Are You a Victim of Probability Neglect?

There is common phrase thrown around in business: If you aren’t growing you’re dying. In business there are two types of growth, organic and inorganic. Organic growth refers to increasing sales internally, generating more revenues with your existing business assets. Inorganic growth refers to growing sales by expanding to new locations, acquiring other businesses in the industry, and sometimes even expanding outside of your industry.

A common misconception is that organic growth is less risky and less costly than inorganic growth. But as humans we are actually inherently bad at assessing risk. Referred to as probability neglect, we assume that common activities we engage in are inherently safer and less risky than less uncommon activities.

A common example of this bias is how most of us feel about driving a car compared to flying. For most of us driving a car is an everyday event, something we think very little about. But flying is uncommon relative to driving, even for the heartiest road warriors among us. Most of us express at least some level apprehension while flying that we do not experience while driving.

But the reality is that driving is much more dangerous than flying. In fact, you are 600 times more likely to be killed in a car on your way to the airport than on a plane itself. Yet we feel that driving is much safer than flying.

Business growth is the same. Many of us feel apprehensive about growth, especially inorganic growth. The prospect of buying another business can be intimidating. And that is understandable, buying a business is not a common activity for most of us. Most of us do not buy businesses every day. But inorganic growth can actually be less risky and less expensive than traditional organic growth.

Organic Growth

Organic growth is the strategy of driving more sales and production through your existing business. To grow organically there is a certain amount of investment you have to make in your business. It may be in the form of equipment, an expanded facility, bringing on additional staff, or training.

Growing organically is often perceived as a low risk way to grow a business. Some business owners are of the opinion that the existing business already has the infrastructure, people and tools in place so buying another business would merely duplicate what is already in place. As a result there is sometimes a preference to invest in hiring more employees or expanding the capacity at the exiting location to grow.

But there are some drawbacks to organic growth. Organic growth tends to be gradual over time. There is also a natural limit to how much growth you can generate from any given location. In a market that is shrinking or consolidating organic growth can be difficult due to increased competition or a shrinking customer base. Organic growth can also be expensive, requiring large investments in staff, training, marketing, tooling, and capacity.

Inorganic Growth (Acquisitions)

Inorganic growth is the strategy of business expansion through buying and integrating businesses. Inorganic growth also requires substantial investment to grow the business, but less than may be assumed at first glance.

For example, consider the organic growth approach. Assume there is an opportunity grow organically, but in order to achieve that growth the business has to invest in office and administrative staff to manage the increased workload (perhaps and additional estimator or CSR, or perhaps both). Using round numbers, assume that investment in year 1 is $100,000. As a result of that investment you hope to increase sales by about $500,000 annually.

But consider an acquisition. With the same $100,000 investment, along with the addition of appropriate bank and seller financing, you could easily purchase a business that generates $700,000 in revenues, perhaps even $1,000,000 or more in revenues. In this scenario an acquisition represents an alternative yet affordable path to growth.

In addition to acquiring a larger sales base, the acquisitions-based approach has a number of additional unique benefits:

  1. The initial investment is a one-time investment as opposed to the investment in staff, which requires continual reinvestment in the form of salaries and wages;
  2. The acquired business is a “going enterprise”, and has the equipment, customers, and employees to generate revenues day one;
  3. The newly acquired business also provides the opportunity of additional upside;
  4. The acquisition provides the opportunity to develop economies of scale, and actually reduce the overall cost structure of the business;
  5. Additional locations increase the relative value of the cash flows of the business;
  6. The acquisition provides diversification and lowers the overall risk of the business;
  7. The acquisition exposes the business to additional markets and customers that it otherwise may not have access to;
  8. The acquisition provides a level of certainty around sales growth that may be absent in the organic growth scenario.

Which one is best?

There is no one correct answer and each strategy has its own trade-offs. But inorganic growth is less risky and less expensive than is often perceived. It also represents a faster way to build scale and competitive advantage in a consolidating marketplace. It has the distinct advantage of materially increasing the overall value of a business prior to a sale when executed properly. One of the quickest and most effective ways to increase the value of your business is through business acquisitions.

If you are contemplating an acquisition, or have been approached by one of the large consolidators to sell I am happy to walk you through different scenarios and to identify the areas that I can add value to your business. 2016 will likely be a busy year in buy / sell activity, perhaps one of the busiest ones yet. Please use my contact page to get a hold of me; subscribers please email me directly. I keep these conversations confidential.

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