Understanding Financial Risks and Benefits of Acquisition Entrepreneurship

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The following is adapted from Buy Then Build: How Acquisition Entrepreneurs Outsmart the Startup Game

If you have ambitions to become a successful businessperson, the chances are that you will want to own your own business. According to Thomas Stanley and William Danko, authors of the best-selling book, The Millionaire Next Door, effectively 100 percent of non-retired millionaires who live in the United States own their own businesses. Out of that group, about 20 percent are professionals running a medical or service business, and the balance are entrepreneurs and small business owners.

John Bowen, CEO of CEG Worldwide and coauthor of The State of the Affluent, concluded through his research that some 80 percent of the affluent are either retired or own their own company. Further, an astounding 91 percent of everyone having over $5 million in net worth owns their own company. This trend suggests that the wealthier someone is, the more likely they are to own a business.

Owning your own business is not only an opportunity to provide value through products and services, but it’s arguably the best way for most people to build real wealth. The good news is that you don’t need to build a business from scratch. Acquisition entrepreneurship —purchasing a business with the intention of growing that business—provides an affordable route to business ownership for many people.

Let’s be clear, however. Buying a business is not a guaranteed route to a high net-worth ranking. Nor does it mean that acquiring a company purely for financial gain is a good idea. Rather, it points to the fact that being the owner of a successful business can be a great investment vehicle, and that those who make the most of it can finish big. In this article, we’ll discuss both the potential and the risks of acquisition entrepreneurship.

How to Identify a Good Investment

If you’re considering acquisition entrepreneurship for the first time, your primary question may be how to identify a valuable opportunity. There are three fundamentals you should keep in mind: return on investment, margin of safety, and upside potential.

The concept of return on investment (ROI) is simple. If you invest $100 and it generates $6 back to you every year, then every year that you own that asset you will receive a 6 percent ROI.

The next logical question then is how much cash flow should a certain investment return? The answer is found in the risk profile of the investment. A United States-backed treasury bond is considered about as safe of an investment as possible. Today, they are generating 2.5–3 percent on invested capital, or enough to keep up with expected inflation during the time of ownership, but not much more.

Conversely, a startup is considered one of the riskiest investments around. And rightfully so. The infrastructure, proof of concept, product market fit, and revenue all need to be built from zero. As a result, any return to an investor is unlikely, so the average positive return needs to be very high to compensate for the risk.

A business with under $5 million in revenue and a track record of positive ongoing cash flow for fifteen years is somewhere in the middle. It’s significantly safer than a startup, but not nearly as secure as a US-backed security.

Investing in a startup is like putting all your money on red at the roulette wheel. Sure, it might come in, and if it does you’ll get a great return. But there’s a high chance it won’t, leaving you with nothing to show for your investment.

Buying treasury bonds is like working the same job for forty years. At the end of your career, you’ll have a pension. The risks are low and so are the chances of surprise. It’s a safe choice.

Purchasing a business is like backing yourself to win a race. With skill and dedication, you can succeed, but there are no guarantees.

Determining Your Margin of Safety

The question is how to determine what constitutes an acceptable level of risk for you. The risk-return spectrum dictates that the more risk an investor takes the greater the return needs to be. Unfortunately, the “high risk, high return” model frequently plays out in the high-risk part winning out and producing lower returns.

Warren Buffett, widely considered one of the most successful investors in the world, practices what’s called value investing. The fundamental belief of value investing is that there is an intrinsic value to every company. This intrinsic value is not an exact number and is subjective in nature. In loose terms, it can be derived by calculating a liquidation value, then observing the additional value a company produces over and above that: competitive advantage, brand awareness, and present value of future cash flows, for example.

Buffet is notorious for investing only in offerings he understands, focusing on tangible assets and earnings, and buying when the price is favorable to its intrinsic value. The built-in assets, infrastructure, and earnings of the company in this case create a margin of safety for the investor.

Benjamin Graham and David Dodd, regarded as the inventors of value investing, coined the term margin of safety in 1934. It was so fundamental to Graham’s thinking that he was quoted as saying, “Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, margin of safety.”

