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Buying a Business: Opportunities and Risks

Chess pieces on a board

Chess pieces on a board

If you’re working on expanding your business, you may want to consider adding a new company to your portfolio. Buying an existing business in your field can be an effective way to expand your brand, attract more customers and increase your revenue. For many people, growing a business through acquisitions is easier than internal expansion, but it is not without risks.

Advantages of buying a business in your field:

  • Less to learn.
    When you were just starting out in your business, you put time and energy into learning the industry, creating a business plan and developing your operational procedures. When you acquire a new business, all of that hard work pays off. Since you already know where the pitfalls and opportunities lie, you can easily add on a new business, without needing to invest more time into learning processes.
  • Less risk.
    Starting a new business always comes with some risk, but when you buy an existing business, everything is already in place: the sales, earnings and organization. You may need to make improvements to the business plan and processes, but that is still less risky (and much easier) than starting from scratch.
  • Lower costs.
    When you acquire a company in your field, your costs will be spread out over a larger quantity of products. Therefore, your per-unit fixed cost will be lower, a concept known as “economies of scale.” Producing more products may also enable you to purchase supplies in bulk, which also costs less.
  • Geographic expansion.
    Expanding into a new area will increase your customer base as well as your sales. It may also open up new advertising opportunities that would be inefficient in a limited area.
  • Vertical integration.
    Your new acquisition may allow your business to vertically integrate, meaning that your company controls more than one level of the supply chain. This could mean owning your supplier, in order to lower costs and ensure quality standards, or owning your distributor, in order to lower transportation costs or have more control over the retail experience.

    Take Apple, for example. They are a vertically integrated company, because they control what happens to their product at every stage of the process. They manufacture their own hardware, develop their own software, and then sell the finished product through their own retail stores.
  • Product line expansion.
    Buying a business may provide you with an opportunity to expand your product line. For example, when Proctor and Gamble acquired Natura Pet Products, they were able to broaden their existing line of pet foods to include the holistic and natural segment of the market.

    What new acquisition would allow you to expand your own products or services?

Easier to calculate intrinsic value.
Calculating the intrinsic value of your business is crucial when it comes to investing your retained earnings, but it can be a difficult process. If you buy a business in your field, you’ll have a better understanding of what its future earnings will be, based on both its history as well as your own experience. This will make it easier to determine an accurate intrinsic value of your business as a whole.

Risks of buying a business in your field:

  • Branding mistakes.
    After purchasing a company, you may be tempted to change their branding to reflect your own. While this can work out in your favor, if the company produces a highly regarded product, changing the name or branding could be a huge mistake.

    Take Macy’s, for example. Four years after the company acquired Marshall Field's store in Chicago, 81% of Chicago shoppers still preferred the Field's name over Macy's.

    When Yum Yum Donuts, however, acquired Winchell’s Donuts, they resisted the urge to change the name to Yum Yum. They wisely decided that it would not be worth it to discard a great reputation and name that had taken generations to build.

  • Challenges with integrating the business.
    The business you acquire may have a different operating culture than your own, which can make integration challenging. In your due-diligence process, be sure to look closely at the company’s culture and business practices, and work out all potential problems before closing.

  • Failure to clear seller's liabilities.
    Any company you acquire may have unrecorded liabilities. Usually, the seller will be anxious to disclose these undocumented problems because if they don't, they could face a lawsuit down the line.

    If the seller discloses any unrecorded liabilities or problems, be sure to slow down and take the time to have them fully resolved.

  • Inadequate evaluation of retaining the management.
    Deciding whether or not to retain the management is a decision that should be carefully considered. You may not have the desire or the means to supply your own management, and in that case, you will need to have a clear agreement that the current managers will stay on. In some relationship-driven businesses, keeping the management in place may be key to retaining your best customers.

    If the current management is poor, however, replacing it may be essential to improving the business.

  • The seller’s suppliers won’t sell to you.
    If you are purchasing a competitor in order to add their line of products to your own line, but their suppliers decline to sell to you, your acquisition was a waste of money. Before closing, get assurance from the supplier that they will continue to sell to you.

  • Overleveraging.
    The biggest risk in expanding or making acquisitions is incurring too much debt to finance the business, or “overleveraging.” In business, “leverage” is the use of borrowed funds to accelerate growth and increase the rate of return on an investment.

    While leverage can be a powerful tool, it can quickly become your worst enemy. If you are unable to pay back your debt, you run the risk of losing your company.

    If you are offered favorable financing from a seller, keep in mind that he may not be too concerned with your risk. After all, if you can't make the payments, he will simply put you in default and take the business back.

    Other ways to prevent overleveraging:
    • Don't borrow at all. Build through the use of retained earnings.
    • Restrict borrowing within two very conservative limits:
      • Restrict the annual debt service to a small fraction of your conservative annual cash flow.
      • Borrow long-term and pay off short term. For example, if you plan to repay in 3 years, borrow for 6 years.
  • Inadequate accounting controls.
    The existing accounting system may not be adequate to manage your company as a whole. Review the overall needs with your CPA before closing and have the necessary systems and people in place.

    Your acquisition program should include an audit of your annual financial statements. This is expensive but essential in order to secure financing and reassure any other involved parties.

For more information on how to buy a business, including how to decide how much you should pay and a list of the top ten Dos and Don’ts, check out Session 9 of MOBI’s Starting a Business Course, “Buying a Business or Franchise.” Also, don’t forget to complete section 9 of MOBI’s business plan template, “Prepare for Acquisitions,” to ensure that you’re ready to buy.

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Aug 4, 2017