On April 11, 2011 there was a blog post written by James Altucher on Forbes.com titled “The Easiest Way To Succeed as an Entrepreneur“, in which he says that the most important rule for entrepreneurial success is to have a customer before you start your business.   The article is a worthwhile read.  I’d like to suggest that one of the easiest ways to have customers for a business venture is rather than starting a business, contact a business broker or investment banker and buy one.  If you have a great innovative idea, what’s wrong with buying a business that already has a significant customer base for a complementary product or service?  Cross selling a new product or service to customers that a business has already developed trust with will often be far easier than organically growing a customer base.

As the Fed has pursued quantitative easing, many economists are worried that if not reigned in at the right time it may usher in inflation.  Already there are signs of food price inflation.  One of the methods of controlling inflation will be for the Fed to increase the federal fund interest rate.  If you were considering buying a $2 million business and you were going to get a loan for 70% of the price, for a $1.4 million loan with a seven year amortization and term, if you wait and interest rates increase by 2% it will cost you about $1,400 more per month, $16,800 more per year, and $117,600 more over the life of the loan.

While many businesses have struggled over the past few years’ recession, many that I’ve been talking with during the fourth quarter of 2010 and the first quarter of 2011 have shown strong performance as of late, and I know many who performed pretty well during the entire recession.  If you are able to find a business that is attractive to you, survived the down turn, and is performing well, it may be a great time to buy.  While nobody knows exactly what will happen with interest rates and when (if they did they could make a lot of money off being right!), who doesn’t think the probability is that they will be higher 1-2 years from now?

In a February 25, 2011 Harvard Business Review blog posting titled “Nine Things Successful People Do Differently” Heidi Grant Halvorson provides suggestion about behaviors of successful people that can be adopted by anyone to lead to greater success at achieving their goals.  In addition to these nine behaviors, I would like to suggest a tenth:  start or buy a business.

In a July 2010 research paper, “Business Owners, Financial Risk, and Wealth” by Tami Gurley-Calvez for the Ewing Marion Kauffman Foundation, data suggests that the median household income for business owners is $87,000 versus $42,000 for non-business owning households, and median household net worth for business owners is $497,000 versus $94,000 for non-business owning households.

 

One of the most successful investors of our time, Warren Buffett, is also a serial business acquirer.  Since this blog’s focus is on business acquisitions I encourage prospective business buyers to learn from the master.  While there are a variety of books available about Buffett and his investing style (and some are quite good), why not read books like “The Intelligent Investor” by Benjamin Graham, who was a mentor to Buffett – and most of the concepts in Graham’s writings are still relevant today despite being published several decades ago?

Also, why not read Buffett’s annual reports and his accompanying letter to shareholders?  The letter to shareholders is often full of interesting and humorous anecdotes and metaphors along with some excellent insights.  You can find them going back to 1977 on Berkshire Hathaway’s website:  http://www.berkshirehathaway.com/

Here’s a link to the 2010 letter:  http://www.berkshirehathaway.com/letters/2010ltr.pdf

A few comments I’d like to share from it:

Last year – in the face of widespread pessimism about our economy – we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment. Of this amount, $5.4 billion – or 90% of the total – was spent in the United States. Certainly our businesses will expand abroad in the future, but an overwhelming part of their future investments will be at home. In 2011, we will set a new record for capital spending – $8 billion – and spend all of the $2 billion increase in the United States.

Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of “great uncertainty.” But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.

Don’t let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.

We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America’s best days lie ahead.

I know that there has been an abundance of pessimism in our country over the past couple of years.  Sometimes you hear someone who talks about being optimistic about the future, but they don’t really have much skin in the game, and so are dismissed.  So, when I read that Berkshire Hathaway will be doing capital spending of over 90% of $8 Billion in expenditures in the US in 2011, it’s reassuring that one of the most successful people in the world is confident of a bright future for our country.

All things considered, the third best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks. (The two best investments were wedding rings.) For the $31,500 I paid for our house, my family and I gained 52 years of terrific memories with more to come.

While obviously Buffett is talking about non-financial benefits as being important considerations in calculation of investment returns when it comes to his house, there are other interesting lessons to be learned from his comments.  You see different studies that show average home-ownership periods that are typically from 3-7 years depending on the source.  Buffett has lived in his home for 52 years – and he could easily live anywhere he wants.  The lessons I take from this are:  frugality; contentedness – the importance of buying things you like and then holding them long-term rather than constantly wanting something new or different; and that “things” aren’t a necessary component of happiness.

John Kenneth Galbraith once slyly observed that economists were most economical with ideas: They made the ones learned in graduate school last a lifetime. University finance departments often behave similarly. Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it “anomalies.” (I always love explanations of that kind: The Flat Earth Society probably views a ship’s circling of the globe as an annoying, but inconsequential, anomaly.)

