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Should I Buy a Business or Start a New One?


Your Options


The costs involved in setting up your business depend on which path you take into business. The main options are:

  1. starting up a brand-new business from scratch,

  2. buying an existing business, and

  3. purchasing a franchise.


Starting from Scratch


Many people prefer or need to start a business from nothing. In some ways this is the most difficult option, but it also gives you the most control over how the business will develop and operate.

What are the Main Advantages?
  • Building a business from nothing gives you the most freedom. You decide on every aspect of the business, and build the business to be exactly how you want it.

  • It is usually cheaper to get started: you do not have to come up with an amount to purchase the business.
What’s the Downside?
  • You will not have an existing customer base, meaning that you will not receive money from sales straight away.

  • It is unlikely you will know with certainty exactly when your business will be able to provide you with the income you need to financially support yourself.

  • There is less certainty that your particular business will work, or that it will work in the location you want to operate it in.
What about Finance?

When starting a brand new business, it is likely that you’ll need to rely on your own money and assets. It is more difficult to get a loan or attract an investor since the business will not have a track record of being successful – it is very risky to invest in a business which does not yet exist! A bank may lend you money if you have assets (such as a house) to use as security, but otherwise it is common for banks not to offer business loans until the business has already been up and running for six months or more.

Many small business owners therefore ‘start small’. They use what resources they have to start operating, and then build the business as more money becomes available. You may be able to start in this way, however, there may still be a need to call on others for funding. This is especially likely if you need to fit-out premises or buy expensive equipment. Although there are some forms of financial assistance available, these are limited.

Also bear in mind that starting small with little funds and very few assets may also mean it will take time to build a customer base. It can be even longer before your business gets to the point where it can financially support you! You therefore need to make sure you have enough money available, or another source of income, to support you over this time.


Buying a Business


In some cases it makes more sense to buy a business. Opportunities for purchasing can happen in many ways. Sometimes an employee is offered the chance to buy a business they work for, or sometimes a family member will sell a business to another family member. Often, however, there is no pre-existing relationship between the seller and the buyer. In these cases, the purchase is more risky, as the buyer knows less about the business.

Even so, buying a business is a useful way to get into business for yourself. You at least know that the business model has worked up until now, so it is not as risky as starting a new business from scratch. On the other hand, you may not be able to make all the changes you want straight away and you might have to live with the consequences of some of the previous owner’s decisions. For instance, you may need to continue offering certain products and services to keep the existing customers happy, even if you do not really want to offer them long term.

What are the Main Advantages?
  • Buying an existing business allows you to avoid the risky start-up period.

  • You can check the business’s past performance, ensure you have loyal customers, and confirm there are skilled employees who intend to stay with the business.

  • You can be reasonably confident the business will operate well with the assets which are all included in the purchase price – it is less likely you will be surprised with unexpected costs.

  • You are likely to have immediate cash inflows and should be able to pay yourself a decent wage right from the start.
What’s the Downside?
  • The initial cost. You will somehow need to be able to finance a lump-sum purchase price.

  • It may not be as easy to make changes as you would like.

  • The possibility of hidden problems. You might not find out until after you purchase the business that it has some serious problems. This is why due diligence is important.

  • If the business has a bad reputation, it can be difficult to change it.
Factor to Consider

Keep in mind that a business with an excellent track record might have completely relied on the skills of the owner: without the owner, it may be worthless.

What about Finance?

Banks are more willing to lend money for someone to buy an existing business than they are to lend money to start a business from scratch. This is because the business has a track record, and is therefore less risky. The bank can look at past financial statements and make their own estimates of whether the venture is likely to be successful. Nonetheless, buying a business can be very expensive and lenders usually require business owners to contribute about 40% in equity.

What is Due Diligence?

Due diligence basically involves carrying out a detailed background check to make sure everything is as it appears. Check factors such as:
  • If it is likely the owner is selling for the reasons they have told you.

  • Whether anyone is taking legal action against the business.

  • That the business owns the key assets it needs to operate and that these are in good condition.

  • The real value of the inventory which is being purchased.

  • All contracts the business has entered into, including employment agreements.

  • Who the key staff are and whether they will stay after the sale.

  • Changes in the industry.

  • The level of competition and whether this is increasing.

  • How loyal customers are, and how likely it is they will stay around following the sale.

