Friday, August 23, 2013

Buy vs. Build Model

LBO vs Start-Up = ???

It Depends...

In 2005, I bought out an under-performing telecom company, by buying out their lease. Personal savings, friends and family contributed the necessary capital for me. It was a small retail-centric company. Two years later, I sold the business to a larger regional company. I lost a lot of money. Lesson learned? Equity is expensive.

When considering buying an existing business or launching one from scratch, there are a number of variables that entrepreneurs should consider:

1. High Margin or Low Margin: High margin businesses are more profitable, but require more capital (cash) to fuel that high margin. Low margin businesses are less profitable, but tend to sell themselves. The telecom company I acquired was immensely profitable on a per sale basis. But the volume was terrible. Fixed costs can be considered a sunk cost:  you have to pay certain expenses regardless of your sales cycle. Whereas Low margin businesses have high volume revenue streams which can carry your fixed costs, even if your company is in the red. For instance, large retailers remain in the red until after September.

High margin businesses consume a substantial amount of capital to launch from scratch. Think about most sophisticated technology and biotech companies. They require a large capital base to sustain capex, develop products, move products, hire talent, enter markets, capture market share, defend market share, absorb mistakes, develop new products, evolve business model, acquire horizontal or lateral companies, and the list goes on.

2. Working Capital : Running out of cash happens. Even worse, negative cash flow or ZERO sales can kill you. How do you fund working capital requirements? Unless your business can receive cash upfront per sale, you're better off borrowing money from a bank, vendor or alternative sources, versus using cash. Buying an existing company allows you to use cash flow from operations to sustain or even grow your business. Whereas most start-ups have a quicksand-like burn rate because they don't have tangible assets to leverage against.

There are always ways around working capital requirements. Depending on the product or service, you can revenue-split, re-package or re-sale a competitors product. You can also utilize a work-in-progress system. If you can get around this issue, then perhaps launching a company with a clean slate might make sense.

3. Don't reinvent wheel. Make a better wheel. When considering buying or building a business, I tend to consider my options by developing a "buy vs. build" model. Although similar to a replacement cost valuation, my model considers the cost of trial and error (volatility), the cost of developing a brand, probability of market acceptance, projected churn rate and the cost of technical know-how.

Your competitive advantage (and not passion, unless passion is your competitive advantage) is the most important asset you have as a business person. This could include market knowledge, financial/human/technical resources and timing. If you can afford time (long duration) and other resources, then market knowledge could be acquired.

But then again, that's why companies engage in mergers and acquisitions. Time can be lethal.

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