chapter 5

BUILD IT OR BUY IT?

Starting a Business vs. Buying One

 

 

 

 

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.

Some people know they want to own their own businesses but aren’t sure exactly what type of business to choose. If you fall into this category, or if you are worried about the difficulties involved in starting a business from the ground up, the good news is that there are other options: buying an existing business, buying a franchise or buying a business opportunity. Depending on your personality, skills and resources, these three methods of getting into business may offer significant advantages over starting from scratch.

e-FYI

If you’re looking for a business to buy or a broker to help you in your purchase, stop by bizbuysell.com. In addition to searching 47,000 businesses for sale and broker listings, you can order business valuation reports or research franchises.

Buying an Existing Business

In most cases, buying an existing business is less risky than starting from scratch. 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 do not 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 If you’re not careful, you could get stuck with obsolete inventory, uncooperative employees or outdated distribution methods. To make sure you get the best deal when buying an existing business, take the following steps.

The Right Choice

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 are 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 are 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 cho sen 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.”

“Play by the rules. But
be ferocious.”

-PHILIP KNIGHT,
CO-FOUNDER OF NIKE

You can also run your own “Wanted to Buy” ad describing what you are looking for.

TAXING MATTERS

You are investigating a business you like, and the seller hands you income tax returns that show a $50,000 profit. “Of course,” he says with a wink and a nudge, “I really made $150,000.” What do you do?

 

There may be perfectly legal reasons for the lower reported income. For instance, if the seller gave his nephew a nonessential job for $25,000 a year, you can just eliminate the job and keep the cash. Same goes for a fancy leased car. One-time costs of construction or equipment may have legitimately lowered net profits, too.

 

What to watch for: a situation where a seller claims he or she made money but just didn’t report it to the IRS. If this happens, either walk away from the deal ... or make an offer based on the proven income.

Remember, 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.

Contacting a business broker is another way to find businesses for sale. Most brokers are hired by sellers to find buyers and help negotiate deals. If you hire a broker, he or she will charge you a commission—typically 5 to 10 percent of the purchase price. The assistance brokers can offer, especially for first-time buyers, is often worth the cost. However, if you are really trying to save money, consider hiring a broker only when you are near the final negotiating phase. Brokers can offer assistance in several ways:

• Prescreening businesses for you. Good brokers turn down many of the businesses they are asked to sell, either because the seller won’t provide full financial disclosure or because the business is overpriced. Going through a broker helps you avoid these bad risks.

• Helping you pinpoint your interests. A good broker starts by finding out about your skills and interests, then helps you select the right business for you. With the help of a broker, you may discover that an industry you had never considered is the ideal one for you.

• Negotiating. During the negotiating process is when brokers really earn their keep. They help both parties stay focused on the ultimate goal and smooth over problems.

“Pretend that every
single person you meet
has a sign around his
or her neck that says
‘Make Me Feel
Important.’ Not only
will you succeed in
business, but you will
succeed in life.”

-MARY KAY ASH, FOUNDER
OF MARY KAY COSMETICS

• Assisting with paperwork. Brokers know the latest laws and regulations affecting everything from licenses and permits to financing and escrow. They also know the most efficient ways to cut through red tape, which can slash months off the purchase process. Working with a broker reduces the risk that you’ll neglect some crucial form, fee or step in the process.

A Closer Look

Whether you use a broker or go it alone, you will definitely want to put together an “acquisition team”—your banker, accountant and attorney—to help you. (For more on choosing these advisors, see Chapter 11.) These advisors are essential to what is called “due diligence,” which means reviewing and verifying all the relevant information about the business you are considering. When due diligence is done, you will know just what you are buying and from whom.

The preliminary analysis starts with some basic questions. Why is this business for sale? What is the general perception of the industry and the particular business, and what is 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. (For more questions to ask before purchasing an existing business, refer to the checklist starting on page 44.)

If the business still looks promising after your preliminary analysis, your acquisition team should start examining the business’s potential returns and its asking price. Whatever method you use to determine the fair market price of the business, your assessment of the business’s value should take into account such issues as the business’s financial health, earnings history, growth potential, and intangible assets (for example, brand name and market position).

Business Evaluation Checklist

If you find a business that you would like to buy, you will need to consider a number of points before you decide whether to purchase it. Take a good, close look at the business and answer the following questions. They will help you determine whether the business is a sound investment.

• Why does the current owner want to sell the business?

• Does the business have potential for future growth, or will its sales decline?

• If the business is in decline, can you save it and make it successful?

• Is the business in sound financial condition? Have you seen audited year-end financial statements for the business? Have you reviewed the most recent statements? Have you reviewed the tax returns for the past five years?