  • The business’s finances.
You are looking for a business which will provide you with a reasonable return on your investment. In other words, you want to eventually get your money back, along with a profit.
 
Factor to Consider

How easy would it be to get your money out if your situation changed? Could you sell the business quickly and easily?

How much should you pay to buy a business?

The value of a business can be broken down into two parts:

  1. Assets. The sum total of everything the business owns, minus whatever it owes (liabilities).

  2. Goodwill. This is the value that the business has in addition to its assets. For example, a business might have a large, loyal customer base, great staff, or an exciting future.
A common method of valuing a business, and working out if the amount of goodwill asked for by the current owners is reasonable, is the capitalisation rate method.

The capitalisation rate method involves dividing the expected profits of the business by a percentage called the ‘capitalisation rate’. The capitalisation rate is basically the rate of return you expect from the business.

Capitalisation Rate Method Formula




The lower the capitalisation rate, the longer it will take for you to earn back the purchase price of the business. If profits are constant over time, a capitalisation rate of:
  • 100% means you only pay for one year’s worth of profits – you will earn back your investment in one year.

  • 50% means you will earn back your investment in two years.

  • 10% means you are paying for 10 years’ worth of profits! It will take you 10 years to earn your money back!
Get professional advice from an accountant when working out an appropriate capitalisation rate. However, in general, it should be at least 20%. The lower the rate, the higher the purchase price. You need to make sure that the rate reflects the risk you are taking on. Expect to pay more for an established business in a profitable market and less for a recent business in a newer, untested market.
 
Factor to Consider

When buying a business, check carefully to see if you would get a better return from another investment, even if that is just leaving your money in a savings account. If another option would give better returns, do you still have a good reason to buy the business?


Operating a Franchise


If you don’t want to start from scratch or buy an existing business, you can take a middle path by buying a franchise. Franchises are a hybrid business model, halfway between working for yourself and working for someone else.

When you buy a franchise, you are generally buying the right to operate a proven business model. Popular examples of franchises include fast food restaurants, supermarkets, cleaning services, and gardening services.

The franchise system involves two levels of people: the franchisor, who offers their trade mark, business name and systems, and the franchisee, who pays an initial fee, and then royalties, to operate under the franchisor’s business name.
 
Factors to Consider

Buying into an established franchise is less risky than starting from scratch because of:
  • Proven strategies and processes

  • An established brand

  • Skipping the risky start-up phase

  • Support and advice from the franchisor (franchise seller) to get you started
If the franchise you are considering does not offer all of the above factors, be extra cautious about becoming a franchisee.

If the franchise you are considering does not offer all of the above factors, be extra cautious about becoming a franchisee.

Since the strength of a franchise rests on its business model being the same in all cases, franchise agreements heavily restrict what you can do. Franchise ownership limits your freedom to change branding, expand the business, or branch out into new areas of operation. It even affects operational matters such as the way you promote the business. Rules are set by the franchisor and set out in the franchise agreement.

As such, franchise ownership is not recommended if you would rather ‘do your own thing’. Buying a franchise is quite like entering into a partnership. Both franchisor and franchisee must be able to work together for success.

Choosing a Franchise

Buying a franchise does not automatically mean business success. The franchise needs to be right for you and the area you intend to open in, and you will have to put in a lot of work. Also note that there are several types of fees you must pay – you typically pay a large initial franchise fee, plus ongoing fees. Some franchises which appear attractive may require you to pay so much in fees that you cannot make a decent profit.
 
Factor to Consider

With a franchise, you buy rights to use a brand and business model for a particular period of time. Keep in mind there is a chance that after this period of time has ended, the franchisor may not want to renew the agreement. You need to be confident your initial investment can pay off within this timeframe.

Just as with buying a business, you should do due diligence before investing in a franchise. Talk to other franchise owners to get their opinion on how well the business model works, how profitable it is, and what level of support the franchisor offers. Also make sure that you understand the industry.

Pay special attention to who is responsible for marketing. The franchisor typically provides national marketing, but it is left to the franchisee to see to local marketing. Furthermore, as noted previously, there may be restrictions around what you can and cannot do. This can be a significant cost.
 
Tips

Avoid franchisors whose business success is based on the competence of the original owner: it is likely to be hard to replicate this success without that person.

Avoid franchisors who are willing to allow anyone to buy a franchise: the actions of a few bad franchisees will reflect on the others.