This margin of safety refers to when an investor only purchases securities when the market price is significantly below its intrinsic value. More recently, Warren Buffett and his partner, Charles Munger, made the concept popular by using it to attain extraordinary results.

One way to illustrate the margin of safety in buying a small business compared to other forms of entrepreneurship is by considering how much is at risk and the odds that the company could completely fail.

Backing into an approximate by reviewing multiple sources, it seems that about 80 percent of small businesses transact for an amount below $1,000,000. Let’s use the entire amount of the transaction ($1,000,000) rather than the invested down payment since this encompasses the total risk associated with the acquisition.

According to the Small Business Administration, default rates of small business loans are currently right about 2 percent. Similarly, according to the Thompson Reuters/PayNet Small Business Delinquency Index (SBDI), the amount of small business loans that go delinquent on the national level has been running under 1.5 percent since 2012.

This means the $1 million at risk when acquiring a business has about a 2 percent chance of failure. This is a drastically different profile than building from scratch. If you equate not failing with success, then buying a company has an approximate 98 percent success rate.

Like Graham, Dodd, Munger, and Buffet, acquisition entrepreneurs build in a margin of safety, simply by starting with acquiring profitable revenue first, then building from there. If you purchase a solvent, successful business, choose carefully to ensure that it is not at high risk of disruption, and run that business intelligently, there is no reason why it should suddenly fail. Any investment carries a risk, but the risks of sensible acquisition entrepreneurship are not large. The better news is that it’s often possible to gain excellent returns using this method.

Assessing Upside Potential

No doubt you want to ensure that your investment doesn’t disappear on the breeze. Having a margin of safety is critical for protection if the worst should happen, but that’s not why we invest. We invest because of the upside potential available in an investment.

As an acquisition entrepreneur, you are not simply a passive investor. You can be active in your business, using your time, commitment, and skillset to grow revenue and increase earnings. This is where entrepreneurs have the advantage over all other investment classes and are really able to hit the acceleration pedal. If you were attempting to increase your appreciated value in real estate, for example, there’s not much you can do. The market moves, and the value of the homes move with it. It’s not even called “appreciation” in business, it’s just called building value. And after you buy, you are going to build.

Perhaps your most critical initiative as an acquisition entrepreneur will be to grow your business. In the four years following March 2013, revenue reported by ultra-small businesses (those generating under $1 million in revenue) increased 20 percent.[7] Revenue is one of the key drivers of business value, and the same report signals a 13.5 percent increase in transaction price over the same time period.

Business can and grow at 10 percent or more in revenue per year over the prior year. A business with an aggressive growth rate reaps tremendous value increase. If a 10 percent growth rate is achievable in your business, then it will be twice the size it is today in just seven years. The cash flow increases and the value of your asset increases, providing a vehicle for building wealth.

Acquisition Entrepreneurship as a Vehicle for Tremendous Growth

Put all the above together and you can see how purchasing and building a business can be a route to both success and fulfillment. The ROI can be considerable, the margin of safety is usually sufficient to make the investment worthwhile, and the potential upside is enormous.

This is no passive investment, where you simply deposit your money and wait for it to appreciate. It’s an active vocation, in which you exchange both financial resources and your entrepreneurial abilities for the satisfaction of a thriving business.

Now you’re doing something you love, paying yourself, building your team, growing your business, building equity through your debt payments, and reinvesting when needed. Heck, you might even choose to accelerate the growth of your company through additional acquisitions and fund them entirely through the cash flow of your business.

The key is that your business has one thing that no other investment has. You. And you are a value creator. Do not wait. Get to work immediately building value. If you do this, acquisition entrepreneurship could be one of the best investments you ever make.

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For more advice on the risks and benefits of acquisition entrepreneurship, you can find Buy Then Build on Amazon.

 

Walker Deibel

Walker Deibel

Walker Deibel is an entrepreneur and advisor. He is the author of Buy Then Build: How Acquisition Entrepreneurs Outsmart the Startup Game.