Why You Should Consider Buying an Existing Business

For many years, experts have been predicting that Baby Boomers (around 72 million Americans) would over the course of the following two decades, begin to sell or bequeath some $10 trillion worth of assets, held in over 12 million privately owned businesses, according to research by the California Association of Business Brokers. Research suggests that as much as 70% of these firms will either be sold or bequeathed. Clearly, this suggests an increase in the average annual number of businesses sold in the United States.

Merger and acquisitions

Many of these sales may occur within the Baby Boomer cohort, who, statistics tell us, form businesses at higher rates than any other cohort in America. More precisely, Baby Boomers aged between 45 and 64 have the highest rate of business formation in America, and Boomers aged 55 to 64 have the highest rate of business formation of any age group.

Baby Boomers will not just be selling, many will be buying Boomer owned businesses. Many Boomers are still too young to retire and have ample skills, capital accumulated from savings and investments and many have found that small business ownership is more stable than working for a large company, and are willing to enter the world of entrepreneurship. This is especially true during the pandemic era when safety nets that were supposed to protect ordinary people from the ills of the economy, have proved too small to sustain them.

So, not only do younger entrepreneurs have an opportunity to buy businesses previously held by Baby Boomers, but younger Baby Boomers themselves have the opportunity to take advantage of 12 million businesses coming onto market in the next two decades.

Research by the US Census suggests that over 50% of American businesses are owned by Boomers. Findings from the latest survey from done by the small business financing company Guidant Financial, and online credit firm, LendingClub Corporation, back these findings up, showing that 57% of small business owners are over the age of 50. Their survey showed that baby boomer’s top three industries were Beauty, Business Services, Fitness, Food and Restaurant, and Health. Intriguingly for the prospective buyer, cash flow problems or lack of capital, are the top two challenges for boomers in the running of their businesses.

So far, the glut of supply has not led to a decline in valuations, and it is true that this may not happen, given the amount of credit swirling around with nowhere to go. Business valuations have held as businesses have been sold.

Boomers are particularly interested in the kind of buyers that they will sell to. For many of these buyers, selling is not about funding their retirement, but about finding someone to carry on their legacy and make their businesses more successful. Consequently, business owners tend to be very selective about who they strike a deal with.

Given that they are often financially strong enough to wait for the right buyer to sell to, and because they are so clear about what they want from a buyer, they have the patience to see out bad offers as they wait for the right buyer. When they have found the right buyer, they are usually very helpful in working on the transition to new ownership, so that their businesses are prepared to succeed under new ownership.

As big as this opportunity is, many will question whether it is an opportunity worth pursuing. Michael Gerber, in his book, The E-Myth Revisited, presents some sobering facts for the budding entrepreneur. Among these salient facts is that 40% of all new businesses fail within the first year, and 80% of all new businesses fail within the first five years of their existence. In other words, as a risk-reward proposition, new businesses are extremely high risk, with not enough reward to justify the risk. An entrepreneur may do better by buying existing companies with a track record of success, thereby tilting the odds of survival sharply in his favour.

Allied to this expected abundance of supply of businesses for sale in the next two decades, is a dearth of buyers. In an ideal world, Gen-Xers and Millennials would be snapping at the heels of this opportunity, ready to buy businesses as quickly as you can get title loans online from CarTitleLoanLenders USA, but given the harshness of the economic climate for those cohorts, the demand is coming largely from other Boomers and those few Gen-Xers and Millennials who have the resources to enter the market. This poses a problem of succession planning and continuity for the owners of these businesses, and the communities and workers who rely on these businesses. It is also the perfect opportunity for an entrepreneur to pounce: with supply so high and demand limited, valuations are likely to be very attractive and this for businesses with proven track records. In other words, by taking on less risk, the entrepreneur gives himself the opportunity to make outsized profits based on attractive valuations.

Let us consider the benefits of buying an existing business.

Embracing risk culture

Reduction in risk

Many entrepreneurs think that startups are just cheaper to start than existing companies, and that this cost advantage translates to startups being less risky options than buying existing businesses. However, the acquired businesses are usually less risky to operate than a startup. For example, an acquirer may pay $1 million for a business with cash flows that generate $250-300,000 per year. As Acquira notes, many small businesses sell for less than 3 times their annual cash flows. Given the large supply in businesses available for purchase because of baby boomers looking to retire, Acquira, experts in this field, suggest that only 10-20% of businesses listed for sale by Boomers will actually be sold.

BizBuySell’s figures for 2018 indicate that only 10,312 businesses were sold in 2018. This shows just how big the opportunity is for entrepreneurs who want to become acquisition entrepreneurs.

