Buying a Business Is Less Risky Than a Startup
Owning and operating a business, being your own boss, is an inextricable part of the American Dream. It’s no coincidence that a particularly common mantra for politicians—both Democrat and Republican—is “small business is the backbone of the American economy.”
And it’s true. According to data from the Small Business Association, in 2016, small businesses accounted for 99.7% of firms with paid employees.
A small business is your way to build and maintain the American economy while also generating wealth and securing your and your family’s financial future. You can achieve this goal by starting a business or by purchasing a business, but the two methods are not interchangeable.
The most obvious path to owning a business is to start a business. But starting a business from scratch requires more than just a desire to do so.
You need to have an original idea for a product or an untapped market for an existing product; you need money and time to develop the idea. You’ll also need to acquire and set up equipment, hire the right employees, and market to get customers. With all of these obstacles, it’s not a surprise that the same 2016 SBA study from above indicated that nearly 50% of startups fail within 5 years. If we extend out to 10 years, that number jumps up to nearly 90%!
Thousands of people do start and run successful businesses every year, and for newly-emerging industries it is the only path. It can be personally and financially rewarding, but, all in all, starting a business is a risky endeavor for an entrepreneur. Especially in a well-established industry.
Yet, there is a road less traveled to owning and operating your own small business, and it is the subject of this guide. When done right, buying a business can bring the same financial and personal benefits of a startup, but, importantly, it can also be less risky.
By opting to purchase a “going concern” business, you can avoid creating a new idea for a product or fighting for some small percentage of an industry’s market share. A going concern business also has equipment, employees, and an existing customer base. For the most part, you can step right in and operate it.
The SBA statistics are much more favorable toward the purchase of an existing business. The chance that an entrepreneur who buys a successful, existing business will still be in business after five years is 90–95%.
So, let’s compare a couple aspects of starting versus buying a business to see just what benefits buying a business can offer.
Not surprisingly, customers are the most critical element of any business, and if you buy a good business, you also take over the seller’s customer base. The transition from seller to buyer is seamless for customers, and all of the business’ goodwill goes to the buyer. There’s no lag time between opening your doors and having customers buy from you.
With a startup, though, you start off with 0% of the market share and have to struggle to grow your slice of the pie. That means convincing customers to buy your new product or service or, even worse, to switch from their current vendor.
Why is acquiring customers tough? Human nature.
Most people have daily routines (I know I do!). They buy their groceries, gas, and coffee from the same places day in and day out. The same holds true for less-frequent services too, like auto repair or internet providers.
Think about it: It requires 100% more effort to do something rather than nothing? Inertia is like a massive cement block weighing down your potential customers as you try to dislodge them from their ever-deepening commercial ruts. It can be done, but sometimes it can seem like a Herculean task.
With a startup you have to discover through trial and error your unique value proposition, identify whether consumers agree with that value proposition, and then convince them to act on that value proposition by purchasing or switching to your product or service.
This is a huge stumbling block for many startups. CB Insights, a venture capital database, did a post-mortem on 101 failed startups and found that 42% of those startups failed because there wasn’t a market for their product or service.
Again, an existing business has already surpassed this hurdle and has shown that there is a viable market for its product or service.
Price Isn’t the Answer
Let’s assume that the product or service of your startup will be accepted by the market or already has been. You still have to siphon off customers from other businesses. Unfortunately, too many startup owners think, “I’ll draw customers in by offering the lowest price.” Though this seems reasonable—everyone wants a deal, after all—be careful.
Price shoppers are fickle. The marketing investment you’ll make to bring in a price shopper will be lost the minute the competition offers a better price. And the competition will always offer a better price. As a startup, your financial runway is limited, and your price margins are thin. The competition knows this and have probably taken steps to create barriers to competition. They can easily undercut you or outbid you in the short term.
This relates to a deeper truth that the real value in customer relationships is the second, third, and subsequent purchases (i.e. lifetime customer value). You do not and will not get those purchases from price shoppers. You get those from developing and engaging with an established customer base, which comes pre-packaged when you purchase a business.
More fundamentally, price isn’t the real concern for the vast majority of people even if they may mistakenly think that it is. What they really want and mean by price is value.
If asked, all prospects will claim they’re concerned about price. But price is a primary motivation for only about 15% of consumers. The rest just don’t know how to compare one business to another. So, they use price as a default comparison variable because it’s quantifiable and easily compared.
