Download Chapter 5 – Build or buy

Chapter 5 – Build or buy? [PAC]

Pros & Cons of starting from scratch vrs Buying an existing business

How to buy a business
 Evaluating an existing business
Due diligence
Valuation & Financial Analysis

Case study on successful business acquisition – taking and growing business
to the next level
Buying an existing business
An entrepreneur may decide to purchase an already existing business either
through the acquisition of issued shares (in the case of a company) or through
the acquisition of assets of the company (in the case of sole proprietors,
partnership and companies). Note though that in the case of partnerships, it is
possible also to acquire part of a business through the acquisition of the 'stakes'
held by other partners. An outright acquisition of a partnership though is
essentially an acquisition of the assets of that partnership rather than an
acquisition of the different stakes of the partners as the effect of a 100% sale
would be to dilute the initial partnership set up.
Buying an existing business is another way to make a foray into entrepreneurship,
arguably the fastest pathways to entrepreneurship. The entrepreneur who
decides to go by this route saves time cost and energy required to plan and
launch a new business.
The answer to the question whether to start or to buy your business is one that
has no clear cut answer. There are both pros and cons to buying vs. starting your
own business.
Pros of buying vs. Starting your own businesses
Faster route to entrepreneurship: It may offer an 'easier' and quicker route for the
entrepreneur seeking to start on his or her own. The seller of the business would
already have spent time and effort in identifying the relevant target and
developing a value proposition to attract this target. For example it is likely to
have:
 Customers:
 Employees
 Suppliers
 A great location
A history of success could be an indicator of future success. However this is not
always the case. However, it is important for the entrepreneur to understand
what factors have led to the past success to ensure that he can replicate those
successes when he takes over the business.
Experience of the previous owner: In many cases in which the business has a
long history of success, the new owner may be able to negotiate with the
previous owner to stay on for a short time to introduce him to customers, suppliers
etc. Even if he does not stay on, it is often possible to at least tap into his wealth
of knowledge in the form of an informal 'quasi consultant'
Easier to find finance: The risk involved in purchasing an existing business with a
demonstrated track record of success is lower than for a completely new
business. It is therefore relatively easier to find money to fund such purchases. In
addition, it is generally easier to find money for other financing needs of this
business because (at least in the cases of successful businesses) there is a stream
of cashflows and assets against which banks could lend.
Difficulties of buying vs. Starting your own businesses
 Cultural/Employee related issues: The employees that are 'inherited' with the
purchase of the business may not be the employees that the new business
owner may necessarily want to work with. They may have their own ways of
doing things that may be inconsistent with what the new owner plans for the
business. The culture of the enterprise may be different from what the new
owner wants and implementing change could be difficult.

Customer and supplier relationships may not be inherited: It should not be
taken for granted the customers would continue to patronise the business
without the old owner. This is true of smaller businesses such as hairdressing
shops where the relationship with the customers is very personal. In addition, it
should not be taken for granted that the new business would inherit the
current suppliers or indeed on the same supply terms.

