By Eugen Klein, B.Comm(UREC), CRES, ARM®, RI, FRI
Real Estate Broker
When I present to investor groups on the subject of buying a business, I am often met with incredulous looks that slowly turn to understanding and interest as I make my case for the advantages of being a business owner. Because by their nature, businesses have more flexibility, complexity, risk, revenue, net return, and time demands than comparably priced investments, people rarely take the time to evaluate all the positive features of taking over a business in operation.
There are several reasons why one should buy an operating business. The most obvious is the return that a business will offer a purchaser or investor. The income multiplier on a typical business may run from 2x to 5x; for an investment property the multiplier may be 10x to 20x; this means that the same net income stream will cost the purchaser four to five times as much when they buy a investment property instead of a business. For example, we have a closing next month on a business that has a normalized return of $150,000, at a purchase price of approximately $350,000. A commercial building generating $150,000 net would cost in the neighbourhood of $2,000,000, almost six times as much.
There is good reason to purchase investment property. In general, investment property has less inherent risk and greater liquidity than businesses. However, if you base your decision to purchase a business on established customer base, experienced employees, a recognized market position and solid business operating systems, you can often get an amicable combination of bank or vendor financing.
A concern of many new business owners is the loyalty of clients – particularly if the exiting owner has a strong or unique personality with which the business has become identified. Careful structuring of the transaction can protect the buyer through a transition period wherein the owner remains involved to train the new owner and introduce him or her to the clients. Although difficult to value, client lists are of immense value to a purchaser even if outdated; it can be a good avenue to generate return business that will cover any shortfalls during the transition period.
It is important when taking over a business that the experienced, skilled and predictable employees are retained. They often know the business operations inside and out, and if the transition is handled well they can be re-energized by new ownership; the injection of fresh leadership can be a catalyst for employee creativity. However, employees naturally fear change and instability so it is important that they are not made aware of the transaction too soon. Usually, the buyer is allowed to talk with key employees only after a purchase and sale agreement has been signed and it is certain that the buyer will buy the business. It is extremely important for both buyer and seller not to mishandle this process.
An established business has the additional advantage that its products, marketing techniques, and systems for accounting, inventory tracking, employee payroll and production have all passed the basic Darwinian test of the free market: survival. Rather than building from scratch, one is in the position of an expert race car mechanic, tinkering delicately to obtain optimal performance.
All buyers must use common sense and remember that potential buyers create the market. In order to help with the task of arriving at a good approximation of value, here are six guidelines useful to calculate earnings:
Examine the most recent year’s earnings on the seller’s latest tax return. It would make sense to look at the last three years, but only to establish a revenue trend; remember as a buyer you are buying the future and not the past. Use these figures to determine projected annual future earnings with you as the new owner. Be aware that such future earnings will depend on your ability as owner; expect that you may have difficulty maintaining the same level of sales over the short term as you gain experience and understand your responsibilities.
Look at the tangible and intangible assets. If there is real estate and inventory included in the sale, your position is theoretically less risky because it is believed that real estate could be sold more easily on the open market and inventory for resale could be more easily liquidated than other business assets. Generally, inventory is valued at cost. Aside from the real estate and inventory for re-sale, other assets should already be included in the multiple-derived business value as they are needed to generate the projected future earnings.
If there is real estate involved but it is not for sale, rental expenses must be subtracted from the earnings figure. The seller did not have to pay rent if he or she owned the property where the business is located, but this would not be the case for you as the buyer. You must take future rent expense into consideration. Conversely if you are buying a business with land, you may wish to structure the transaction so that the ownership of land is under a separate entity from the business. In that case be sure that if you include the land revenues in the valuation of the land, you subtract them in the valuation based on the earnings of the business. Don’t pay for the same thing twice.
Management (owner’s) salary, perks, and certain one-time expenses should be added back to the earnings calculation, if these expenses were subtracted from the profit on the tax returns or financial statements. Businesses tend to maximize deductible expenses to minimize taxes. Likewise, depreciation / amortization should be added back to your earnings calculation. This is a non-cash expense, meaning the owner does not have to pay out of pocket each year.
Earnings = NPBT + OS + FB + D&A
NPBT = Net Profit Before Tax
OS = Owner’s Salary
FB = Fringe Benefits
D&A = Depreciation & Amortization
Intangible assets include such things as goodwill, an owner’s agreement to not compete, or an owners agreement to provide training or consultation during the transition period. These are accounted for in the value of the business by using a multiple of earnings, even though such assets may well be treated separately at business closing for tax purposes.
Once you have calculated projected annual future earnings, (also known as EBIT, Earnings Before Interest and Taxes) and had your calculations verified by professional accountants, you must consider the risks involved in owning the business. How much you are willing to pay given the risks involved will determine the right earnings multiple. For most businesses somewhere between 3 to 5 times EBIT is reasonable. The multiple is less when there are few tangible assets and more when the business is uniquely attractive.
In summary, the valuation of a business is based on an earnings multiple. The right multiple is, in the eyes of buyers, a matter of assumed risk. Buyers feel better about buying tangible assets that they can appreciate with their five senses – things like real estate and equipment. On the other hand, buyers can also be enticed when there is clearly an attractive opportunity to make money.
