Thursday, September 01, 2005

Build versus Buy

The other day some events at work reminded of the age-old build-versus-buy debate – it’s a topic of always bubbling below the surface in corporate development.  I’ve seen some scholarly papers on the topic (see, e,g, here), but in my view it’s pretty simple:  

  • You build whatever you can

  • You buy only that which:

  • You can’t build (e.g., certain patents, compelling brand names, scarce electromagnetic spectrum)

  • You can’t build fast enough to meet your strategic needs (e.g., big chunks of customers, smaller competitors in a growing segment)

  • You can get cheaper than building (bankruptcy!)

What this means for negotiating deals and valuing companies is that you always have to know whether the acquisition target is something you could (realistically) build.  If you can build it in an acceptable time frame, you will likely have a value gap with the seller.  Why?  For the simple reason that it probably cost the seller about the same to build it, and people who build businesses usually do so to make money.  The seller will want a cash flow multiple, or a certain return on what they’ve invested, or some other magic number.  You’ll be focused on creating NPV compared with what it costs to build.  Outcome – unless the seller is very motivated, you won’t have a deal.  

To my point of quickly eliminating “loser” deals before you waste too much time on them – unless it’s on the discount rack, don’t get bogged down with stuff that your company can just as well build.


Parkite said...

Interesting.........i don't see many larger companies that have the buy discipline that you describe. In a small, entrepreneurial startup, where capital is tight, i think you see the discipline you describe. However, in larger, mostly public companies, especially the ones with plentiful cash flow, there is a need to "do something" (rather than returning cash to shareholders). Typically this means acquiring a competitor or entering a new, unrelated market. I read somewhere about the staggeringly low success rate of acquisitions. I forget what the figure was, but it was very, very low.

Josh King said...

Sure - the dimmer the prospects for organic growth, the greater the ability to justify (rationalize?) the need to acquire something. And yes, the success rate for acquisitions is quite low, particularly when it comes to major mergers. All the more reason to approach every potential deal with a lot of skepticism.