THE STORY
Back in 2001, Howard Schultz and 57 partners bought the Seattle Sonics professional basketball franchise for $200 million. During the time that Howard Schultz owned the Seattle Sonics, the team suffered annual losses. It is claimed that while Schultz owned the team, the combined operating losses were $60 million.
Yet, in spite of being a business that showed no signs of making a profit, Schultz and his partners sold the Seattle Sonic team in 2006 for $350 million. That is $150 million more than what they paid for the team and $90 more than they paid if you subtract the annual losses. In fact, they supposedly turned down an offer of $425 million (more than twice what they paid for the team) from Larry Ellison, CEO of Oracle, because he wanted to move the team away from Seattle.
This is not a fluke price. In 2004, the New Jersey Nets basketball franchise sold for $300 million and the Cleveland Cavaliers basketball team (and its arena) were sold in 2005 for $375 million.
Willamette Management Associates is an expert in the area of sports franchise valuation. One of their representatives says that it is very difficult to use income flows as a means of evaluating sports franchises. To quote a 2002 paper they wrote on the topic,
“The discounted cash flow method is often used in the valuation of sports franchise intangible assets. However, it may be difficult to use this method in the valuation of the sports business enterprise. This is because many sports franchises either earn negative income or do not generate sufficient income to support the prices paid in actual team sales.”
So it appears that even though the business itself can be a perpetual money loser, in the world of sports franchises that does not mean it is a bad investment. According to the Seattle Times, the annual rate of return on the investment of Howard Schultz and his partners, when you consider the selling price and other factors, was probably around 10.6%. That’s a pretty good return for investing in something that loses money.
THE ANALOGY
At the end of the day, the basic goal of capitalism is to find good returns on investment. As the story above illustrates, it is possible to get very good returns on investment on businesses that provide little to no profitability on an annual basis. The return on investment for the Seattle Sonics did not come from the operating earnings, but rather from the selling price.
Now you may be thinking that such opportunities occur only in the world of sports. However, recent trends seem to be indicating that this trend is creeping ever more into the rest of the business world. Just look at some of the prices that hedge funds have been paying recently for businesses that are not very prosperous. Even businesses that lose money are being snapped up at relatively high prices by these hedge funds.
When devising business strategies, there appears to be a strategic option to consider running a business not to necessarily make money through earnings, but rather to gain virtually all of the profits at the point when the property is sold. This is called the “build to flip” strategy.
THE PRINCIPLE
The build to flip strategy takes a different perspective on the question “who is my customer.” Instead of seeing the customer as being the person who pays you for your goods or services, this strategic alternative sees the customer as the person you eventually sell the business to. Taking the adage “please the customer” to heart, the build to flip companies run their business more to make an eventual buyer of the firm happy rather than to make the business operation’s customers happy.
For example, during the dot com bubble of the 1990s, many start-ups had as their strategy the goal of eventually selling the business to Cisco Systems. Cisco had a policy that they would only buy firms located in one of three areas—Silicon Valley, Austin Texas, or the Research Triangle in North Carolina. The reason was that it was too difficult to manage the Cisco empire if all the subsidiaries were scattered all over the place.
Start-up companies knew this policy, so if their goal was to eventually be bought out by Cisco, they knew that they had to locate the business in one of these three areas, even if it was inconvenient to them or to their operating customers. After all, they saw Cisco as their ultimate customer, and if that is what Cisco wanted, then that is what they did.
I personally saw this principle in action when I was in the grocery business. A number of independent grocers, when they got near retirement age, wanted to sell their businesses. These grocers knew how the large supermarket chains thought when considering the purchase of an independent grocer. Large grocery chains believed that it was easier to take a store with high volumes and leverage the volume into higher profitability than it was to take a low volume store and increase its volume. In fact, these chains would prefer to purchase a high volume store that lost money over a low volume store with modest profits, because they believed the high volume store had more upside potential.
Knowing this, the independent grocer thinking of retiring would for a year or two abandon the idea of making a profit and focus all of the strategic effort on doing whatever it took to increase sales volume. They would do this even if the tactic made little economic sense in the long run or even if the tactic was unsustainable in the long run. After all, the eventual buyer of the business wanted to buy sales volume and typically set its purchase price on a multiple of sales. So to give the “customer” what they wanted, the independent grocer would raise the sales volume, regardless of the consequences.
Once the sales volume from these tactics started to peak, the independent grocer would sell the company to the supermarket chain. This strategy would make the independent grocer wealthier than if they had run the business as normal prior to the sale. So as you can see, the idea of getting a good return when losing money is not just a principle for sports franchises.
Even on a smaller level, I have seen this policy used in the real estate business. It is not uncommon for someone to own property on the far outskirts of a city. The owner of the property knows that if they wait a few years, the city will grow out to where his land is. At that time, it will become very profitable to sell the land to a developer. To sell now would bring a lesser return. So what do you do with the property in the mean time, while waiting for the city to grow in this direction?
Well, you don’t want to put a lot of capital into the land, because you are going to only hold it a short time. Since you do not know how the eventual new owner will want to use the property, you don’t want to use the property in such a way that would limit the flexibility of the new owner to do what they want. So what do many of them do?
They put a miniature golf course on the property. The cost to do so is very low, and it leaves a lot of flexibility for the next owner, since a miniature golf course can be easily removed, leaving the land ready for just about any use. The golf course does not have to make a lot of money. Even if it helps cover just a portion of the interest on the real estate, it is beneficial. After all, the goal is to make most of the return on the sale of the land, not the operation of the miniature golf course.
If you are trying to sell a company, there are many decisions that you might make differently if you look at a potential buyer of the firm as the true customer. For example, if you know that potential buyers of the company prefer to operate on particular computer platforms, you may want to run your business on that platform as well, even if it is not your personal preference.
Instead of spending a lot of time making calls on operating business prospects, you may want to divert more energy to speaking at seminars or in getting articles published in places where potential buyers of the company will get exposed to you in a favorable light. The idea is to make it a priority to think about ways to make your company appear more valuable to a potential buyer of the company.
There is something to be learned from running your business as if it were a sports franchise.
SUMMARY
There is more than one way to get a good return on your investment. One way is to focus on getting nearly all of your return at the point in which you sell the company (the build to flip strategy). This tends to be the way that sports franchises have worked for decades and it appears to be an increasingly viable strategy outside the sports world. This is especially true given all of the hedge fund money out there looking for companies to buy. In this strategy, the idea is to look at the eventual buyer of the firm as your true customer and to make decisions based on how it would please this eventual buyer.
FINAL THOUGHTS
If it is true that the majority of the profits of a business strategy could come at the point at which the company is sold, then it must also be true that a lot of the value in the acquiring company could be destroyed if it purchases companies unwisely. Making most of your value by purchasing properly (rather than selling properly) is another way to build a strategy.
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