When considering whether to start a new business from scratch or buy into a business that is in operation, one must consider the question of financing. Very rarely do purchasers have adequate cash to be able to start out-right, and to handle the ongoing drain on resources which preceeds revenue flow. More favourable financing terms are always available to the buyer of an established business because of these advantages: existing customer base, experienced employees, established market position and tested systems. There are also a wider range of financing options uniquely available; such as vendor financing and financing by suppliers of the business.
As an advantage to the purchaser, financing an ongoing business makes the vendor, banker and suppliers in essence partners in the business, sharing some of the risk. Every creditor feels more secure with an established entity and most banks do not finance new start-ups at all. For on-going businesses, vendor financing at below-market rates is commonly available without the same security requirements as other arms-length lenders.
A buyer of a going concern often has immediate cash flow. In fact, in most cases, that’s what has been carefully protected by the financing partners: the vendor, the bank, and the suppliers. These lenders will only agree to participate in transactions that make sense to them. They know they won’t get paid unless the cash flow works for the new business owner – which also gives them a strong vested interest in seeing the purchaser succeed. Contrast this with a new start-up, where the buyer must fund the start-up for months and sometimes even years until the business gets going. Most start-ups fail, in fact, because they run out of money as they are in the process of succeeding.
Overall, there is less risk in purchasing a business than in starting one, even if there are major areas which need improvement.
Why do people start new businesses? Some people can genuinely see a new need in the marketplace and fill it. Sometimes, there are no businesses for sale in a certain category. But, in many cases the reasons for starting one’s own businesses from scratch can usually be found in ego. One should be careful that the logical reasons to start a business from scratch do not exist simply to rationalize an emotional decision based on personal pride.
One common rationalization is that the prospective entrepreneur wants a “clean business” without the inherent liabilities of a going concern. In truth, it is better to take over an operation where the liabilities or flaws are well known, rather than to start something new and proceed in ignorance. Asset sales are always a possibility instead of share sales so that no legal liabilities are assumed. In the best of situations the problems in a business may actually be an advantage to the purchaser who wins in two ways – firstly by obtaining a reduction in price or discount on the assets because of the liabilities of the business, and secondly by starting from a position of debt, allowing future profits to be written off. Very often a seller may be experiencing difficulties because of a lack of resources or in a part of the business that is outside their area of expertise. If the purchaser has the right expertise and is well positioned, such opportunities are a virtual goldmine.
The idea that there are operational systems that can’t be changed is usually wrong; small businesses are usually quite flexible and changeable. Employees usually welcome enlightened change, and consulting with the best employees can provide valuable insight. One should become familiar with business systems during the due-diligence period of the transaction and should make sure that an extended training period by the vendor is specified. The best technologies often evolve over time and through experience, neither of which are available to new businesses. This is one of the greatest hidden costs of the ego-driven start-up.
The most commonly given reason for starting from scratch, however, is to avoid paying for “goodwill” or “blue sky”. In reality, you will pay for it one way or the other. Either the vendor is paid for goodwill or you have to put in lots of extra money into working capital to develop goodwill yourself. There is no free lunch.
Two common mistakes made by naive buyers are the purchase of a worthless franchise or any network multi-level marketing (MLM) “opportunity”. There are legitimate franchises which are a reasonable investment of time and money; there are few legitimate network marketing companies. The vast majority of MLMs follows business principles which are completely unsound.
A good franchise should give you instant market position and/or a protected territory, proven operational systems with excellent long term support, a proprietary technology, and perhaps even some financing. The support is especially important for those franchises which portray themselves as “home-based businesses”.
The long term value of a good franchise should take into account the demographic trends of its location in addition to the information received from the franchisor. If possible, one should look at case studies of similar franchises in similar locations to be able to realistically evaluate the potential. Meet with other franchisees to check the legitimacy of franchisor projections against real income and expense numbers. If you are buying an existing franchise you can usually count on the revenues remaining very steady.
The best franchises will have already done most of your planning and set up for you, and will pre-screen both you and your suggested location to ensure it will be successful (so that you can produce stable revenues for them). Be aware that some franchises are extremely selective with the people they will allow to own one of their businesses – you want to be aware of this when you are planning your exit strategy.
Something to avoid at all costs: “network marketing” or “multi-level marketing” (MLM). “Businesses” that require you to resell the opportunity to your friends and neightbours to build a multi-level organization are more ill advised that a bad franchise. The failure rate for MLMs approaches 100%.
Most network MLMs sell “unique” products. Understand that these are products which could not make it in the normal retail distribution channels. Hence the need for a pyramid scheme which locks you into a vertical structure and forces you to spend most of your time seeking out and indoctrinating new members, rather than marketing and selling your product. Don’t believe that it’s a part time effort. No start up is ever part time. The only way an MLM works is if you get in early, recruit others and sell hard during the early growth curve, then bail out before the inevitable crash. This is not a good way to build a business career but it is a great way to hurt people you are close to.
Remember that in the end, your revenues and those of all the people above and below you in the chain must come from product sales. If your attraction to the business has more to do with the idea of skimming margins off other people’s sales than a genuine interest in the product line, what makes you think your business can possibly succeed? It is bad enough to mistake personal enthusiasm for a product for general market appeal; it is consummate inanity to base revenues on a product in which you yourself have no confidence.
If you want to sell products, buy a retail store. The margins are better and you won’t alienate your friends and relatives. To get other people to sell for you so that you can make money from their efforts, hire salespeople for your store. That’s the way it is done in the legitimate world of business.