• Have you seen copies of all the business’s current contracts?

• Is the business now, or has it ever been, under investigation by any governmental agency? If so, what is the status of any current investigation? What were the results of any past investigation?

• Is the business currently involved in a lawsuit, or has it ever been involved in one? If so, what is the status or result?

• Does the business have any debts or liens against it? If so, what are they for and in what amounts?

• What percentage of the business’s accounts are past due? How much does the business write off each year for bad debts?

• How many customers does the business serve on a regular basis?

• Who makes up the market for this business? Where are your customers located? (Do they all come from your community or from across the state or are they spread across the globe?)

• Does the amount of business vary from season to season?

• Does any single customer account for a large portion of the sales volume? If so, would the business be able to survive without this customer? (The larger your customer base is, the more easily you will be able to survive the loss of any customers. If, on the other hand, you exist mainly to serve a single client, the loss of that client could finish your business.)

• How does the business market its products or services? Does its competition use the same methods? If not, what methods does the competition use? How successful are they?

• Does the business have exclusive rights to market any particular products or services? If so, how has it obtained this exclusivity? Do you have written proof that the current business owner can transfer this exclusivity to you?

• Does the business hold patents for any of its products? Which ones? What percentage of gross sales do they represent? Would the sale of the business include the sale of any patents?

• Are the business’ supplies, merchandise and other materials available from many suppliers, or are there only a handful who can meet your needs? If you lost the business’s current supplier, what impact would that loss have on your business? Would you be able to find substitute goods of the appropriate quality and price?

• Are any of the business’s products in danger of becoming obsolete or of going out of style? Is this a “fad” business?

• What is the business’s market share?

• What competition does the business face? How can the business compete successfully? Have the business’s competitors changed recently? Have any of them gone out of business, for instance?

• Does the business have all the equipment you think is necessary? Will you need to add or update any equipment?

• What is the business’s current inventory worth? Will you be able to use any of this inventory, or is it inconsistent with your intended product line?

• How many employees does the business have? What positions do they hold?

• Does the business pay its employees high wages, or are the wages average or low?

• Does the business experience high employee turnover? If so, why?

• What benefits does the business offer its employees?

• How long have the company’s top managers been with the company?

• Will the change of ownership cause any changes in personnel?

• Which employees are the most important to the company?

• Do any of the business’s employees belong to any unions?

To get an idea of the company’s anticipated returns and future financial needs, ask the business owner and/or accountant to show you projected financial statements. Balance sheets, income statements, cash flow statements, footnotes and tax returns for the past three years are all key indicators of a business’s health. These documents will help you do some financial analyses that will spotlight any underlying problems and also provide a closer look at a wide range of less tangible information.

Among other issues, you should focus on the following:

• Excessive or insufficient inventory. If the business is based on a product rather than a service, take careful stock of its inventory. First-time business buyers are often seduced by inventory, but it can be a trap. Excessive inventory may be obsolete or may soon become so; it also costs money to store and insure. Excess inventory can mean there are a lot of dissatisfied customers who are experiencing lags between their orders and final delivery or are returning items they aren’t happy with.

LET’S MAKE A DEAL

Sort on cash? Try these alternatives for financing your purchase of an existing business:

• Use the seller’s assets. As soon as you buy the business, you’ll own the assets—so why not use them to get financing now? Make a list of all the assets you’re buying (along with any attached liabilities), and use it to approach banks, finance companies and factors (companies that buy your accounts receivable).

• Bank on purchase orders. Factors, finance companies and banks will lend money on receivables. Finance companies and banks will lend money on inventory. Equipment can also be sold, then leased back from equipment leasing companies.

• Ask the seller for financing. Motivated sellers will often provide more lenient terms and a less rigorous credit review than a bank. And unlike a conventional lender, they may take only the business’s assets as collateral. Seller financing is also flexible: The parties involved can structure the deal however they want, negotiating a payback schedule and other terms to meet their needs.

• Use an employee stock ownership plan (ESOP). ESOPs offer you a way to get capital immediately by selling stock in the business to employees. By offering to set up an ESOP plan, you may be able to lower the sales price.

• Lease with an option to buy. Some sellers will let you lease a business with an option to buy. You make a down payment, become a minority stockholder and operate the business as if it were your own.

• Assume liabilities or decline receivables. Reduce the sales price by either assuming the business’s liabilities or having the seller keep the receivables.

• The lowest level of inventory the business can carry. Determine this, then have the seller agree to reduce stock to that level by the date you take over the company. Also add a clause to the purchase agreement specifying that you are buying only the inventory that is current and saleable.