Academics’ current practice of teaching Black-Scholes as revealed truth needs re-examination. For that matter, so does the academic’s inclination to dwell on the valuation of options. You can be highly successful as an investor without having the slightest ability to value an option. What students should be learning is how to value a business. That’s what investing is all about.

A couple of comments – I, too, think that too many financial planners, wealth managers, pundits, and professors continue to inappropriately and inaccurately crow about efficient markets.  The reality is that they aren’t.  Many will hypothesize that you can’t beat major market indices year after year, and, in fact, these same individuals don’t – so they assume that nobody else can, and by peddling their flawed theories to others, they also ensure that many other’s won’t beat the markets, either.  One of their biggest flaws is over-diversification.  Broad diversification will, in fact, help reduce the risk of performing significantly worse than the overall market, but it also will pretty much assure that you won’t beat the market.  If instead of trying to reduce risk by loading up on too many businesses that an investor has a poor understanding of, and instead they analyzed and valued companies and then only invested in those companies that they felt had very low risk factors, upside potential, durable competitive advantages, and that were priced lower than an estimated intrinsic value, they would have a far higher probability of beating the market.  Of course, doing so, requires developing an understanding of what gives a company value.

I’m lucky because my career as a business broker assisting people with buying and selling small to mid-sized businesses has lead to, and reinforced, my knowledge of business valuation, and my hobby of investing gives me insights and knowledge that I also apply to the evaluation of small businesses.  As a result I’m both a better business broker and a better investor.  I started getting more serious about analyzing stocks about 8-10 years ago, and for most of the years since then I have significantly beat the major indices.  For example, in 2009 my portfolio performance was up by roughly 36%, in 2010 it was up about 22%, and as of today (March 7, 2011) my year-to-date increase is roughly 9%.   I’m not sharing this to brag about my stock portfolio performance, but rather to reinforce that anyone who is committed to truly understanding businesses and how to value them, and goes about a disciplined approach to investing, where they treat a stock purchase the same way as they would if buying an entire company, may, with any luck, do significantly better than market indexes (and if you are investing your own money you will not be stuck paying money manager fees, which further rob you of returns).

I recognize that not everyone wants to take the time to read through a bunch of annual reports and select a variety of securities to invest in, then continually monitor them over time.  If that’s the case, perhaps your best bet is to buy and run a small business.  If you work with a quality business broker or M&A Advisor to buy a business that has the right risk-reward relationship and you develop deep knowledge and expertise while also actively managing it, you may have far greater control of the business’ performance and have the potential of significantly out-performing the stock market.

Codiligent is having a drawing to give away an Apple iPad.  In addition, when you enter the contest, you may elect to receive a free white paper, “What Business Buyers Want: Preparing For A Successful Business Sale”  that describes the characteristics of a business that are most commonly evaluated by business buyers.  By understanding these issues that impact business marketability and value, it may help you to better prepare for a future business sale.

Codiligent’s iPad Sweepstake eligibility is restricted to those who own at least 50% of a business, are a key executive in a business, or are in select occupations that are related to preparing to sell and exit a business (i.e. CPAs, attorneys, management consultants, investment advisors, bankers, etc.).  See the official rules for details on eligibility requirements.  Sorry if you don’t meet eligibility requirements, but if you know of someone else who does, please send them the link to the entry form.

Here’s a link to the entry form and rules:  Official Codiligent iPad Sweepstake Entry Form

 

Today’s Wall Street Journal has an article by writer Rosalind Resnick, “10 Reasons to Start a Business This Year” which echos many of my posts from the past year, but coming from a business brokers perspective my focus has been on why it’s a good time to buy a business rather than start one.  Whether you are interested in starting a business or buying one, there are a variety of issues that make this a very opportune time to make the switch from being an employee (or being unemployed) to self employment or business ownership.  Three of Resnick’s points that I think are particularly relevant to present conditions are:

1.   You’ll never get laid off again.

2.   There’s a huge talent pool just waiting to be tapped.

3.   Consumers and businesses have started spending again.

Another blog that I enjoy reading is Small Business Trends.  A few days ago, there was a post titled, “2011 Outlook:  Small Businesses Optimistic About Economy, Ready to Reinvest and Hire” which included results from a survey, “Small to Midsized Business Plans for 2011” that provided an encouraging outlook for the upcoming year from entrepreneurs.

A couple of important conclusions:

1.  Of the 1,002 Small to Midsized Businesses that responded, 72% believe the economic outlook will stay the same or improve during the next 12 months.

