Sooner or later, the notion of buying somebody else's business occurs to every company. It's notorious that big companies get half of such purchases wrong. With smaller firms, the mistakes are certainly no fewer.
The hit/miss ratio of one very sophisticated City investor is typical. It created a fund to win higher returns by picking unquoted companies. Over 50 buys were selected, no doubt with all 'due diligence': a third got sold for losses, five of them whoppers.
Almost as many investments yielded a profit, and the remainder are by no means all among 'the living dead' (an eloquent description). But the overall aim of outdoing quoted investments was missed - for when smaller firms fall, they can drop a long way, and very fast.
That's why venture capitalists set such apparently greedy targets; they aim to multiply their money no less than ten times in five years. They need that cushion so that the successes outweigh the inevitable failures - and their avaricious formula has lessons for everybody.
When thinking of buying a business, what do you want it to be worth in five years, say? Divide that sum by ten, as the venture capitalists do, and that's your target for after-tax profits. How will that bullseye be hit? Can it be done at all?
Unless the gold is within reach, and the buyer knows how, the potential buy had best be shunned like several plagues - at the price on offer. The alternative is to work back from the feasible profits to establish a yardstick for offering less to the eager seller.
He may refuse - but what have you lost? The world's most successful investor, Warren Buffett, in building his billions from investments as far apart as a furniture supermarket and Walt Disney, firmly refused to invest until he found a real bargain. If the buying urge becomes burning, or even addictive, grim mistakes are certain.
First time round, the investment house mentioned above rushed in where Buffetts would have feared to tread. Second time round, it was less foolish and looks like being more successful overall. All the same, a third of the second batch of investments sold for losses.
Those making one-off company purchases need 100% hit ratios. The non-financial safeguards are clear from the fund's experience. First, never invest in strategic weakness - ensure that the business is well-placed in its market, or will reinforce a strong position in your own.
Ted Forstmann made his fortune from that first principle. For example, he got excited over a company making, of all things, porcelain miniatures, solely because it dominated that market. He had his early disasters, though, including a company whose recording tape didn't dominate anything.
A fellow victim not long ago sent Forstmann a chunk of the offending tape with the message, 'never, ever, ever forget your roots.' In other words, learn from your mistakes. But fewer errors will follow if you only buy a business which you know almost as well as your own (if not as well). Andit requires homework to divine the target's true strength.
People are often tempted, however, to brush that issue aside, buying a business with a weak market position, poor assets and feeble management - on the argument that their genius will wonderfully improve all three. Sometimes the magic works: mostly it doesn't. It's obviously far better to buy strong businesses with strong managers.
If the management isn't strong enough, the defects may not appear before purchase. If they surface thereafter, remove or reinforce the defectives without delay. Missed budgets and falsified forecasts are always a horrendous sign. Remember Geneen's Law: a missed first quarter is a missed year.
The fund's paramount lesson, however, is elementary commonsense: don't overpay. An old rule of thumb is to pay no more capital than the buy earns in sales - and preferably much less. That leaves room to recover if a mistake has been made, and skeletons start tumbling out of cupboards.
One thing is certain. The bad news will come before the good. No buyer of smaller companies will tell you any different. As an immortal phrase has it, 'lemons ripen faster than cherries.'
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