TIP

Study the financial records provided by the current business owner, but don’t rely on them exclusively. Insist on seeing the tax returns for at least the past three years. Also, where applicable, ask for sales records.

• Accounts receivable. Uncollected receivables stunt a business’s growth and could require unanticipated bank loans. Look carefully at indicators such as accounts receivable turnover, credit policies, cash collection schedules and the aging of receivables.

• Net income. Use a series of net income ratios to gain a better look at a business’s bottom line. For instance, the ratio of gross profit to net sales can be used to determine whether the company’s profit margin is in line with that of similar businesses. Likewise, the ratio of net income to net worth, when considered together with projected increases in interest costs, total purchase price and similar factors, can show whether you would earn a reasonable return. Finally, the ratio of net income to total assets is a strong indicator of whether the company is getting a favorable rate of return on assets. Your accountant can help you assess all these ratios. As he or she does so, be sure to determine whether the profit figures have been disclosed before or after taxes and the amount of returns the current owner is getting from the business. Also assess how much of the expenses would stay the same, increase or decrease under your management.

• Working capital. Working capital is defined as current assets less current liabilities. Without sufficient working capital, a business can’t stay afloat—so one key computation is the ratio of net sales to net working capital. This measures how efficiently the working capital is being used to achieve business objectives.

• Sales activity. Sales figures may appear more rosy than they really are. When studying the rate of growth in sales and earnings, read between the lines to tell if the growth rate is due to increased sales volume or higher prices. Also examine the overall marketplace. If the market seems to be mature, sales may be static—and that might be why the seller is trying to unload the company.

WARNING

Who are the business’s employees? Beware, if it’s a family-run operation: Salaries may be unrealistically low, resulting in a bottom line that’s unrealistically high.

• Fixed assets. If your analysis suggests the business has invested too much money in fixed assets, such as the plant property and equipment, make sure you know why. Unused equipment could indicate that demand is declining or that the business owner miscalculated manufacturing requirements.

• Operating environment. Take the time to understand the business’s operating environment and corporate culture. If the business depends on overseas clients or suppliers, for example, examine the short- and long-term political environment of the countries involved. Look at the business in light of consumer or economic trends; for example, if you are considering a store that sells products based on a fad like yoga, will that client base still be intact five or ten years later? Or if the company relies on just a few major clients, can you be sure they will stay with you after the deal is closed?

Law and Order

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 liabilities in business take many forms and may be hidden so deeply that even the seller honestly doesn’t know they exist. How do you protect yourself? First, 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.

WARNING

Make sure you’re in love with the profit, not the product. Many people get emotional about buying a business, which clouds their judgment. It’s important to be objective.

Second, 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. The cost of having a lawyer evaluate a business depends on your relationship with the lawyer, the complexity of the business and the stage at which the lawyer gets involved. Generally, costs range from $3,000 to as much as $35,000 for a comprehensive appraisal.

If you’re considering buying a business that has valuable intellectual property, such as a patent, trade secret or brand name, you may want an intellectual property attorney to evaluate it. Generally, this will cost from 0.5 percent to 3 percent of the business’s total selling cost.

The Art of the Deal

If your financial and legal assessments show that the business is a good buy, don’t be the first person to bring up the subject of price. Let the seller name the figure first, and then proceed from there.

Deciding on a price, however, is just the first step in negotiating the sale. More important is how the deal is structured. David H. Troob, founder of D. H. Troob & Co., a New York brokerage and investment firm, suggests you should be ready to pay 20 to 50 percent of the price in cash and finance the remaining amount.

You can finance through a traditional lender, or sellers may agree to “hold a note,” which means they accept payments over a period of time, just as a lender would. Many sellers like this method because it assures them of future income. Other sellers may agree to different terms—for example, accepting benefits such as a company car for a period of time after the deal is completed. These methods can cut down the amount of upfront cash you need; however, you should always have an attorney review any arrangements for legality and liability issues. (For more ideas on financing your purchase, see “Let’s Make a Deal” on page 47.)

An individual purchasing a business has two options for structuring the deal (assuming the transaction is not a merger). The first is asset acquisition, in which you purchase only those assets you want. On the plus side, asset acquisition protects you from unwanted legal liabilities since instead of buying the corporation (and all its legal risks), you are buying only its assets.

On the downside, an asset acquisition can be very expensive. The asset-by-asset purchasing process is complicated and also opens the possibility that the seller may raise the price of desirable assets to offset losses from undesirable ones.

The other option is stock acquisition, in which you purchase stock. Among other things, this means you must be willing to purchase all the business’s assets—and assume all its liabilities.