Business may be overpriced: There is always the risk that the seller may paint
the business to look so good as to get a good price for it. So it is quite possible
to inherit a business with many 'skeletons in the cupboard' which in effect take
away from the sale price. It is therefore important to carry out extensive due
diligence before proceeding with the purchase.
Due diligence on the acquisition of a business [add more detail]
Due diligence in the context of purchasing a business is the process of research
and investigation of a company to determine the feasibility of pursuing the
business opportunity represented by the company. It is effectively organised
'common sense' to find out information about the company to enable you
decide whether or not to pursue that company.
The objective is to use factual data to make the evaluation. However, where the
plan is to keep the existing management there is a subjective layer of assessment
added to due diligence to ask the question whether the management team
can take the company to the level proposed by the intended purchaser.
In carrying out due diligence, you will never have all the information and the
detail of information required will depend on the purchaser's plans for the
business. For example if the purchaser intends to bring his own management
team to run the company after purchase, he will focus more on investigating the
industry and its prospects (using for example Porter's five forces framework).
However, if he intends to keep the management team, the prospective
purchaser will focus more on the skills, track record and competency of the
management team.
Due diligence guidelines
 Ask, Ask, Ask: You should ask as many questions as you can of the seller, its
management and other stakeholders.
 When you hear an answer, make sure you also see the answer: This means
don't just rely on the seller or management to feed you with fanciful answers.
Double check things. If they tell you they have 3 warehouses in Kumasi, go
and visit these warehouses to ensure they are in fact warehouses not simply
sheds in Kumasi.
 Use the Colombo method:That is, inquire politely but persistently. Also ask key
questions multiple times in a variety of ways – in this case you are looking for
consistency in answers.
 When co-investing do your own due diligence:Don't rely only on the due
diligence carried out by the other co-investors.
 Painstakingly review information about all aspects of the company: The point
of due diligence is to help you make an informed decision about whether or
not to proceed with making the purchasing decision you are contemplating.
As a result, you should ensure that you find out as much as you can about the
company. Review financials (see audited financial statements, calculate the
key financial ratios and carry out a ratio analysis). Review key documentation
such as contracts, R&D information etc. Ask questions about the product or
service and find out about the key drivers of the business. Check the trend for
sales, market share, cashflow etc. Visit the physical plant if any, speak to key
customers and supppliers.
VALUATION
LEGAL ISSUES
 non compete etc
Franchising
Franchising is a form of licensing by which the owner (the franchisor) of a
product, service or business method obtains distribution through affiliated dealers
(the franchisee). In return for the franchisor's support in starting the business, the
franchisee pays the franchisor an initial fee and would usually pay an annual
royalty based on gross revenues for the franchisor's continued support and the
use of brands, trademarks or business formats. Examples of franchises in Ghana
are “Steers” and Western Union. A good international example is McDonalds. A
franchise typically involves investing in a proven business model. Typically,
people go for a franchise because they do not want to take all the risks of
entrepreneurship but rather want to benefit from the resources of the franchising
organization. This may take the form of sharing R&D, advertising development
etc.
Advantages of franchises for the Franchisor
Fast growth: Franchising can enable a business grow fairly rapidly (especially in
new markets) even in spite of limited resources and infrastructure. By identifying
franchisees who are willing to put some of their own resources into growing and
developing the business in their markets, franchisors can quickly establish a
significant presence that might otherwise not have been possible.
Economies of scale: Franchising with the rapid growth potential that it offers,
gives an opportunity to the franchisor to spread costs of marketing, supply and
purchasing over a wider volume base and as a result is able to achieve lower
cost of sales and greater profits per unit.
Cashflow: Franchising gives the franchisor a constant cashflow in terms of regular
fees from the franchisees. In addition to the annual royalty based on gross
revenues that the franchisees pay the franchisor, the franchisor also makes
money from the franchisees by charging the franchisees to provide certain
additional services such as training, set up consulting, marketing and advertising
etc. In some instances also, the franchisor will acquire the relevant property and
then rent it on to the franchisee typically at a margin.
Motivation & Market knowledge: Franchising enables the franchisor to tap into a
pool of highly motivated individuals who have good local knowledge. Because
they tend to have their own capital invested, franchisees are far more motivated
than employees could be. Also, (especially in the case of expanding into
markets not local to the franchisor), franchises provide an opportunity to tap into
a wealth of local knowledge through the franchisees who will be conversant with
that market.
Does not dilute ownership: Franchisors do not give up a stake of their equity to
franchisees. Franchisees simply pay to replicate their proven business in particular
markets. The ownership of the franchisor therefore remains undiluted.
Disadvantages of franchises for the Franchisor
 Loss of control over operation: Typically, the franchisor may try to use a legal
framework to be able to control as much of the operations of the franchisee
as possible so as to ensure that there is consistency in quality, appearance etc
in its franchises. In reality though, the day to day operations of the franchise
really lie within the domain of the franchisee and not the franchisor. In the
case of a large franchise for example such as McDonalds, it may be difficult
to completely 'police” every franchisee to ensure that he or she is conforming
to the franchise 'norms'

Loss of contact with customers: The customers of a particular franchise are in
fact the immediate customers of the franchisee rather than the franchisor. The
franchisor therefore may not get as much contact with the customers as he or
she would if the business was directly owned.

