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Saturday, October 26, 2013

Buy, don't start a company

In doing research for my first (journal) article on 3D printing, I found an interesting article that suggests young entrepreneurs should consider buying a small growth business rather than start one from scratch.

The story (from the October 28 dead tree edition of Forbes) is about Stanford alumnus Rob Cherun and a course he took that changed his career goals from McKinsey consultant to one-man LBO artist:
Cherun’s inspiration was a little-known but increasingly popular course at Stanford called “Strategy 543: Entrepreneurial Acquisition.” This second-year elective is a fast-paced, two-week primer on how to become a one-person version of KKR or Blackstone Group, carrying out your own tiny takeover and installing yourself as chief executive officer. …

Every year second-year Stanford students like Cherun stampede into S-543 to learn the essentials of raising money, finding an acquisition target and closing the deal. Instructors Peter Kelly and David Dodson–two longtime entrepreneurs and investors themselves–take only 40 students per session, and that doesn’t come close to satisfying demand. Months before this autumn’s class began, every slot was claimed, and another 26 students hovered on the waiting list. Frustrated aspirants will get a second shot in the spring, thanks to a new scheduling expansion.
Columnist George Anders cites a study of “search funds” that concluded that the occasional home run (100:1 return) produces a pretax IRR of 34%, even allowing for a 50% failure rate.

In Cherun’s case, money was the easy part: after four Stanford instructors ponied up, Cherun and a partner raised more than $500k for their search and a promises of equity funding for an actual deal.

The entrepreneurs bought 90% of a Canadian company that monitors construction sites for thefts. The 35-year-old founder remained as a minority partner and got to spend more time with his wife and kids without having to travel across the country. The new owners have doubled revenues to $10m (loonies?) annually.

However, these Stanford students face a sizable opportunity cost. In almost the same issue, Forbes proclaimed Stanford the “best” US business school, based on the difference between pre-MBA salary ($80k) and post-MBA ($221k) salaries that (net of tuition and lost wages) left them on average $100k richer after five years. The generous salaries for the elite graduates of the Stanford class of 2008 were aided by placements at Apple, Google and the top consulting firms (Bain, BCG, McKinsey); these were 5 of the 6 employers most preferred by MBA students (#4 on the list is Amazon).

Three other schools (Chicago, Harvard, Wharton) also had $200k post-graduation salaries. My undergrad school, MIT, ranked 12th -- just ahead of UCLA, Berkeley and Virginia; my grad school, UCI, ranked #62 (up from #69 in the last ranking).

It takes great confidence to walk away from the certain cash to run a small company. (Stanford students are nothing if not confident.) The risk is probably lower if (as in Cherun’s case) the company has a track record and (as recommended by Stanford) can be bought for 6x EBITDA.

Except for the last point, this looks like a win-win, providing a liquidity opportunity for entrepreneurs who can’t take the company to the next level. Still, having a residual equity stake (and a meaningful management role) makes it a lot more attractive for founders who might have trouble letting go of their baby.