The final purchase contract should be structured with the help of your acquisition team to reflect very precisely your understanding and intentions regarding the purchase from a financial, tax and legal stand-point. The contract must be all-inclusive and should allow you to rescind the deal if you find at any time that the owner intentionally misrepresented the company or failed to report essential information. It’s also a good idea to include a noncompete clause in the contract to ensure the seller doesn’t open a competing operation down the street.

“You don’t have to be a
genius or a visionary or
even a college graduate
to be successful. You
just need a framework
and a dream.”

—MICHAEL DELL, FOUNDER
OF DELL COMPUTER

Remember, you have the option to walk away from a negotiation at any point in the process if you don’t like the way things are going. If you don’t like the deal, don’t buy. Just because you spent a month looking at something doesn’t mean you have to buy it. You have no obligation.

Transition Time

The transition to new ownership is a big change for employees of a small business. To ensure a smooth transition, start the process before the deal is done. Make sure the owner feels good about what is going to happen to the business after he or she leaves. Spend some time talking to the key employees, customers and suppliers before you take over; tell them about your plans and ideas for the business’s future. Getting these key players involved and on your side makes running the business a lot easier.

Most sellers will help you in a transition period during which they train you in operating the business. This period can range from a few weeks to six months or longer. After the one-on-one training period, many sellers will agree to be available for phone consultation for another period of time. Make sure you and the seller agree on how this training will be handled, and write it into your contract.

If you buy the business lock, stock and barrel, simply putting your name on the door and running it as before, your transition is likely to be fairly smooth. On the other hand, if you buy only part of the business’s assets, such as its client list or employees, and then make a lot of changes in how things are done, you’ll probably face a more difficult transition period.

Many new business owners have unrealistically high expectations that they can immediately make a business more profitable. Of course, you need a positive attitude to run a successful business, but if your attitude is “I’m better than you,” you’ll soon face resentment from the employees you’ve acquired.

Instead, look at the employees as valuable assets. Initially, they’ll know far more about the business than you will; use that knowledge to get yourself up to speed, and treat them with respect and appreciation. Employees inevitably feel worried about job security when a new owner takes over. That uncertainty is multiplied if you don’t tell them what your plans are. Many new bosses are so eager to start running the show, they slash staff, change prices or make other radical changes without giving employees any warning. Involve the staff in your planning, and keep communication open so they know what is happening at all times. Taking on an existing business isn’t easy, but with a little patience, honesty and hard work, you’ll soon be running things like a pro.

TIP

For more information when investigating a franchise or business opportunity, check out this helpful resource: The FTC provides a free package of information about the FTC Franchise and Business Opportunity Rule. Write to: Federal Trade Commission, 600 Pennsylvania Ave., Washington, DC 20580, or visit ftc.gov.

Buying a Franchise

If buying an existing business doesn’t sound right for you but starting from scratch sounds a bit intimidating, you could be suited for franchise ownership. What is a franchise—and how do you know if you’re right for one? Essentially, a franchisee pays an initial fee and ongoing royalties to a franchisor. In return, the franchisee gains the use of a trademark, ongoing support from the franchisor, and the right to use the franchisor’s system of doing business and sell its products or services.

McDonald’s, perhaps the most well-known franchise company in the world, illustrates the benefits of franchising: Customers know they will get the same type of food, prepared the same way, whether they visit a McDonald’s in Moscow or Minneapolis. Customers feel confident in McDonald’s, and as a result, a new McDonald’s location has a head start on success compared to an independent hamburger stand.

WARNING

Is a franchise or business opportunity seller doing the hustle? Watch out for a salesperson who says things like “Territories are going fast,” “Act now or you’ll be shut out,” or “I’m leaving town on Monday, so make your decision now.” Legitimate sellers will not pressure you to rush into such a big decision. If someone gives you the hustle, give that opportunity the thumbs-down.

In addition to a well-known brand name, buying a franchise offers many other advantages that are not available to the entrepreneur starting a business from scratch. Perhaps the most significant is that you get a proven system of operation and training in how to use it. New franchisees can avoid a lot of the mistakes startup entrepreneurs typically make because the franchisor has already perfected daily routine operations through trial and error.

Reputable franchisors conduct market research before selling a new outlet, so you can feel greater confidence that there is a demand for the product or service. Failing to do adequate market research is one of the biggest mistakes independent entrepreneurs make; as a franchisee, it’s done for you. The franchisor also provides you with a clear picture of the competition and how to differentiate yourself from them.

Finally, franchisees enjoy the benefit of strength in numbers. You gain from economies of scale in buying materials, supplies and services, such as advertising, as well as in negotiating for locations and lease terms. By comparison, independent operators have to negotiate on their own, usually getting less favorable terms. Some suppliers won’t deal with new businesses or will reject your business because your account isn’t big enough.