A Track Record of Success

When you buy an existing business, you are buying a business with a proven business model and clear competitive advantages. The world is obsessed with growth businesses and start-ups, but these come with huge risks, as we have said, among which are the risk of absolute failure. Buying into mature businesses, forged through time, tilts the odds of success dramatically in your favour.

This is a strategy that Warren Buffett has employed over many decades at Berkshire Hathaway, where he has bought private businesses in addition to publicly listed firms, with a focus on time-tested, mature enterprises. One of his most successful investments was his purchase of Nebraska Furniture Mart from retail legend, Rose Blumkin.

As an investor in a business, you want to invest in businesses with a long track record of success because long-term results are better at allowing you to judge the performance of a business, than short-term results. We can assign more certainty or confidence to our conclusions when analyzing a business with a precord proven over a long period of time, than a younger business.

Statistically, the relationship between past and future performance is stronger for longer periods. Put simply, the older a business, the more we know about how it will perform in the future.

So, investment risk declines substantially because the odds of capital preservation and a return on capital increase. A long track record means that you can evaluate a business through various economic conditions. For example, a business that is 10 years old will have experienced the subprime crash and the Covid-19 recessions, as well as the period of growth in between. This makes it easier to analyse and predict how the business will perform under conditions of severe stress.

This is important to know because periods of economic growth can mask the effects of risky decision-making, effects which are only visible under economic downturns. A business may take on a lot of debt over the course of an economy’s boom phase, and grow quickly, giving the impression that the business is superbly led, but, when a downturn hits, that business may face substantial losses. Seeing a business perform under different conditions, therefore, gives a more complete picture of the performance of the business.

Given the vastly reduced risk, it is easier to obtain financing for the purchase of an existing business because the business model is proven, and the business will often earn revenues and after-tax profits.

As we have seen with many startups, early success is not an indicator of long-term durability. Often, a startup grows fast and therefore attracts significant competition, and this can impact the ability of that startup or any business within that sector to earn economic profits.

Brand protection

Existing Brands

A company is, among other things, a brand. When you as an investor buy an existing business, you are buying a brand. Brands are everywhere, and yet they are incredibly difficult to build. The brands every consumer is aware of is just a fraction of all existing brands, and includes brands launched within the last 12 months, some with a lot of marketing expenditure tied to them, and many destined to fail.

If you think this is an insane idea, consider this: of the multitude of beverages out there, how many can you name right now? Very few. And that speaks to how many you would be willing to buy. Brand-building is hard, even for those companies whose revenues and profits depend upon their brands. There are several reasons for this.

1. Many Brands Lack Clear and Compelling Objectives

As with everything, there are exceptions: the great brands such as Amazon, Google and Apple, and many more, often have clear and compelling objectives. Without clear and compelling objectives, it is impossible to create a “sticky” brand.

2. Pressure To Compete On Price

Businesses, especially startups in fast growing markets, often pressure to compete on price in order to win market share, and the greater the competition in the market, the more businesses are forced to keep prices low, sometimes below cost of production and often, as is evident with many IPOs recently, this leads to businesses that do not make any profits.

A mature business is likely not at that phase in its evolution where it has to subsidize its customers’ expenditure, and so, it has greater pricing power and a greater ability to earn economic profits. This is even more so in the categories in which Boomers dominate, which may not be fast growing, but where established players earn economic profits.

3. Highly Competitive Markets

Startups are often founded in fast growing markets with attractive addressable markets. Often, revenue growth can reach exceptional levels. High returns on invested capital (ROIC) attract competition, and capital expenditure, leading to elevated asset prices and heightened business valuations, while at the same time driving the market toward excess capacity, and economic earnings below the cost of capital, a situation that the economist, Joseph Schumpeter, referred to as the ”gale of creative destruction”, the “process of industrial mutation that continuously revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one”, which forces capital to flee the market, reduces prices, destroys excess capacity and reduces competition until profitability is restored. In other words, competition may be good for consumers, but it can have a destructive impact on the economic profits of businesses within a market.

Competitors can arise from different sources. For example, many food brands have witnessed competition from diet brands like Healthy Choice and Weight Watchers. The snack category has seen Budweiser’s Eagle brand become a major competitor to brands like Frito-Lay. Many times, new products can provide alternatives to existing products, the way carbonated water, bottled water, and fruit-based drinks have challenged the soft drink market.

Competition leads to pressure to spend on marketing, reduce prices or even subsidize consumer expenditure, and enhance brand complexity. It also makes it harder for businesses to retain or grow market share. Hyper-competitive markets are very efficient, which means that the space for profits and arbitrage opportunities are very, very narrow. Brands tend to be narrowly positioned, the serviceable addressable market shrinks, even as the total addressable market expands.

