New entrepreneurs are often torn between buying an existing business and launching a new company from scratch. The decision is not simple because buying an established business has both advantages and disadvantages.
Advantages of buying an established business
In most cases, buying an existing business is a safer option than starting a new company. Furthermore, running an established business is easier than operating a new venture. However, there are a number of other reasons why buying a company is more attractive than starting one.
1. The business has a valuation
Starting a new business from scratch is always a gamble. You never know how much it will cost you until you do it. Furthermore, new projects are notorious for going over budget.
On the other hand, buying an established business is different. The company has a valuation that you can check against industry standards or comparables. You also have the option to get an appraisal that provides a professional opinion on the value of the business.
2. The company has a track record
Established companies have track records that you can review. You can determine how that company performed in the past under different conditions. Forecasting the company’s future performance is also easier and more accurate. Having this information lowers your risk dramatically.
3. You can take a salary
Entrepreneurs who launch a new business must live off their savings for some time. This scenario creates uncertainty and puts substantial pressure on the founder. They have to wait until the business generates enough income to pay themselves a salary. On the other hand, most acquisitions allow you to take some form of compensation immediately. Owners are usually employees of the business and get a regular salary. Additionally, you may also receive profits/distributions from the company.
4. Getting financing for an acquisition is easier
Getting financing to buy a business is much easier than getting a new venture funded. Acquisitions under five million dollars are usually financed with help from the Small Business Administration (SBA). Getting an SBA -backed acquisition loan is easier than getting conventional financing. SBA-backed loans have flexible qualifications requirements and provide competitive rates/terms.
5. You can use leverage to your advantage
Buyers usually don’t have enough resources to buy the whole business. Instead, they finance most of the purchase. Transactions that use a large portion of financing are considered leveraged buyouts. Most small business leveraged buyouts are financed using SBA-backed financing.
In some cases, buyers can finance up to 90% of the project cost. The remaining 10% must come directly from the buyers as an equity injection. Leverage has advantages and disadvantages and should be considered a double-edged sword. It can increase your returns if things go well. However, it can also wipe out your equity quickly if things don’t go as planned.
6. The business has customers
The company already has an established market, customers, and reputation. Having customers in place is an important benefit because building a customer base is difficult and time-consuming. Buying a company allows you to leverage the previous owner’s efforts and experience.
7. The business has supplier relationships
Having established suppliers can be just as important as having customers. The previous owner has already gone through the effort of qualifying suppliers and negotiating contract rates. Many new business owners underestimate the amount of time it takes to find reliable suppliers.
8. The business has an infrastructure
Another advantage of an acquisition is that the business should have the entire infrastructure it needs to operate. Infrastructure includes items like real estate, machinery, and equipment. Buyers can also use the current infrastructure to forecast maintenance and expansion costs more accurately.
Keep in mind that buyers often take the acquisition as an opportunity to make infrastructure improvements. The specifics of the business determine the size of these improvements. However, the financing is usually bundled with the acquisition loan.
9. The business has systems and processes in place
A big part of an acquisition is the “know-how” that is built into the business. A well-run business should have systems and processes in place. These are invaluable, especially to business buyers who don’t have sufficient industry experience.
The company should have systems and processes to handle activities such as:
- Supplier management
- Customer acquisition and management
- Operations, and so on
10. The business has employees
Most small business acquisitions include the option to keep the existing employees of the company. Along with the customers and the company’s systems, the employees are one of the most valuable assets of a company.
On the other hand, launching a new venture requires finding talented employees. This process is difficult and time-consuming. Unfortunately, many new entrepreneurs underestimate how hard this task is.
11. You can retain existing management
An acquisition allows you to retain existing management. These individuals are key employees because they help you run the business. Current managers can also provide stability and knowledge during the transition to the new owners.
12. Sellers can train you
Lastly, most purchases include a period of training by the seller. Training can take a few weeks or a few months. During the training period, the seller will teach you how to operate the business. Buyers can use this training as an opportunity to learn important information from the seller’s experience. This training provides you with valuable know-how.
Entrepreneurs who start a company from scratch don’t get this important benefit. Consequently, they learn from experience and by making their own mistakes.
Acquisitions also have some disadvantages
Buying an established business usually has a lower risk than starting a new company from scratch. However, acquisitions are far from perfect. The wrong acquisition can have serious problems and end up losing money.
Buyers always have an uphill battle during due diligence. The seller has access to all the information and the incentive to get paid as much as possible. Consequently, they may not be as forthcoming with information as you need them to be. This situation puts buyers in the position of making an offer without having all the information they need.
Keep in mind the following disadvantages of buying a business:
1. You could buy a bad business
One significant risk of buying a company is that you could end up buying a bad company. The last thing you want to buy is a troubled company that someone wants to unload. You can do careful due diligence and still miss indicators of problems. Ultimately, an acquisition is a calculated risk.
2. The business could be overvalued
Another disadvantage is that you could buy an overvalued business. There are ways to minimize this risk, but buyers can never eliminate it. Invest in the services of a reputable business appraiser. If you are uncertain of the company’s value, consider getting a second appraisal. Having two valuations gives you a better idea of the company’s actual value.
3. Due diligence is never perfect
If done well, the due diligence process should uncover any significant problems. However, the process is far from perfect, and buyers can miss problems. This situation leaves buyers exposed to the risk of buying a company that looks good on paper but fails to perform in real life.
4. Accounting can be notoriously spotty
Buyers rely on the company’s financial reports to determine past performance. They also use these reports to forecast the company’s future performance. Unfortunately, small companies are notorious for having unreliable accounting reports.
Unscrupulous sellers can manipulate the numbers to make the business appear more attractive. These manipulations can be as blatant as using false information. However, they can be as subtle as using deceptive accounting. At a minimum, buyers should retain a CPA or similar advisor to help them evaluate the company.
5. The current owner’s motives for selling aren’t always clear
The current owner’s reason for selling the company will never be clear to you. The seller and the broker will use common explanations and tell you that the seller is “pursuing new opportunities,” “retiring,” or “reducing their workload.” These explanations should be viewed with caution. The seller could be hiding their true intent.
You have no way of knowing if the seller is selling for other reasons. For example, the seller may believe that demand for services will drop and wants to cash out while the market is still hot. Do as much research as you can about this possibility. The seller’s real motivation is extremely important.
6. Existing customers may not be loyal to you
It’s common for small business owners to form friendship bonds with their customers. These relationships are good for businesses but can make acquisitions harder. Customers may not want to stay on and work with the new owner. They may also start demanding concessions (e.g., price discounts) as a condition to stay with your company. Lastly, buyers may face a situation in which clients start comparing them against the previous owner.
7. Staff may not be loyal to you
Many small business owners develop a strong bond with their employees. Loyalty from the owner to their employees (and vice-versa) is a hallmark of many small companies.
Unless they are under contract, employees are under no obligation to stay on with the new business. There is always the risk that they will take the acquisition as an opportunity to look for a new job elsewhere.
8. The business could have a bad reputation
Gauging a company’s reputation during due diligence can be notoriously difficult. Buyers cannot call all the customers before the acquisition to ask for their opinion. Consequently, you could buy a business that looks good on paper but has a bad reputation.
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Given the complexity of how businesses can be purchased and the products that are used, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.