Is Franchising Right for You?

An oft-quoted saying about franchising is that it puts you in business “for yourself, but not by yourself.” While that support can be helpful, for some entrepreneurs, it can be too restricting. Most franchisors impose strict rules on franchisees, specifying everything from how you should greet customers to how to prepare the product or service.

That’s not to say you will be a mindless drone—many franchisors welcome franchisees’ ideas and suggestions on how to improve the way business is done—but, for the most part, you will need to adhere to the basic systems and rules set by the franchisor. If you are fiercely independent, hate interference and want to design every aspect of your new business, you may be better off starting your own company or buying a business opportunity (see the “Buying a Business Opportunity” section starting on page 65 for more details).

TIP

Call the appropriate agencies to see how franchising is regulated in your state. Then keep the addresses and phone numbers for key state officials on file so you can contact them later if you have specific questions.

More and more former executives are buying franchises these days. For many of them, a franchise is an excellent way to make the transition to business ownership. As an executive, you were probably used to delegating tasks like ordering supplies, answering phones and handling word processing tasks. The transition to being an entrepreneur and doing everything for yourself can be jarring. Buying a franchise could offer the support you need in making the switch to entrepreneurship.

Do Your Homework

Once you’ve decided a franchise is the right route for you, how do you choose the right one? With so many franchise systems to choose from, the options can be dizzying. Start by investigating various industries that interest you to find those with growth potential. Narrow the choices down to a few industries you are most interested in; then analyze your geographic area to see if there is a market for that type of business. If so, contact all the franchise companies in those fields and ask them for information. Any reputable company will be happy to send you information at no cost.

Of course, don’t rely solely on these promotional materials to make your decision. You also need to do your own detective work. Start by going online to look up all the magazine and newspaper articles you can find about the companies you are considering as well as checking out Entrepreneur magazine’s FranchiseZone (entrepreneur .com/franchise). Is the company depicted favorably? Does it seem to be well-managed and growing?

Check with the consumer or franchise regulators in your state to see if there are any serious problems with the company you are considering. If the company or its principals have been involved in lawsuits or bankruptcies, try to determine the nature of the lawsuits: Did they involve fraud or violations of FTC regulatory laws? To find out, call the court that handled the case and request a copy of the petition or judgment.

If you live in one of the 15 states that regulate the sale of franchises (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington and Wisconsin), contact the state franchise authority, which can tell you if the company has complied with state registration requirements. If the company is registered with D&B, request a D&B Report, which will give you details on the company’s financial standing, payment promptness and other information. And, of course, it never hurts to check with your local office of the Better Business Bureau for complaints against the company.

Does the company still sound good? That means your investigation is just beginning. If you have not already received one, contact the franchisor again and ask for a copy of its Franchise Disclosure Document, or FDD (previously known as a Uniform Franchise Offering Circular, or UFOC). This disclosure document must, by law, be given to all prospective franchisees 10 business days before any agreement is signed. If changes are made to the FDD, an additional five days are added to the 10-day “cooling off” period. If a company says it is a franchise but will not give you an FDD, then contact the FTC—and take your business elsewhere.

The FDD is a treasure trove of information for those who are serious about franchising. It contains an extensive written description of the company, the investment amount and fees required, any litigation and/or bankruptcy history of the franchisor and its officers, the trademark you will be licensed to use, the products you are required to purchase, the advertising program, and the contractual obligations of both franchisor and franchisee. It specifies how much working capital is required, equipment needs and ongoing royalties. It also contains a sample copy of the franchise agreement you will be asked to sign should you buy into the system, as well as three years’ worth of the franchisor’s audited financial statements.

The FDD has been revamped to make it less “legalistic” and more readable, so there is no excuse for failing to read yours very carefully. Before you make any decisions about purchasing the franchise, your attorney and accountant should read it as well.

WARNING

Exaggerated profit claims are common in franchise and business opportunity sales. Is a company promising you will make $10,000 a month in your spare time? If it is a franchise, any statement about earnings (regarding others in the system or your potential earnings) must appear in the Franchise Disclosure Document (FDD). Read the FDD and talk to five franchise owners who have attained the earnings claimed.

Franchise Evaluation Worksheet

This will help you determine the attractiveness of each franchise you’re considering. Assign each franchise a column letter. Answer each question along the left-hand side by assigning a rating of 1 to 3, with 3 being the strongest. Total each column after you’ve finished. The franchise with the highest score is the most attractive.

IT’S SHOW TIME

Franchise and business opportunity trade shows can be a great opportunity to explore business investment packages. Attending one is exciting—and overwhelming—so you need to prepare carefully.

