Should I Buy an Existing Business or Open a New One?
Acquiring an existing business could be a great idea, but if you will be a first time business owner it is probably a good idea to find a franchise resale. Just as with starting a new business, you will have much better odds of success as part of a franchise system. There is a big difference between managing a large business and owning a small business. As a former corporate executive, I had a fair amount of business experience prior to becoming a business owner.
However, like a lot of former executives, I really wasn’t ready for all of the unknowns associated with running a small business. No longer do you have the support staff to take care of all of the functional roles such as accounting and finance or human resources, real estate, legal etc. If you buy into a franchise system, they will teach you how to efficiently manage all of these functions. If you acquire a non-franchised business, the only training you may get is from someone who may be great at running the business, but terrible at prepping you to do so.
Standing in line to get permits and dealing with phone or utility company representatives can be frustrating, but not knowing what things need to be addressed is what can create big trouble for your new business. With an existing franchise unit the books will likely be clean and you will have access to a well designed training program. The franchisor has a vested interest in your success so you will be trained by professionals who know how to teach you to run the model the way it was designed to work. Good franchisors are very involved in vetting any potential buyers of their existing units and they will work hard to help you succeed.
The biggest challenge with an acquisition is access to a quality business. It can be very difficult to find something worth buying. We are still near the bottom of the market as it relates to resale businesses and it is tough to find an existing business that offers a significant advantage over starting a new one. Trying to find a business by looking through broker listings posted on various websites can be very frustrating. The reality is that many of the best businesses are never listed with a broker. They are typically sold to a family member, an employee, a competitor or a friend of the business owner. In other words, there are already people waiting to purchase the business before the owner is ready to sell it. When the owner is ready, he simply goes to the people he knows and offers it up and if one of them wants it, he has his lawyer process the transaction and it is a done deal before the general public ever knows it was for sale.
Often, many of the businesses listed at business for sale sites have some serious flaws. You have to consider that by virtue of it being listed on a website, none of the owner’s friends, family, employees or competitors were interested in buying his business, so what does that tell you? Quite often the business is just simply overpriced, but many times there are bigger problems that may prove difficult for the new owner to overcome. Things like a bad image can be fixed, but a bad location can only be fixed by moving, which can be costly. If you want to buy an existing business it is often going to be a “fixer upper,” so you should have experience in turning around flagging profit centers and be ready to spend the time and money required to do so.
If you really want to find a good acquisition target, try some old fashioned networking. Business owners know other business owners and they can help you with introductions. Poke around at the local chamber of commerce or the Rotary Club. Talk to as many business owners as possible and ask them who they know that might be ready to sell. One of the best sources of high quality businesses that might be good targets for acquisition will be the CPAs in your market. These folks keep the books and do the taxes for the local business community and they will know if their clients are ready to sell. Consultants who work with franchisors can be a great resource too, because many franchisors help their franchisees find buyers, so the business is never listed on a broker site.
The other issue besides access to a suitable acquisition is cost. Some people want to buy cash flow, but this can be expensive. Depending on the business type you can expect to pay three to five times earnings, meaning that if the same rate of return holds after you buy the business, it will take you three to five years to get back to zero. This can work out OK using borrowed funds if you can cover the debt service, support the growth of the business and meet your personal needs off of the existing cash flow. Unfortunately, when a business changes hands it can also lose customers and there can be a decline in sales before they start to rise again. Additionally the purchase of the business comes along with liabilities like rent, utilities, cost of goods and payroll that need to be met even if sales are slipping.
Sometimes the biggest costs associated with an acquisition are the ones that you will never know about until you own it. It is kind of like buying a used car. Even the best inspection can miss things that you won’t know about until you drive it for a while. All of this is not to say that an acquisition is a bad idea, but thinking that it involves far less risk than a start up is not exactly settled science. The price associated with buying a healthy existing business can be several times what it costs to start a new one. If you are not afraid of sales and marketing, you can start a new business, keep a lot more of your money in other investments and build your own revenue base while growing your equity at a much faster pace.
Just as with an acquisition, a start up is far less risky if you are working within a proven franchise model. The total investment for developing a franchise can range from a few thousand dollars for a simple home based business to several million for a hotel. The total investment represents the costs of the franchise fee, furnishings, fixtures and equipment, inventory, site improvements, permits, professional fees, initial marketing and any other costs directly related to opening your business. On top of this the operating capital required to fund the initial operation of the business can add several thousand additional dollars per month until the cash flow breakeven point is achieved.
Each franchise company has qualifying financial criteria that generally considers the net worth or liquidity of the potential franchisee. The requirements vary from company to company, but they serve as a rough gauge as to whether the candidate has the financial wherewithal to successfully start one of their outlets.
The basic rule of thumb is that you will need approximately 30 percent of the total investment in liquid funds and you can finance the remaining 70 percent (provided you have assets such as savings or home equity to collateralize the loan). Generally, the total investment figure does not include much working capital. The total of your budgeted monthly operating expenses combined with your personal living expenses for about a year is what you will need in addition to the 30 percent in liquid funds.
One of the biggest reasons businesses fail is because they are undercapitalized, so it is crucial that you have a good cash reserve or other streams of income until your business becomes profitable. Most reputable franchise companies will not grant a franchise to someone who is not clearly qualified, so if close scrutiny of your financial background is not required, this should be a red flag about the franchisor.
When franchise shopping, it is important to look in a price range that is appropriate to your resources. Everyone has different levels of risk tolerance and some people have a working spouse that can cover the personal living expenses while the new business is getting started. It is usually a good idea not to invest more than half of your net worth into a new business venture.
If it sounds like it takes a lot of money, it certainly can be, but the number of choices is vast and there are opportunities in most price ranges. The benefits of being a successful franchise owner can be substantial and purchasing a franchise is an excellent way to start a business. Just be sure to stay in your price range and do not overextend your capabilities. Remember, your first business doesn’t have to be your last business. If you don’t get overextended and you do it right, you will have cash flow and or equity that you can use later to develop bigger and better businesses down the road.
Dan Brunell is President of Dearborn West, LLC, an international business opportunity brokerage headquartered in Southern California.
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