Perhaps the most solid way to improve your chances of succeeding in your own business is to buy an existing business. If you put the same effort into improving an existing business that you would otherwise put into starting a new business, the results can be powerful indeed.
Change Your Business Approach
Most people, when they buy a small business, tend to run it in the same way that the previous owners did, and the results tend to be pretty much the same. But if you apply all the advice I have to offer, have the mind-set and energy that you would approach a start-up with, and rethink every aspect of the business, the results can be terrific.
For example, when I was a student at Harvard Business School, the school licensed student concessions, or small businesses that students could bid on running each year. I successfully obtained the license to publish The Harvard Business School Directory, essentially a souped-up phone and address book. The previous year, the two student partners had a net income of about $11,000, or about $5,500 apiece, continuing a general pattern of modest increases over prior years.
With my background being in start-up businesses, I approached this business with the energy, thinking, and planning that would go into a start-up. I put together a commissioned sales team of college students on summer vacation, and we sold three times as much advertising as the prior partners did, and at significantly higher rates. My net profit was $30,000—a 300 percent improvement, and by far the highest student income from a concession in the history of Harvard Business School!
The advantage of buying a successful business in comparison to starting a new one can be overwhelming. Perhaps the biggest plus is that a huge amount of risk and uncertainty are eliminated. There are not only existing customers, but also a track record of what is selling and what isn’t, and you know at what prices they are selling. Because the basic business infrastructure is already in place, you can focus on improving the existing business, rather than on reinventing the wheel.
The most important asset you may acquire in buying a business is the customers. Even with a great product or service, building clientele can take time. Make sure the customers are satisfied and that they will remain loyal to the business after the current owners have sold out.
Identify and assess the value of all key employees. Arrange to meet with them. Ask yourself: How critical are the current employees to the business? Do the salespeople have strong relationships with key customers? Would a particular engineer or designer’s talents be difficult to replace? How important is the role of the current owner? You might even consider offering incentives to certain employees to ensure that they remain with the business at least through the transition period.
Leases are not always listed on a casually assembled balance sheet, yet they can be a tremendous hidden liability. Find out whether the current owner personally guaranteed the lease(s) and ascertain whether or not the landlords will insist that you personally guarantee them as well.
There are important regulations to consider as well. Environmental legislation, in particular, places the burden of polluted property cleanup on current owners and, in some cases, leaseholders. Find out whether the property was ever owned or leased by a manufacturer who was involved in activities that created hazardous wastes, which could have contaminated the soil. Find out whether or not any cleanup action has already been taken.
Don’t take historical financial statements at face value, especially if a satisfactory audit letter from a CPA firm does not accompany them. Don’t confuse a compilation (basically adding up the numbers provided by the client) or a review (a compilation with a few ratios figured out) with an audit. Only an audit requires that a CPA test financial information. If the seller offers you projections, don’t even look at them!
Chances are, if the business has receivables, their value is overstated. Carefully examine an aging of the receivables and determine what amount is outstanding past normal industry practices (nominal stated terms are often ignored). Then assume that an appropriate amount of receivables that are still current will also become bad debts.
The market value of the inventory is almost certainly going to be a lot less than what was paid for it. While larger businesses tend to have a fair amount of slower-moving items in inventory, small businesses can have an even higher percentage of “dead wood,” as they are often more hesitant to write down or sell off obsolete items.
Make sure that you are not walking into a competitive minefield! Is a price war beginning? Are your competitors slashing their margins to the bone? Did the current seller hear advance reports of a powerful international corporation entering their market niche?
Much more so than with buying a house, you should consult an attorney who is familiar with small businesses before signing an offer to buy. This is particularly important because of the many hidden liabilities you may be taking on, such as contracts, employment obligations, pending litigation, bills to vendors, leases, and more.
You need to have a firm agreement with the current owner as to with whom, at what stage of the negotiations, and under what conditions you can discuss your interest in buying the business. Telling key customers that you are considering buying a business that is not yet publicly for sale can pose a risk to the business and expose you to potential litigation from the current owner.
Start by carefully estimating the net positive cash flow for the next five years, after subtracting a good salary for your talents—one that is in line with your market value if you were employed in a similar management capacity elsewhere. Then determine the appropriate multiple of earnings to use to arrive at a fair valuation.
The appropriate valuation should reflect the amount of risk inherent in the business and the importance of your efforts in making the business succeed. Valuation is worth spending a lot of time thinking about, hence elsewhere I offer several different valuation methods and additional thoughts on this topic.
Takeaways You Can Use
- Approach the existing business like a start-up.
- Buying an existing business can eliminate a lot of risk and uncertainty.
- Do thorough homework on every aspect of the business you are purchasing.
- Be honest and detailed in your valuation.