 

Before the show:

• Consider what you are seeking from a business investment. Part time or full time? What type of business do you think you would enjoy? Consider your hobbies and passions.

• Figure out your financial resources. What is liquid, what can you borrow from family and friends, and how much do you need to live on while initially running the business? What are your financial goals for the business?

• Get serious. Dress conservatively, carry a briefcase, leave the kids at home, and take business cards if you have them. Show the representatives you meet that you are a serious prospect.

At the show:

• Take a moment to study the floor plan of the exhibitors listed. Circle the businesses you recognize or that look interesting. Make sure you stop by these booths during your visit.

• Don’t waste time. Pass by the sellers who are out of your price range or do not meet your personal goals. Have a short list of questions ready to ask the others:

1. What is the total investment?

2. Tell me about a franchisee’s typical day.

3. What arrangements are made for product supply?

4. Is financing available from the franchisor?

5. Ask for a copy of the company’s FDD. Not all franchisors will give you one at the show. This is acceptable, but if you are serious about an opportunity, insist on a copy as soon as possible.

• Collect handout information and business cards from the companies that interest you.

After the show:

• Organize the materials you collected into file folders. Then read through the information more closely.

• Follow up. Call the representatives you met to show them you are interested.

Calling All Franchisees

One of the most important parts of the FDD is a listing of existing franchisees as well as franchisees who’ve been terminated or have chosen not to renew. Both lists will include addresses and phone numbers. If the list of terminated franchisees seems unusually long, it could be an indication that there’s some trouble with the franchisor. Call the former franchisees, and ask them why the agreement was terminated, whether the franchisee wasn’t making the grade, or whether he or she had some type of grievance with the franchisor.

Next, choose a random sample of current franchisees to interview in person. This is perhaps the most important step in your research. Don’t rely on a few carefully selected names the franchisor gives you; pick your own candidates to talk to.

Visit current franchisees at their locations. Talking to existing franchisees is often the best way to find out how much money individual stores actually make. You’ll also find out what their typical day is like, whether they enjoy what they do and whether the business is challenging enough. Most will be open about revealing their earnings and their satisfaction with the franchisor; however, the key to getting all the information you need before buying is asking the right questions. Here are some ideas to help get you started:

• Was the training the franchisor offered helpful in getting the business off the ground?

• Is the franchisor responsive to your needs?

• Tell me about a typical day for you.

• Have there been problems you did not anticipate?

• Has your experience proved that the investment and cost information in the FDD were realistic?

• Is the business seasonal? If so, what do you do to make ends meet in the off-season?

• Have sales and profits met your expectations? Tell me about the numbers in the business.

• Are there expansion opportunities for additional franchise ownership in this system?

• If you knew what you know now, would you make this investment again?

Since running a franchise involves an ongoing relationship with the franchisor, be sure to get the details on the purchasing process—everything that happened from the day the franchisee signed the agreement to the end of the first year in business. Did the parent company follow through on its promises?

“Starting a company is
the best stage of a
startup. There’s the
creative aspect. You also
have to articulate your
idea. There are a million
things going on.”

-KATRINA GARNETT,
FOUNDER OF CROSSROADS
SOFTWARE

Talk to as many franchisees as you can—a broader perspective will give you a more accurate picture of the company. Take careful notes of the conversations so you can refer to them later. Don’t hesitate to ask about sensitive topics. One of the most important questions a prospective franchisee should ask, but rarely does, is “What conflicts do you have with the franchisor?” Even established, successful companies have conflicts. What you need to find out is how widespread and common those conflicts are.

Talking to franchisees can also give you something you won’t get anywhere else: a feeling for what it’s like to run this business day to day. Thinking solely in economic terms is a mistake if you end up with a franchise that doesn’t suit your lifestyle or self-image. When you envision running a restaurant franchise, for instance, you may be thinking of all the money you’re going to make. Talking to franchisees can bring you back to reality—which is a lot more likely to involve manning a fry station, disciplining employees and working late than cruising around in your Ferrari. Talking to franchisees in a variety of industries can help you make a choice that fits your lifestyle.

WARNING

If your visits with current franchisees result in each one telling you they are unhappy or would not make the investment in this franchise again, think long and hard about your own decision. If they feel the franchisor has let them down or has a flawed program, you should look more carefully before taking the plunge.

Many franchisees and franchising experts say there’s no better way to cap off your research than by spending time in a franchisee location to see what your life will be like. Buyers should spend at least one week working in a unit. This is the best way for the franchisor and franchisee to evaluate each other. Offer to work for free. If the franchisor doesn’t want you to, you should be skeptical about the investment.

