition. Still, companies that have strong balance sheets and deep liquidity hold a major advantage: buyers with the cash to close promptly can distinguish themselves from the competition. Bear in mind though that you may not have to fund acquisitions solely from cash already on your balance sheet. If you are a profitable, growing company, you also may be able to tap private equity capital for your acquisition strategy.

#2: Stick with targets you know: This volatile, uncertain period is not the time to buy unfamiliar companies. However, it may be the best time to acquire businesses that you have been following for some time, and that are now available at more attractive valuations. Look for companies that have been affected by market dislocation or financial pressure, but that are otherwise sound. If there are problems, make sure they can be fixed, given the constraints on credit and cash flow in a slow-growth environment. Even at very low prices, some of your targets may be more trouble than they are worth.

#3: Understand counterparty risk: One key element of your due diligence is counterparty risk. Though the company itself may be sound and adequately capitalized, can the same be said of the individuals and businesses on which it depends? Are its customers facing credit constraints that may affect demand? Could problems along the supply chain impact the company’s ability to make its sales targets? A lot of things to seriously consider.

#4: Set a clear path to return on investment: Before you close on an acquisition, ask yourself the following questions: How long should it take to recoup my investment and begin reaping positive returns? Is there any way to accelerate that payback? Are there risks that might make that payback period longer than expected? Being disciplined about acquisitions is always a smart strategy—one that is even more crucial during periods of economic uncertainty.

#5: Walk away if the price is too high: Prices for target companies have dropped, at least in theory, since the economic downturn began. Still, some shareholders, especially those in closely held businesses, may not be eager to sell at what they view as fire sale prices. If there is no pressing need for liquidity, they may prefer to wait for better times. As a buyer, you should expect seller resistance and build in time for longer negotiations. If the price is too high given current uncertainties, refuse to pay it.

#6: Take your time and choose carefully: In heated markets, buyers are often pressured to act quickly, rushing through due diligence and putting an offer forward before another acquirer can act. By contrast, the current market environment demands that buyers slow down and proceed cautiously. Make sure the acquisition really fits your strategy, take a hard look at pricing, and, most important, do not allow an acquisition to jeopardize your core business. A poorly chosen acquisition can distract your team and consume your capital at a time when you need most to focus.

By applying these guiding principles, you can focus your acquisition strategy in today’s challenging markets. Remember that depressed acquisition multiples create opportunities for stronger companies to consolidate share and eliminate competitors. Although less plentiful than before, capital for financing acquisitions is still available for well-run companies

Weigh All the Different Costs

When expanding, the costs keep coming. And a common problem when expanding a business is the underestimation of costs. Keep a close tab of all the building costs, equipment costs, tax costs, inventory costs, changes to accounts receivables, and the addition of support staff as things you need to carefully weigh when building your operations.

As for acquisitions, most will require some outside help, such as lawyers, attorneys, and other investment bankers and advisors. That translates to a bounty of fees. And the more complex the transaction is, the larger those fees will grow. Then there are other obvious integration costs such as those for IT and accounting systems.

The success of the acquisition will rest on your ability to realize all the cost savings and revenue opportunities that looked so appealing on paper. Though your acquisition might provide you with vast economies of scale—extra office space and savings on rent, procurement and insurance, and more—you may also end up with new employees that were promised extra vacation, bonuses, and promotions by the previous management.

Bottom Line: Try as you might to turn over every rock during the due diligence process, be prepared for some serious, potentially costly surprises no matter how you decide to expand.

The Verdict

So you still think your managers, infrastructure and industry have what it takes to support an expansion strategy and that the costs won’t run you into the ground?

Then ultimately the decision on whether to build a new business versus buying another company comes down to whether you want to get into a new geography or product line right now.

If so, making an acquisition is likely the way to go. But if you’re the more methodical type who needs to put your stamp on every aspect of your business and does not handle well the fear of the unknown (and every deal has an unknown), then a build-out strategy is probably the best course of action for you.

Looking forward to doing business with you and to continue being your resource for deals, capital, relationships and advice.

Your feedback as always is greatly appreciated.

Thanks much for your consideration.

Comments

  1. Pingback: Investment Challenges and Opportunities we see in China

  2. Joanne WeilandJoanne Weiland

    Hi Ziad, Thank you for sharing your incredible insights with us. With this one post you could create – 1. multiple blog topics 2. series of articles 3. questionnaire 4. tips (that you could sell) Your extensive expertise is obvious. Many people can benefit from utilizing your knowledge before making major decisions like this. Create, Collaborate, Celebrate! Joanne

  3. Riyad HRiyad H

    Dear Ziad Thanks for your the useful and usual thoughts and ideas. The exampls of successful and failure stories of expansion by build new business or buy already existed one ; ARE SO MANY. A qualified and focused management as your , will be capable to achieve the goal of highest ROI. Regards Riyad

  4. mark hannamark hanna

    Very well written piece; I’m still learning to trust my intentions, which can be rather mind numbing when deciding which choice is best. The breadth of your experience shows in this post, and may help define my own expectations.

  5. Allen HamiltonAllen Hamilton

    Ziad; Great post. We evaluated all your comments and feel the same on making a decision. Now listed on Frankfurt Exchange as (2CN) We are Hollywood Classics Network. Looking for a $6 Million funding for up to 3 years and executing an IPO after the second year. Management experience and contacts are our key to success. Profit potential is extremely positive.

  6. Ron NametkoRon Nametko

    Hello Ziad.. Great Post and it was great of you to share your knowledge and experience. More people should have the opportunity to review your post. Ron Nametko, Magic Sports Complex

  7. Gary BeydounGary Beydoun

    Excellent Ziad! This a road map for the entrepreneur who is ready for business and deserve to be published in Inc Magazine or similar business publications!!!.

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