So, price isn’t the shortcut to get customers to switch. Instead, you’d have to get them to change their normal routines.
When you buy a business, you may also have access to something that startups struggle to get: funding.
The traditional startup is financed in one of two ways: bootstrapping or debt. The economic environment from 2008 until 2012 or 2013 caused the availability of these traditional funding sources to dry up. Recently, banks have begun lending more readily. According to the SBA and IBBA, 2017 was a strong year for small business lending, and business brokers are optimistic about the outlook for 2018.
Bootstrapping relies on the savings or available credit of the founder(s) to finance the business. If you are a younger entrepreneur, chances are you haven’t had time to stockpile the resources necessary to bring a startup to market. Likewise, startups or new entrepreneurs lack the ability to prove to lenders their ability and willingness to repay debts.
In most small business purchases, on the other hand, the seller will hold paper on (i.e. finance) a substantial part of the purchase. The buyer will provide a down payment, but the business funds the future payments to the seller through its continued revenue. In essence, the business pays for itself over time.
Even better, you might also be eligible for SBA guaranteed financing with a business purchase!
Up to this point I’ve been speaking about a certain type of business buyer, one who’s looking to make an investment for the future. Let’s call this an investment buyer. This entrepreneur wants to buy a business for its income stream and potential for future growth.
But I certainly don’t want to make it seem like the only reason to purchase a business is to make an initial venture into the business world. Buying a business can also be a vital part of a strategic plan to grow an existing business. We’ll call this entrepreneur a strategic buyer. In this situation, he purchases a business for access to a component of the company that can be used to improve or expand his existing business at a lower cost than organic growth through internally generated sales or expansion.
Sabre and Dunder Mifflin
Consider a company that sells printers, let’s call it Sabre, and it wants to sell its products into a new market. It could try to sell directly to that market. But its sales would be limited by the experience and credibility of its sales team in that market and by its understanding of the market’s needs and terminology. It would, in essence, be a startup, with many of the problems and concerns that we laid out earlier.
If, on the other hand, Sabre decided to buy a paper company, let’s call it Dunder Mifflin, which already served the new market, it would acquire Dunder Mifflin’s customer base and products or services, as well as an experienced sales force with a reputation and staff experienced with the new market.
Dunder Mifflin is a strategic acquisition because, in addition to the cash flow coming from Dunder Mifflin’s established operations, Sabre can grow its original business by piggy-backing on Dunder Mifflin’s existing distribution network and by selling more of its printers through the new sales channels. It may also be able to improve Dunder Mifflin’s profits by cutting costs from duplicated back office operations.
I don’t want you to think for a moment that buying a business is a cake walk. Whether you are an investment buyer or a strategic buyer, buying a business requires focus and caution. You don’t want to take on the seller’s problems or, worse, pay for something that’s going to be out of business in a few months.
Many (if not most) small businesses for sale are over-priced. Some have serious operational problems and are on the brink of closing. And some business owners are downright dishonest.
The best way to guard against these issues is to educate yourself on the process of buying a business. Then, you should engage professional advisors to investigate the business with you and to prepare all of the proper documentation.
So, you’ve got to be diligent. You’ve got to understand the buying process, know the risks and how to protect yourself from them, and do your homework on the business. You skip these steps at your own peril.
Buying a business can be profitable because you get an instant customer base and, possibly, a source of funding. But, a business purchase is not without risk and must be accomplished the right way with experienced advisors to guide you through the process. When done correctly, buying a business gets you up and running faster with more cash flow than a startup business.
How Can We Help You?
Here at Alexander Abramson, we focus exclusively on business-related legal matters. Our attorneys have advised closely held businesses and business professionals on everything from partnership arrangements and business contract matters, to raising equity capital, to buying or selling a business.
Ed Alexander is also a Florida licensed business broker and a shareholder of Fitzgibbon Alexander, Inc., a Central Florida consulting, business valuation, and business brokerage firm.
Our staff strives to create a wonderful client-experience by actively listening and maintaining open lines of communication, consistently meeting deadlines, and being upfront about our pricing and services. Don’t trust the legal needs of your business to an attorney that can’t or won’t offer you the best service possible.
We would love to speak with you directly about how we can help you buy or sell a business. Call us 407-649-7777 to set up an initial consultation.
If you’d like to learn more about buying a business and how you could benefit from these tax incentives, download a free copy of The Guide to Buying a Business.
Inside, you’ll learn tips from a legal insider on how to purchase and run a successful business.