When all your research is completed, the choice between two equally sound franchises often comes down to your gut instinct. That’s why talking to franchisees and visiting locations is so important in the selection process.

Proven Purchase

Buying a franchise can be a good way to lessen the risk of business ownership. Some entrepreneurs cut that risk still further by purchasing an existing franchise—one that is already up and running. Not only does an existing franchise have a customer base, but it also has a management system already in place and ongoing revenues. In short, it already has a foundation—something that is very attractive to a lot of entrepreneurs.

Finding existing franchisees who are willing to sell is simply a matter of asking the parent company what’s available. You can also check local classified ads, or visit Franchising.com, which lists thousands of businesses for sale.

Once you have found some likely candidates, the investigation process combines the same steps used in buying an existing business with those used in buying a franchise. (For a list of questions to ask before purchasing an existing business, refer to the checklist on page 44.) The good news, however, is that you’ll get far more detailed financial information than you would when assessing a franchise company. Where other potential franchisees just get vague suggestions of potential earnings, you’ll get hard facts.

Of course, there is a price to pay for all the advantages of buying an existing franchise: It is generally much more costly. In fact, the purchase price of an existing location can be two to four times more than what you would pay for a new franchise from the same company. Because you are investing more money, it is even more important to make sure you have audited financial statements and to review them with your CPA.

Once in a while, you’ll find a franchise that isn’t doing well. Perhaps the current owner isn’t good at marketing, isn’t putting forth enough effort or isn’t following the system correctly. In this case, you may be able to get the existing franchise for what it would cost to buy a new franchise—or even less. It’s crucial, however, to make sure the problem is something you can correct and that you’ll be able to get the location up to speed fast. After all, you’re going to have immediate overhead expenses—for employees, royalties and operating costs—so you need some immediate income as well.

Also be aware that even if a particular franchise location is thriving, it does not necessarily mean the parent company is equally successful. In fact, sometimes franchisees who know the parent company is in trouble will try to unload their franchises before the franchisor goes under. Carefully assess the franchisor’s strength, accessibility and the level of assistance they provide. Do not settle for anything less than you would when buying a new franchise.

Buying a Business Opportunity

If a franchise sounds too restrictive for you but the idea of coming up with your own business idea, systems and procedures sounds intimidating, there is a middle ground: business opportunities.

TIP

Put yourself in the franchisor’s shoes. You want to deliver a FDD only to qualified candidates who appear serious about the investment because each copy costs several dollars to reproduce. Show you are serious about their program and are genuinely interested in the information in the FDD, and you increase your chance of receiving one early in the process.

A business opportunity, in the simplest terms, is a packaged business investment that allows the buyer to begin a business. (Technically, all franchises are business opportunities, but not all business opportunities are franchises.)

Unlike a franchise, however, the business opportunity seller typically exercises no control over the buyer’s business operations. In fact, in most business opportunity programs, there is no continuing relationship between the seller and the buyer after the sale is made.

Although business opportunities offer less support than franchises, this could be an advantage for you if you thrive on freedom. Typically, you will not be obligated to follow the strict specifications and detailed program that franchisees must follow. With most business opportunities, you would simply buy a set of equipment or materials, and then you can operate the business any way and under any name you want. There are no ongoing royalties in most cases, and no trademark rights are sold.

However, this same lack of long-term commitment is also a business opportunity’s chief disadvantage. Because there is no continuing relationship, the world of business opportunities does have its share of con artists who promise buyers instant success, then take their money and run. While increased regulation of business opportunities has dramatically lessened the likelihood of rip-offs, it is still important to investigate an opportunity thoroughly before you invest any money.

Legal Matters

In general, a business opportunity refers to one of a number of ways to get into business. These include the following:

• Dealers/distributors are individuals or businesses that purchase the right to sell ABC Corp.’s products but not the right to use ABC’s trade name. For example, an authorized dealer of Minolta products might have a Minolta sign in his window, but he can’t call his business Minolta. Often, the words “dealers” and “distributors” are used interchangeably, but there is a difference: A distributor may sell to several dealers, while a dealer usually sells direct to retailers or consumers.

• Licensees have the right to use the seller’s trade name and certain methods, equipment, technology or product lines. If Business Opportunity XYZ has a special technique for reglazing porcelain, for instance, it will teach you the method and sell you the supplies and machinery needed to open your own business. You can call your business XYZ, but you are an independent licensee.

• Vending machines are provided by the seller, who may also help you find locations for them. You restock your own machines and collect the money.

• Cooperatives allow an existing business to affiliate with a network of similar businesses, usually for advertising and promotional purposes.

