Should You Start a Business From Scratch or Buy an Existing Business?
In their book, Start Your Own Business, the staff of Entrepreneur Media, Inc. guides you through the critical steps to starting a business, then supports you in surviving the first three years as a business owner. In this edited excerpt, the authors discuss the process you should go through when purchasing an existing business.
When most people think of starting a business, they think of beginning from scratch—developing your own idea and building the company from the ground up. But starting from scratch presents some distinct disadvantages, including the difficulty of building a customer base, marketing the new business, hiring employees and establishing cash flow ... all without a track record or reputation to go on.
If you're worried about the difficulties involved in starting a business from the ground up, you might decide that buying an existing business is a better fit for you. When you buy a business, you take over an operation that’s already generating cash flow and profits. You have an established customer base and reputation as well as employees who are familiar with all aspects of the business. And you don't have to reinvent the wheel—setting up new procedures, systems, and policies—since a successful formula for running the business has already been put in place.
On the downside, buying a business is often more costly than starting from scratch. However, it’s often easier to get financing to buy an existing business than to start a new one. Bankers and investors generally feel more comfortable dealing with a business that already has a proven track record. In addition, buying a business may give you valuable legal rights, such as patents or copyrights, which can prove very profitable.
Of course, there’s no such thing as a sure thing—and buying an existing business is no exception. If you’re not careful, you could get stuck with obsolete inventory, uncooperative employees or outdated distribution methods.
Buying the perfect business starts with choosing the right type of business for you. The best place to start is by looking in an industry you're familiar with and understand. Think long and hard about the types of businesses you are interested in and which are the best matches with your skills and experience. Also consider the size of business you're looking for, in terms of employees, number of locations and sales.
Next, pinpoint the geographical area where you want to own a business. Assess the labor pool and costs of doing business in that area, including wages and taxes, to make sure they’re acceptable to you. Once you’ve chosen a region and an industry to focus on, investigate every business in the area that meets your requirements. Start by looking in the local newspaper’s classified ad section under “Business Opportunities” or “Businesses for Sale.”
And just because a business isn’t listed doesn’t mean it isn’t for sale. Talk to business owners in the industry; many of them might not have their businesses up for sale but would consider selling if you made them an offer. Put your networking abilities and business contacts to use, and you’re likely to hear of other businesses that might be good prospects.
When purchasing an existing business, you'll definitely want to put together an “acquisition team”—your banker, accountant and attorney—to help you. These advisors are essential to what is called “due diligence,” which means reviewing and verifying all the relevant information about the business you're considering. When due diligence is done, you'll know just what you're buying and from whom.
The preliminary analysis starts with some basic questions. Why is this business for sale? What's the general perception of the industry and the particular business, and what's the outlook for the future? Does—or can—the business control enough market share to stay profitable? Are the raw materials needed in abundant supply? How have the company’s product or service lines changed over time?
You also need to assess the company’s reputation and the strength of its business relationships. Talk to existing customers, suppliers and vendors about their relationships with the business. Contact the Better Business Bureau, industry associations, and licensing and credit-reporting agencies to make sure there are no complaints against the business.
While you and your accountant review key financial ratios and performance figures, you and your attorney should investigate the business’s legal status. Look for liens against the property, pending lawsuits, guarantees, labor disputes, potential zoning changes, new or proposed industry regulations or restrictions, and new or pending patents; all these factors can seriously affect your business. Be sure to:
- Conduct a uniform commercial code search to uncover any recorded liens (start with city hall and check with the department of public records).
- Ask the business’s attorneys for a legal history of the company, and read all old and new contracts.
- Review related pending state and federal legislation, local zoning regulations and patent histories.
Legal business liabilities take many forms and may be hidden so deeply that even the seller honestly doesn’t know they exist. Be sure to have your lawyer add a “hold harmless and indemnify” clause to the contract. This assures you’re protected from the consequences of the seller’s previous actions as owner.
Also make sure your deal allows you to take over the seller’s existing insurance policies on an interim basis. This gives you time to review your insurance needs at greater leisure while still making sure you have basic coverage from the minute you take over.