How NOT to Run a Business

I’ve known Jeff for nearly 40 years. Everyone needs that one friend that has your back unconditionally; the person you’d call if you ever found yourself in a real mess. The guy who knows where the bodies are buried and can keep a secret.

Jeff’s that guy.

Unfortunately, Jeff runs an absolute nightmare of a business. It may actually be the single worst business I’ve ever seen in my life. (Don’t worry, he won’t be upset when he reads this. He actually helped me write it and agrees with me wholeheartedly.)

Jeff scours the country looking for industrial machinery that is unloved and underutilized, usually in the old Rustbelt of the upper Midwest. Generally, the sellers are eager to get rid of it, so they sell it to him for a song.

Sometimes the machines need a little tender loving care to get them back to peak condition. No problem. Jeff has a mechanic in his shop with the hands of a craftsman who can fix anything and make it as good as new.

Once the machinery is ready to go, Jeff finds a buyer, usually in a high-growth market like Dallas, and makes the sale, sometimes raking in gross profits of a couple hundred percent or more.

Unlike the stock market, which is global and efficient, the market for used industrial equipment is ridiculously fragmented and inefficient. The sellers tend to be in one part of the country, and the buyers are usually half a continent away. There is no centralized market, and supply and demand vary wildly by region, as do prices. So, a clever trader can essentially find risk-free profit opportunities to buy low in one market and sell high in another.

I’ll give you an example. Jeff recently closed on the single best trade of his career. He picked up a Cemco MVB-84 vertical boring machine at an auction in San Angelo, Texas for a whopping $52 dollars. This is an eight-foot long by eight-foot wide by 4-foot tall, 3,200-pound solid piece of machinery that should be worth a couple thousand dollars in scrap value alone, and he bought it for less than the price of my monthly phone bill.

He just sold it in Oceanview, California for $14,000, plus a $1,300 delivery fee.

That’s a 26,823% return on his initial investment.

So far, it sounds good. It’s a value investor’s dream!

Not so much…

Have you ever tried moving a 3,200-pound piece of metal? Would you have the foggiest idea how to even start?

It also took him two full years to sell it. And for all he knew, it might have taken a lot longer than that. Meanwhile, it sat in his shop, taking up space. Would you have 64 square feet of floor space to store something like that, potentially for months or years?

Jeff’s business enjoys fat returns. But those returns are wildly sporadic, and they require major up-front capital. He needs a warehouse. He needs trucks. And he has to pay his mechanic even when the workload is slow.

And good luck getting financing. How eager do you think your bank would be to use a 20-year old Graco Mark V Texspray 1.25 GPM industrial airless paint sprayer as collateral on a loan?

The business is also completely dependent on Jeff’s expertise in the machinery he trades. It involves constant price research and untold hours on the phone and on job sites, sizing up the market. Without Jeff, there is no business. It would literally be worth zero.

I wish my friend the best of luck. I hope that as old men, we can sit in our rocking chairs and have a good laugh about all of this. But there is no way in hell I’d ever want to invest the way he does.

Using poor Jeff as an example of what not to do, let’s look at the conditions to look for when starting a new business.

Make it Asset-Light

Jeff’s overhead is the bane of his existence. Renting a large warehouse and owning a fleet of trucks isn’t cheap. High overhead costs like these perpetually drain his cash flow and limit his flexibility while also making it hard for him to cut his losses and move on to something new.

I started my first business on my kitchen table with a laptop and a bootlegged version of Microsoft Office. It ended up being a failure, but that’s ok. I was able to cut my losses early and move on to the next project, which was more successful. I wasn’t constrained by large sunk investment costs. If I had a shop full of expensive equipment, it would have been a lot harder to walk away to find a better opportunity.

Make it a Business, Not a Job

Jeff’s business is entirely dependent on his skill and expertise. It would be extremely difficult to train someone else to do what he does, and it’s not scalable.

Compare this to something like a McDonald’s franchise. In the early days, the owner might need to take a hands-on approach in running the restaurant. But once the system is in place and the managers trained, the owner can walk away and move on to other projects. The business will essentially run itself. All good businesses are scalable systems that don’t depend exclusively on the labor of the owner.

If Jeff Bezos of Amazon.com fame hadn’t built a system, he’d still be selling books out of his garage. 

Run it with Other People’s Money

Jeff can’t get financing for his business. Banks don’t understand what he does, and they don’t consider his equipment to be attractive collateral. This means he has to rely on retained earnings or really expensive or dodgy non-traditional lenders to grow his business.

Compare that to the hypothetical McDonald’s franchise or to a piece of rental real estate. Banks love to lend on excessively generous terms for businesses like these because they understand them, can model them, and trust the value of the collateral.

If your business is extremely asset-light, you might not need financing. But it’s always good to have access to it, just in case.

Back to my buddy Jeff, he’s recently started a new business building custom barbecue smokers. It doesn’t quite meet my criteria for being asset-light, and financing is still difficult. Though this business is at least scalable. He’s looking at hiring workers to build the product while he focuses on sales.

At the very least, I’m looking forward to sampling the product!