An operating business has two options, grow or die. Every company owner must choose grow once they have revenues.
The two ways to grow your company are (1) to reinvest company profits or (2) to make acquisition of cash-producing assets with company profits.
The acquisition strategy is (a) less risky, (b) grows the company faster and (c) is thirty times more profitable to the business owner over twenty years.
Reinvesting company profits is a slow and risky process
The company owner gambles each year that the reinvested annual profit will increase revenues and profits the following year. If the demand for the company’s product exceeds supply, the owner will use the company’s profits to increase supplies. If the company’s production capacity exceeds demand, the reinvested profits will be used to increase the market for the company’s product or service.
External variables, like competition, local government policies, global economics and even technology advances can easily undermine the best of tactical annual business decisions. My belief and experience tells me that few business owners can sustain annual growth over time, without having a few serious setbacks.
Let’s test this out
Here’s an example. Let’s assume that the business owner wins every annual investment gamble over the 20 years that the owner runs the company. The private company owner starts with a company grossing US$1 million each year and successfully gambles the annual 20% reinvestment profit. In five years, the company should be grossing US$2 million. In twenty years, the company should be grossing US$8 million. Again, this means 100% success each year with no nasty surprises or setbacks of any kind Set up a company in Istanbul.
Bank loans, another possibility
Most business owners soon realize that they can leverage their annual gamble by borrowing money from a local business bank. This increases their risk, but potentially compounds their gross revenues over the twenty-year time frame.
Assuming the business owner can borrow their annual gross revenues each year at 7% interest, they will net 13%/year on the borrowed funds. Their borrowing gamble over 20 years should add about 65% to the company’s annual gross revenues. So the company should be grossing about US$13,200,000, twenty years later.
The problem is that a company borrowing its gross revenues always risks the loss of the company. Assuming that borrowing the company’s gross revenues is an even money bet, it’s a bad bet. The borrowed funds don’t double the gross revenues of the company in twenty years.
Private equity investment?
The alternative for the private company owner is to seek a private equity investment in the company. Again, figuring a 20-year 100% winning streak, the company’s gross will be a multiple of the investment. However, if the company owner sold a fair percentage of the company for tha private equity money, in twenty years the owner would receive the same amount of money for their business as if there hadn’t been private equity investment in the company.
Thus, successful equity investment, as a reinvestment tactic, in a private company should increase revenues and reduce risk of failure, but it won’t increase the owner’s percentage of the sale of the company in twenty years.
Acquiring cash-producing assets, a winning bet
It is usually cheaper to buy a business than create it. An existing business has customers and products. Purchased by an operating company, especially if it is in an aligned business, the acquisition can expand the client base of both companies and factor the potential of sales for both product lines.
The company owner with gross revenues of US$1,000,000 and a reinvestment annual profit of 20% buys a company with revenues of US$1,000,000 and a reinvestment annual profit 20%. The buyer doesn’t discount the revenue and pays US$1 million for the acquired company with 20% down and the previous owner taking back a four-year note at 7%. The company is now grossing US$2 million with a repayment budget of $400,000/year. The buyer should be able to payoff the acquisition debt in less than 2.5 years. Assuming that our repayment interval is 2.5 years and that our company owner wins every bet over twenty years, their M&A strategy, will result in a company with US$256 million in annual revenues.
Why This Explanation Works
The mathematical reason that a twenty-year M&A strategy results in thirty two times greater revenues is that the M&A strategy is based on a geometrical progression and the reinvestment tactic is based upon an arithmetic progression. Also, you can use statistics to show that the M&A strategy is less risky than the reinvestment approach.
The use of publicly traded shares in this M&A strategy reduces the time interval in our M&A geometric progression. If we assume a public company with a million dollars in annual revenue and a 20% reinvestment profit making the acquisitions using 25% cash and 75% shares, the public company would need the seller to hold a $50,000 note for two months. Thus it would take about 8.2 years for a public company, using their shares, to achieve gross annual revenues of US$256 million.
Math models are a signpost
Math Models do not necessarily reflect reality. Usually, there are far more variables in any business equation than can be accurately represented in a Math Model. However, Math Models can be useful in comparing the relative benefits and risks of two strategies where the factors being compared are held constant. In this case, they show that any M&A strategy is the wisest strategy for any business owner intent upon effectively growing their company, over an extended period of time.