2.  About 84% of respondents believe their sales will increase or remain the same during 2011.

If you are considering acquiring a small to mid-sized business, this is important information.  Think about all of the times in the past when you may have said, “If only I had bought (insert Real Estate, Stocks, Gold, Bonds, a particular business, etc.) back in (insert time when the market hit bottom).  I would have done so well financially.”  The bottom of a market is difficult to determine particularly when you are at the bottom (it’s much easier to look in the rear view mirror and recognize it).  Yet, to do well in life you don’t have to buy at the absolute bottom.

Identifying and buying businesses that will likely have much better future performance than they have had in the past 24 months presents a phenomenal buying opportunity.  Many small to mid-size businesses have financially struggled during the past 2 years’ great recession.  Some of these businesses have been seeing improved recent performance.  Yet, since business value is largely based on financial performance, many of these businesses are perceived to be worth much less than they would have been in 2007.  As the economy improves and these business’ financial performance show a corresponding improvement, their values will increase.

In a couple of years will you look back and say, “I wish I had bought a business in early 2011?”

I came across a post on the Small Business Trends blog the other day titled, “Jobs That Increase Your Odds of Being In Business For Yourself” that contains a link to information that indicates which professions have higher levels of self employment.  If you currently work in a profession that has a low level of self-employment, don’t be discouraged if you have the entrepreneurial bug.  There are many professions where it would be difficult for a single self-employed person to effectively deliver products or services.  In some of these professions, it is more likely for someone to start or buy a business with employees.   Also, it is not uncommon for business buyers to acquire companies that are in industries that are different from their prior occupation.

Today I was reading an article by one of the top business valuation experts in the US, Aswarth Damodaran, Ph.D, who teaches at NYU’s Stern School of Business, that caused me to think more about a common error that I see many buyers and sellers of small businesses make when using a discounted cash flow approach to value.  Before I continue on with providing my thoughts on this, if you have an interest in learning more about business valuation I would strongly encourage you to visit Dr. Damodaran’s website:  http://pages.stern.nyu.edu/~adamodar/

OK – on to my thoughts:

When using a discounted cash flow approach to value you develop realistic projections for the expected cash flow that the business will generate in the future, and then you discount those cash flows back to a present value using a risk-appropriate discount rate.  For a business that has higher risk and variability of future expected cash flow, you’d use a higher discount rate than if valuing a lower risk, more stable business.  We won’t go into methodology in this post to discuss how to go about estimating an appropriate discount rate to use (that subject alone can fill books).  However, the concept is that the discount rate compensates for the riskiness of the expected cash flow.   A higher discount rate will result in a lower present value than if using a lower discount rate if both are based on the same expected earnings.

So here’s the common mistake I see small business buyers and sellers make when using a discounted cash flow approach:  they may perceive a business to have some significant risk factors so they will naturally use a higher discount rate BUT (and here’s where the problem lies) they also will use projections of expected earnings based on the risk factors manifesting themselves into lower earnings.  This, in essence, results in a far higher level of discounting than is warranted.  If you are using projections that already assume that risk factors will negatively impact earnings then you have already modeled the risk into those projections and you should be using a far lower discount rate – probably the risk-free rate (long-term US treasury yield).

 

As a business broker I sometimes hear business buyers who are concerned when they look at a business and learn that a large components of its value is “Blue Sky” or Goodwill.  Unfortunately, sometimes their banker will share this concern.  Yet, unless a business is distressed and performing poorly, a large percentage of a business’ value will be in goodwill rather than in tangible assets.  What gives a business its value is its ability to generate cash flow.  While tangible assets may certainly be integral to this, they rarely comprise a large percentage of a business’ value.  The reason that bankers like tangible assets is that if the business totally failed, they still may be able to recover some money by selling the discrete tangible assets.

Let me provide a few publicly traded company examples:

Chipotle Mexican Grill – as I write this, this restaurant chain’s aggregate value of its stock (its market capitalization) is $6.9 Billion.  This $6.9 Billion when added with the company’s long term debt of $4 million, gives a total value of that company of a little over $6.9 Billion.  If you look at Chipotle’s balance sheet, it has about $940 million in assets not including intangible assets.  In other words, its tangible assets represent only 13.6% of its value.

Stanley Black and Decker – at this time, this manufacturer of do-it-yourself tools has a $10.4 Billion market capitalization and about $1 Billion in long term debt, for a total value of about $11.4 Billion.  This company has about $3.993 Billion in assets not including intangibles.  The tangible assets represent about 35% of its business value.

The above two businesses rely more on tangible assets to generate their income than, for example, a consulting firm, an ad agency, or a software development firm.  Yet, would anyone argue that an ad agency that produces $20 million of cash flow has limited value because it only has a couple of million dollars in tangible assets?

While I won’t go into valuation techniques in this blog post (you can read other posts on this site that do), suffice it to say that tangible assets are usually not a strong determinant of overall business value unless a business is not profitable / distressed, or it owns significant un-utilized or under-utilized tangible assets.