A competitive ‘brandscape’ makes it much harder to market the brand to a broad segment of the market as the market becomes balkanized. Competitive dynamics can be destabilized as rivals take on more risks or try novel approaches to gain market share. Finally, competition can lead to a lot of copying, as it becomes harder and harder to develop new ideas and the risks of copying shrink in the face of the difficulties of staying ahead of the curve.

4. Fragmenting Markets And Media

The balkanization of the market means that it is hard for brands to maintain a consistent presence across media. With more media options and media vehicles, mass markets have become very difficult to achieve. Micro segmentation is increasingly becoming the norm. Brands have struggled to achieve consistency and grow.

Brand builders are faced with a dizzying array of options: online advertising, interactive television, event sponsorship and direct marketing, and a host of other options. Often, new options emerge even as we try and get a handle on old options. Functioning across these options without diluting the brand is something that the majority of brands have really struggled with, especially when we include promotional vehicles. For example, giveaway or discount on prices, may be the wrong kind of promotion for a brand that prides itself on quality, because it sends the message that the brand needs to reduce prices to earn sales. Consequently, pressure to conduct such promotions and include things like coupons or cash rebates, can work against the ability of the business to build its brand.

Businesses are taking an increasingly granular approach to markets, looking at smaller and smaller market segments and targeting them with specific media options and vehicles. This creates an impulse to create to break up the brand and develop different identities for each market segment. This, however, is often the wrong way to go, as it leads to problems on the consumer-facing side and for the business itself. This is because media audiences overlap and in that overlapping, are exposed to the schizophrenic brand identity of the business.

Imagine, for example, the effect on the brand when, say, the female customers of Lux, accustomed to their female-focused advertising, suddenly encounter adverts targeted at men. Or consider if Apple users were to be confronted by adverts from Apple for discount phones. In both cases, the diversity of identities would undermine the brand.

Business relationship

Existing relationships

Purchasing an existing business means that you are also purchasing the relationships which that business built, whether they are with suppliers, customers, regulators, or any other market actors. In discussing competitive advantages, one of the key competitive advantages are barriers to entry and one way to prevent the emergence of barriers to entry is to have a broad base of relationships which your rivals will struggle to replicate. With a startup, you are starting from scratch. With an acquisition of an existing business, you are buying the barrier to entry.

A good business will have a lot of deep relationships that will have taken many years to build. Often, as we discussed earlier, the seller will stay on to help with the transition, and part of this transition involves handing over these very valuable relationships.

Narrow focus

In the world of business, having a narrow focus can be a good thing. When you acquire an existing business, you can go straight to thinking about improving and growing the firm.

Your focus can be that narrow because the previous owner has done the hard work of starting up the business. That narrowness is a gift and means that you can do more in terms of optimizing the business, and growing revenues or marketing the business’ products.

Experienced people

One of the great things about acquiring an existing business is the experienced and competent team that comes with that business. Leadership is everything for the business. In an existing business like those owned by Boomers, you will have people who have been in the industry for a long time, who understand it, and have a lot to contribute to that business in terms of ideas and skill. You get people who can help you with the business of maximizing shareholder value and retaining or growing market share.

Good management can achieve great things for a company. Take Apple’s Tim Cook, as an example: he has led Apple in the direction of higher-margin services and has used this period of low-interest debt to aggressively buyback shares, thereby increasing shareholder value. Building from scratch a team of people who can help you grow shareholder value is very hard. Buying an existing business makes that part of your job that much easier.

Cash flow management

Revenue and cash flow

Ordinarily, the sale will be structured in such a way that you can afford to pay the previous owner, earn a meaningful salary, and have funds left over to improve the business, for example, it’s possible to buy a $2 million business with only 10% of the business price paid in the form of cash while the remaining can be paid in the form of loan, a business worth $2 million usually makes around $500,000-$700,000/year in profit depending on the type of business. On the other hand, startups are often starved for cash in the early days of their business and often, as we have said, because growth is so important to them, the early days are characterized by taking more and more of the cash to fund the growth of the money.

Many startup founders are, whether they like it or not, or know it or not, making the bet that they will grow fast enough to earn meaningful market share, and be able to develop competitive advantages that will allow them to earn profits in the future. In the interim, there is seldom any cash available for distribution to shareholders. This is great for those rare startups that become juggernauts, but as we said earlier, most startups fail within 5 years of their existence, so this bet usually amounts to 5 lean years in the hope of profits in the future, and then, failure. Indeed, many experts suggest that the typical startup does not make any profits in the first 3 years of its existence.

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