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REASONS FOR BUYING
"Why buy?" is a daunting question, and unfortunately some buyers fail to look deeply enough at their drive to acquire another company. Some motivations for purchasing make more sense than others. Your reasoning should be watertight because once you've bought a company, you're stuck with it. In this section, I'll provide advice for answering this question for each type of buyer.
ENTREPRENURIAL BUYER
Sometimes individuals want to leave the "rat race" of corporate America to start their own business. With your own company, you have more control and freedom for your creativity. Business ownership also can be a status symbol. And of course, there's the potential for making lots of money.
However, starting a new business is not easy and is filled with risk. According to the Small Business Administration (SBA), there is an 85% failure rate for those businesses in which the founder spent less than six months planning the new venture.
But by buying an existing business, according to this line of reasoning, the risk is reduced. In most cases, you'll have a built-in product line and a clientele that can be leveraged.
But buying a going concern is hardly low risk. Remember that when you adopt a company's preexisting strengths, you also inherit its weaknesses.
The things that can go wrong when you buy a company include the following:
- A competitor can take advantage of the changeover to encroach on your business.
- You may have trouble with the employees.
- A top customer may leave, or relationships with suppliers can change for the worse.
- You might be cash starved as a result of the acquisition.
If you provide a personal guarantee for the money, you will need to pay back the loans if the company fails. It could ultimately mean losing assets like your home.
So consider carefully if you believe you control your risk exposure when you purchase an existing business.
Entrepreneurial buyers are prone to another sort of danger: Such buyers are often driven to buy a company on the basis of emotional reasons. That is, he or she desperately wants to own a business and will rush to do so. Of course, this usually means the buyer overpays and fails to negotiate key terms.
Ultimately, the wisest course for an entrepreneurial buyer is to look at a company purchase from an investment standpoint. That is, you need to make a profit based on the price you pay. An excellent approach is to use the discounted cash flow method (which is explained in detail in chapter 10). Basically, you estimate the cash flows from the business and then discount them to their present value. If this is higher than the purchase price, then the deal is expected to be profitable.
A critical factor for an entrepreneurial buyer is experience. If you have worked in an industry for several years, this certainly provides you perspective. This should help you spot trends, good values, and danger signs. You will also have contacts in the industry.
However, I'm not implying you should shun all businesses for which you lack industry experience. If after much homework you think you can make money from the acquisition, then go for it.
An example of someone who leveraged his industry experience into an effective buyout is famed entrepreneur Gordon Cain. By 1987, the 75-year-old Cain had more than 50 years' experience in the chemical industry. Starting out as an engineer in 1933, he'd ascended to executive-level positions for such companies as Standard Perlite, Westaco Mineral, Petro-Tex, and Sterling Chemical (where he was chairman of the board until 1987).
In 1987, the ethylene industry had been in a major, prolonged downturn. But Cain thought it was on the cusp of reviving. So he arranged financing from investment banks to purchase seven plants from four different companies, which he got at fire-sale prices. His personal outlay was $2.3 million -- or about 2% of the purchase price.
Cain quickly cut overhead costs and also instituted an employee ownership plan. (He believes strongly in the use of equity to motivate managers). Within a year, the ethylene industry made a comeback, and Cain sold his company to Occidental Petroleum. His $2.3 million equity investment turned into about a $100 million profit.
In addition to profit, entrepreneurial buyers are often motivated by creative challenge. Indeed, some have proven to be among the shrewdest businesspeople, able to recognize opportunity where others would see only a losing proposition.
A classic example of noticing a "diamond in the rough" was Ronald Perelman's experience with Technicolor. Perelman achieved his greatest renown as a flamboyant corporate raider in the 1980s, famous for his $1.8 billion purchase of Revlon in 1985. But perhaps his greatest business triumph came in the 1970s, when Perelman started to pay close attention to a company called Technicolor.
The company, an innovator in color technology, had undertaken a diversification campaign that apparently was dragging down the performance of the company. Sensing an undiscovered gold mine, Perelman put up $2 million of his own money and borrowed $118 million to purchase Technicolor. With control of the company, Perelman took swift action, selling off five divisions and much real estate, thereby cutting the debt by $68 million.
He then was free to focus exclusively on the film processing business. In meetings with all the major studios, Perelman was tenacious in convincing them to use the Technicolor systems. It was particularly timely since the film industry was undergoing a major change -- moving toward multiplex theaters. As a result, there was a boom for film processors.
In 1988, Perelman sold Technicolor to Carlton Communications, pocketing a cool $780 million.
SKILL SET FOR ENTREPRENEURIAL BUYERS
Buying a company is not for everyone. It often demands incredibly hard work to turn a buyout into a big-time success. And certain personality traits can be invaluable.
To succeed, you should have the ability to do the following:
- Make tough decisions. (Perhaps you'll need to lay off people or sell off divisions.)
- Generate new business. (You have either a gift for sales or the know-how to hire others that do.)
- Live with big risks. (At any time, a business can fail.)
- Cope with strain on your personal life. (Long hours and irregular hours can make it difficult to have a normal family life.)
- Deal with crisis. (Crisis is inevitable, and you need to be prepared for just about anything.)