Free riding: There is a risk of free riding in the following way: A number of
franchisees work hard to keep the quality and service standards and
contribute regularly to advertising and building the brand. However, a few
'bad apple' franchisees regularly fail to meet the minimum quality and service
levels and fail to contribute to advertising and brand building. However, these
'bad apples' still benefit from the efforts of the former group who are persistent
in meeting quality standards.


Sharing income stream: Rather than earn all the income that comes with
expansion and increased customers, franchisors share this income with the
franchisees in the same way that these franchisees also share in the capital
and manpower risks of expansion and attracting new customers.
Advantages of franchises for the Franchisee
 Safety net: Franchises provide a safety net to a would-be entrepreneur
because they typically are based on proven business models. Consequently,
the risk of failure is lower.

Support in terms of training and R&D etc: In return for paying an annual royalty
to the franchisor, the franchisee benefits from the wealth of the franchisor's
experience. Particularly in the area of training and research & development
as the franchisor takes on the responsibility of training both the franchisee and
his or her staff. This has the advantage of giving a start up franchise the same
depth as an already existing company.

Economies of scale: Although on his or her own, the franchisee has limited
bargaining power and therefore is unable to command lower prices for the
goods and services contracted for, the franchise concept enables him or her
to benefit from economies of scale as the various inputs are purchased
centrally through the franchisor and then passed on to the various franchisees.
Disadvantages of franchises for the Franchisee
 Lack of control: As discussed earlier, one reason why many people decide to
go into business of their own is because of the control and freedom that it
gives them over their enterprise. In the case of franchises though, such control
is limited as franchisees would always be contractually obliged to run their
business according to the blueprint set by the franchisor so that from the point
of view of the outsider it is not obvious that they are owned by different
people. The franchisee would therefore have to choose particular types of
location, hire certain types of individuals, market in a certain way etc.

Quasi-employment: This point is related to lack of control above. Because the
franchisee has to conform in many respects to the franchisor's own predetermined notions of how the business is to be run, he typically has certain
projections to meet in terms of revenue and income. In a way then, a
franchisee's position is similar to that of the employee.

Can be expensive in the long run: The franchising concept enables someone
to tap into an expanding business venture with far less capital than might be
the case if he was starting from scratch. However, in the long run, this could
become a more expensive way of doing business because the franchisor
requires the franchisee to purchase most of his inputs from the franchisor at
prices that may not be the most favourable for the franchisee.

Limit on exit strategy: When the franchisee decides to exit the business, he
may not be free to determine who he wants to sell it to or indeed even who
he may pass on the business to as an inheritance. The franchise agreement
between him and the franchisee would typically limit who he can pass on the
business to.
Mom & Pop/Lifestyle entrepreneurs
Examples are local hairdressers, local kiosks etc. Typically they are businesses run
by people who are primarily looking for their businesses to provide a decent
standard of living. They typically run their businesses without any formal systems in
place and are not concerned about growth necessarily. They typically manage
the business to enable it provide an income to support their families and do not
worry about strategically growing it.
High growth entrepreneur
In contrast, the high growth entrepreneur seeks exponential growth. More likely
than not, this type of entrepreneur is running his business with a business plan and
with the necessary systems in place for cashflow planning, financial
management, strategic planning, marketing etc. Examples include Domod
Aluminum, Ernest Chemist and Spacefon.