“You know what they say, you make money as long as you can buy right. No way I’m paying more than five times earnings for that business.”
Sean (not his real name) is a real estate investor who has done exceedingly well the past decade. We recently had lunch to discuss his interest in redeploying some of his investment dollars into an operating business. “I still love opportunities in real estate, but I want to be more involved in business operations, you know, managing people toward a strategic goal.”
I frequently meet with individuals who want to buy a business. I ask them a common set of questions, including how much they want to invest and their return on investment objectives. Their answers help me focus on finding the right business or help them see that buying a business isn’t such a good idea.
After talking with Sean, I realized his prowess buying investment real estate might not translate to investment in a business. While real estate appreciation is subject to vagaries in the economy, most real estate investors know that long term value is created through the combination of buying “right” and time. Though there are exceptions to every rule, in most cases, a real estate investor cannot do much to materially improve the underlying value of the asset (other than flipping rehab houses, but that’s another thing). The basic formula for success in real estate is to buy “right” then let time create incremental value through asset appreciation and loan amortization.
This success formula does not apply when buying a business. What an investor pays for an operating business has less to do with long-term success than how the business is managed after the sale. Decision making when operating a business can move you forward or move you backward. Those decisions include how you grow revenue, improve margins, hire the best people, etc. Remember, each decision a business owner implements carries potential for upside or risk for downside … each decision might not work, indeed, it might even backfire. Ask anybody who’s hired the wrong sales director; it not only costs money, it sets the business back. How about when the business invests in product development that doesn’t pan out? These are simple examples of the principle that operating decisions and how they are executed is what creates (or loses) investment value with a business.
Allow me to be perfectly blunt: when buying a business, fixation on buying “right” is a reflection the potential buyer doesn’t understand how long-term business value is created.
Sean does not want to pay more than five times for the business because he thinks buying “right” is how he will create value. But, the business he is considering has a strong management team and the margins get better as revenue grows. The potential return on invested equity is substantial. If Sean overpays, by his definition, he would still make a boatload of money if he executes on the right decisions that drive value. But based on what he told me, his investment experience in real estate hasn’t prepared him for that kind of decision making.
JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. Jim is the author of Home Run, A Pro’s Guide to Selling a Business. https://www.amazon.com/Home-Pros-Guide-Selling-Business/dp/1599329239 . He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee. The principles above are true, but the story, names and fact patterns are changed to preserve the parties’ identities.
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