Q: I was planning on buying a small, highly specialized Internet retail business, but I don’t like the idea of paying the 12 times after-tax earnings that the business would sell for. Wouldn’t I be better off starting from scratch than giving away the first 3 to 12 years’ profit?
A: Probably not. An up-and-running business showing any profits means that they have established customers, marketing avenues, and sales momentum. If you put the energy and talent that it takes to start a new business into improving an existing business, you should be able to dramatically increase earnings and recoup your purchase price very quickly. Furthermore, being a specialized Internet business, it probably has excellent growth potential. The 12 times earnings doesn’t sound unreasonable for this kind of business. If growth is strong, the price could even be low.
The key question beyond what the growth rate is: How vulnerable is this business to competitors? Are giant, low-margin online retailers like Amazon chipping away at their market share? Do they have loyal repeat customers or do they have to spend advertising money to attract every single customer, and then only get a onetime sale? What are the barriers to entry? These are just some of the questions I would try to answer.
Q: Can I assume that, like people selling a house, business sellers never expect to get the asking price, but something fairly close to it?
A: Most people selling a business have a very inflated idea of what it is worth, and this view is often reflected in the asking price. Few small businesses sell for anywhere near the asking price, and selling prices at half or even less are quite common. This is especially true when hard assets, such as real estate, are not a major factor. Remember, a business is a much less liquid asset than a house is. In other words, relatively few people are interested in buying a particular type, size, and location of business. So it’s not uncommon for small businesses to sell for only two-thirds or even half of the initial asking price.
Q: How much can I rely on information provided by a business broker?
A: Basically, not at all! The broker makes money only if the sale goes through, and this is almost always in the form of a commission. So, the higher price you pay, the more money the broker makes. More important, the broker’s source of information is typically the seller! A business broker is typically working for the seller, and his or her primary obligation and work is geared to extracting as high a price as possible from the buyer.
Q: I am close to making an offer on a profitable small service business. The business is only 14 months old, but the owner is selling because he is pursuing a terrific opportunity in an unrelated field. What do you think?
A: Don’t do it. When you purchase a business, other than hard assets, you are buying goodwill and forward momentum from an established pattern of doing business. Even if the business really is profitable, the owner couldn’t have created much goodwill or developed an established market position in such a short period of time. Furthermore, I’d always worry about the real reason the business is being sold so quickly—if the new opportunity looks terrific to the seller, then his current business, obviously, looks less terrific. In addition, with a service business, you need to ascertain how much of the business’s success has been due to the personal characteristics or contacts of the proprietor.
Q: I am negotiating to buy a packaging company. Should I be concerned that after the deal is consummated, the seller may start a competing business?
A: Absolutely! An aggressive person can regain market position overnight in a new business through personal contacts, industry reputation, and market knowledge. You should at least have the seller agree to sign a noncompete clause. If you are really concerned, you should also consider paying for the business in partial payments over a period of time.
After I negotiated to purchase Careers and the MBA, a recruitment magazine from the Harvard Business School, a former licensee announced that it was going to compete with me despite a noncompete agreement. I persuaded Harvard Business School to pay the related legal fees and retain title during my first year of operation to ensure the validity of the noncompete agreement. The former licensee did eventually start a directly competing magazine, but waited until after the noncompete period was over, and by that time I was firmly established.
When the former licensee started to compete with me, I launched a new magazine, a recruitment magazine for engineers, to compete with their primary existing business. Eventually, I gained the upper hand in both businesses, and I later added another magazine and sold the whole group of magazines to Stanley Kaplan, a subsidiary of the Washington Post Company.