ON THE LEVEL

Direct sales is a type of business opportunity that is very popular with people looking for part-time, flexible businesses. Some of the bestknown companies in America, including Avon, Mary Kay Cosmetics and Tupperware, fall under the direct-selling umbrella.

 

Direct-selling programs feature a low upfront investment—usually only a few hundred dollars for the purchase of a product sample kit—and the opportunity to sell a product line directly to friends, family and other personal contacts. Most direct-selling programs also ask participants to recruit other sales representatives. These recruits constitute a rep’s “downline,” and their sales generate income for those above them in the program.

 

Things get sticky when a direct sales network compensates participants primarily for recruiting others rather than for selling the company’s products or services. A direct-selling system in which most of the revenues come from recruitment may be considered an illegal pyramid scheme.

 

Since direct-selling programs are usually exempt from business opportunity regulation and are not defined as franchises under state and federal franchise laws, you will need to do your own investigation before investing any money. For more information, check out the Direct Selling Association’s website at dsa.org.

• Direct sales (see “On the Level” above).

Legal definitions of business opportunities vary, since not all states regulate business opportunities. (The 26 that do are Alaska, California, Connecticut, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Minnesota, Nebraska, New Hampshire, North Carolina, Ohio, Oklahoma, South Carolina, South Dakota, Texas, Utah, Virginia, Washington and Wisconsin.) Even among these, different states have different definitions of what constitutes a business opportunity. According to franchise law counsel Joel R. Buckberg, an attorney in Nashville, Tennessee, most definitions contain the following:

• The investor enters into an oral or written agreement for the vendor—or someone recommended by the vendor—to sell goods or services to the investor that allow him or her to begin a business.

TIP

Don’t forget to ask about the franchise or business opportunity’s training program. Find out how long it is, where it takes place and the general subjects covered. Look for a well-organized plan that combines classroom time with field orientation.

• The purchase involves a certain amount of money. In 15 states and under FTC regulations, the minimum investment is $500; in the other 11 states, that figure drops to as little as $100.

• The seller makes any one of the following statements to the investor during the course of the sale:

1. The seller or someone the seller recommends will assist in securing locations for display racks, vending devices, outlets or accounts;

2. The seller will return the money and repurchase what is sold to or made by the investor if the investor is dissatisfied with the investment;

3. The seller will buy any or all of the products assembled or produced by the buyer;

4. The seller guarantees (or, in some states, implies) that the buyer will be able to generate revenues in excess of the amount of the investment paid to the seller; or

5. The seller will provide a marketing plan or a sales plan for the buyer.

If a seller meets the definition of a business opportunity in states that regulate them, it generally means he or she must register the offering with the state authorities and deliver a disclosure document to prospective buyers at least ten business days before the sale is made. (For more information on states’ regulations, check with consumer protection agencies—often a part of the attorney general’s office—in your state.)

Checking It Out

Researching a business is a more challenging task than investigating a franchise. And if the business opportunity you are considering does not provide buyers with a disclosure document, you get a lot less information, so you have to do a lot more legwork on your own.

Whenever possible, follow the same steps you would for investigating a franchise. Check out Entrepreneur magazine’s BizOpp Zone (entrepreneur.com/bizopp). Contact the Better Business Bureau to see if there have been complaints against the company, and if the company is registered with D&B, a financial report will give you details on its financial standing and other information.

Also check with the regulatory agency—either the Commission of Securities or the Commission of Financial Institutions—in the state where the business opportunity has its headquarters. This will tell you if the company is complying with all state regulations. If you discover the company or its principals have been involved in lawsuits or bankruptcies, try to find out more details. Did the suits involve fraud or violations of regulatory laws? A copy of the petition or judgment, which you can get from the court that handled the case, will give you the answers to these questions.

WARNING

Watch out for promises from third-party location hunters. The sales rep may say, “We’ll place those pistachio dispensers in prime locations in your town,” but more likely, you’ll find out that all the best locations are taken, and the next thing you know, your garage is filled with pistachio dispensers. The solution: Get in your car, and check for available locations.

Finally, see if the business opportunity seller will provide you with a list of people who have purchased the opportunity in the past. Don’t let the seller give you a few handpicked names; ask for a full list of buyers in your state. Try to track them down, and talk to as many as you can. Were they satisfied with the opportunity? Would they recommend it to friends?

The path to buying a business opportunity is not as clearly defined as the road leading to franchise ownership. The good news, however, is that you have more freedom to make your business opportunity work. More so than with a franchise, the success or failure of your business opportunity depends on you, your commitment to the venture and the level of effort you put into it. Put that same effort into finding the right business opportunity program, and your chances of success increase exponentially.