What is A Circle of Competence?
Famed investors Warren Buffett and Charlie Munger long ago popularized the mental model of staying within one’s circle of competence as an investment strategy. Staying within one’s circle of competence refers to investing only within areas where one has earned knowledge, skills, and expertise while avoiding investing in areas where one has limited understanding or experience. An investor’s circle of competence may be impacted by their profession, spending habits, lifestyle, or active interests and curiosity. By staying within one’s circle of competence, one increases their information advantages and situational awareness of a given investment. This reduces the likelihood of making poor decisions. Buffett and Munger emphasized that the size of one’s circle of competence is unimportant so long as one knows its boundaries and one’s own limitations.
Circle of Competence in Business Sales
When it comes to business sales, possessing self-awareness of one’s own limitations and staying within one’s circle of competence is extremely important for both buyers and sellers. For business owners looking to sell their business, staying within one’s circle of competence means not attempting to sell their business on their own without the use of an experienced business broker. Objectively pricing a business, confidentially selling a business, and justifying the purchase price based on comparable sales are all areas in which few if any business owners have any familiarity. For buyers of businesses, staying within one’s circle of competence involves an honest assessment of the types of businesses and industries that one should avoid while solely focusing on businesses and industries for which they have familiarity, knowledge, and the right skill sets.
Business Buyer’s Circle of Competence
- Prior to searching for a business to purchase, buyers should always write down what types of industries and businesses in which they are unfamiliar, have no natural interest or curiosity, and do not match their skill sets.
- For example, buyers that are uncomfortable dealing with customers everyday should avoid a retail-related business.
- Buyers that are not mechanically inclined should avoid construction-related industries.
- Buyers that do not have an interest in or familiarity with working in the food service industry should avoid restaurants.
- Although most buyers may take advantage of free training offered by the seller after the sale, they will face a steep learning curve and will be generally less likely to succeed in a business or industry of which they have no prior background or familiarity.
- An important signal that a buyer is attempting to purchase a business outside their circle of competence is when they are overwhelmed or unprepared during formal due diligence.
- After a deal goes ‘under contract’ by virtue of a signed agreement between the buyer and seller, the buyer begins their formal due diligence or a thorough investigation of the financial, legal, and operational aspects of the business.
- Without an understanding of the business and industry in which it operates, a buyer is less likely to know what type of pertinent questions to ask during the formal due diligence process, as well as how to process and weigh the information received.
- As an example, let’s say a buyer is attempting to purchase a coin laundromat which does not have transparent financials since it omits all of the cash sales (quite common in this industry).
- If the laundromat industry is outside the buyer’s circle of competence, then the buyer is unlikely to know that utility bills of a coin laundromat (showing water and gas usage) is a good substitute for traditional financials.
- A buyer that is familiar and knowledgeable about the laundromat industry would know this and would be able to assess the actual sales of the coin laundromat by its usage of water and gas.
- Preparing a thoughtful and pertinent list of formal due diligence questions is usually the best way in which a buyer may determine whether a business lies within their circle of competence.
Buyers Should Not Value Businesses Outside Circle of Competence
Assessing the future prospects, competitive landscape, and structural advantages or disadvantages of a business is very difficult if not impossible when it lies outside one’s circle of competence. Insight and knowledge about industry trends as well as the typical cost structure and challenges faced by most businesses within an industry are instrumental when it comes to placing the valuation of a business in its proper context. Moreover, the physical assets of a business (such as inventory and equipment) are more difficult to value for a buyer unfamiliar with the industry in which it operates. Since physical or tangible assets make up a significant component of the value for many small businesses, it is crucial that buyers understand the distinction between their depreciated value on the balance sheet and their actual worth based on their current condition.
External Lenders and Circle of Competence
Many buyers choose to finance the purchase of a business through external lending backed by the Small Business Administration (SBA). As a part of the SBA-backed qualification process, many lenders impose requirements on the buyer to ensure that they are experienced and knowledgeable about the industry dynamics. Sometimes lenders require prospective buyers to personally hold the requisite license (such as a plumbing license when buying a plumbing company) needed to operate the business or require prospective buyers to show proof of past employment within a similar industry. These requirements implicitly acknowledge the likelihood that a buyer will be more successful (and pay off the loan) when operating within their circle of competence.
The search for the right business should always start with the buyer defining the boundary of their circle of competence and remaining inside the boundary at all times. Business owners can likewise benefit from the wisdom of Buffett and Munger’s advice by leaving the sale of their business in the hands of a trained professional.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.