In the first article in this series, we discussed some pros and cons of franchised businesses for those interested in starting a new business. As we discussed previously, in the wake of the Great Recession and diminished corporate employment opportunities, many people are considering whether to become business owners as a way to provide for themselves and their families. As with franchises versus independent business operations, there are advantages and disadvantages to acquiring an existing business versus going the start-up route.
Benefits of Buying an Existing Business:
- Established Track Record and Customer Base. Probably the biggest advantage of buying an existing business is that the buyer acquires a business with an established track record and customer base. Presumably, the business has a verifiable revenue stream, known costs and established relationships with customers and suppliers. Unlike with most start-ups, it is often reasonable to expect profits from the get go after the acquisition. The buyer of an existing business will hopefully benefit from established brand identity and customer loyalty. In addition, the buyer can spend more of his or her time on increasing business efficiency and revenues rather than the myriad necessary but non-revenue generating tasks associated with a start-up business, such as acquiring equipment and supplies, hiring employees and establishing policies and procedures. In addition, an existing business may have a great location that would be hard to duplicate as a start-up.
- Financing for the Purchase of an Existing Business May be More Readily Available. It is usually easier to obtain financing for the purchase of an existing business with verifiable profits from a bank or other financial institution. In addition, the sellers of such businesses may agree to finance part of the purchase price.
- Experienced Employees. Buying an established business often brings with it knowledgeable, experienced employees who are proven performers.
- Potential Post-Acquisition Support from the Seller. Many sellers will agree to consult with the new buyer about the business as part of the purchase price or for separate compensation. This can be invaluable to the new business owner.
- Reduced Risk. For these reasons, carefully selecting and purchasing an existing business can be less risky than starting a new business. However, as set forth below, that is not always the case if a buyer isn’t careful and hasn’t surrounded himself or herself with experienced professionals such as a knowledgeable attorney and CPA. Moreover, as with any business venture, the ultimate success of failure of the business will likely be due primarily to the buyer’s personal efforts.
Disadvantages of Buying an Existing Business:
- Buying an Existing Business is Often More Expensive. Buyers of a successful existing business have to expect to pay a sometimes significant premium over what the current assets of the business are worth. This “goodwill” value is the cost to the advantages identified above such as established customer relationships and experienced employees. Moreover, many sellers have unrealistic conceptions of what their business is worth, and some businesses may be difficult to value accurately. Therefore, there can be substantial risk of overpaying for an existing business. Doing so may result in the expected return not being realized even if the business still performs well after the acquisition. In addition, there may be too much leverage if the money used to purchase the business is all or mostly borrowed.
- Vanishing Goodwill. Related to the generally higher cost of buying a successful existing business is the problem of vanishing goodwill. As one example, a buyer of an existing business must consider that even if the business has an established and loyal customer base, is this primarily because of the personal efforts or skills of the seller? If so, can the buyer duplicate those efforts and maintain those relationships? If not, the buyer may find that these customers are not as loyal as was thought, and the premium paid was too high. The same may apply to a key employee who is upset he wasn’t given an opportunity to buy the business and leaves the new owner.
- Hidden Problems. Sellers of a business will rarely volunteer information about potential hidden problems with the business they are trying to sell. For example, is the inventory that the buyer is acquiring outdated? Is that key employee going to move to California next summer because their spouse was relocated there? Are there other employment issues that are not apparent, such as employees who don’t want to make improvements or other changes at the behest of the new owner? Is that supply contract that has proven so beneficial to the business likely to be renewed and on what terms? Sometimes undisclosed problems are even more serious, such as threatened or pending litigation, or the fact that the landlord is not going to renew the lease next year because the building is being sold.
The good news is that most of these risks or disadvantages to buying an existing business can be reduced or eliminated by conducting careful due diligence and crafting an appropriate agreement with the seller. To do this, the buyer of an existing business should partner with experienced legal counsel and a good CPA. For more information on this topic, please contact Scott Simmons at (804) 622-1262.
Attorney:
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