The number of people seeking to own their own business increases every year. The majority of them have no past experience with the process, and most will not enlist the services of a professional until it is too late. This article is intended as a starting point for those who think they do not need help. While it is no substitute for professional assistance, it might help some new entrepreneurs avoid some of the more obvious pitfalls. In addition to basic rules, there are several real-life examples.
There are pros and cons of buying into a franchise, as opposed to buying an existing business. This article does not address those issues. Rather, this article is focused on the considerations that apply in either case. This article will also not address due diligence and the benefits of substantive due diligence, which is discussed in the above article, “Beyond the Checklist”. Instead, here are five questions every budding entrepreneur must answer and five things every budding entrepreneur must keep in mind:
Whether you are buying a business or a franchise, you need to understand what you are getting in exchange for your investment. If, for example, you are buying into a restaurant franchise, you need to determine whether the franchisor’s experience and brand recognition justify the fees and royalties. If you are buying an existing business, you need to assess the value of the hard assets, the existence and importance of patents, trade secrets, or other intellectual property, the brand recognition, and the importance of the existing talent. In either case, if you could start a competing business yourself, you need to determine why you are paying someone else? If the answer is that you feel more comfortable with an existing business or with knowing you can get help from a franchisor, you still need to answer the question because you need to know if there are barriers to entry to prevent competition.
Consider the bagel wars from a couple decades ago. When Bruegger’s began testing the concept of a bagel store, it had no name recognition and no established customer base. On the other hand, there were no other national franchises in the bagel business. The main reasons for becoming a franchisee instead of opening your own store were the chance to be on the ground floor if it took off and the expectation that Bruegger’s would establish company stores and other franchisee stores in order to bolster the brand name. The problem, however, is that there was no real barrier to entry for others. As a result, several other bagel chains popped up and decided to compete directly by locating stores in locations where Bruegger’s had already set up shop. A lot of people lost a lot of money in the battle for dominance in the bagel market.
People obviously sell businesses because they want to retire, they have health issues, or they simply want to do something different. The problem is that so many opportunities are promoted as easy-money, turnkey operations, and there does not seem to be much of a reason to unload something that requires so little work. Furthermore, if it’s such a great opportunity, why is it being offered to you instead of the owner’s relatives, friends, etc. Franchises are a little different because the model depends upon finding people who will have a financial interest in each location. Just the same, if a franchisor also has company locations, you should wonder why it doesn’t want yours.
Frequently, the owner is aware of changes in the industry that are going to adversely impact performance. A client bought a business that sold refurbished automobile computer diagnostic equipment. When car companies first started installing computer chips in cars, dealerships were the only ones who had the diagnostic machines because they were the only ones likely to service the vehicles while they were under warranty. As the warranties began to expire, other auto mechanics began getting the work and they needed to buy the computer diagnostic equipment to be successful. Initially, that was a great business because it was like selling the first VCRs – nobody in the target market already owned one. Unfortunately, by the time the client owned the business, most of the target market already owned refurbished diagnostic machines. Furthermore, manufacturers began offering longer warranties and dealers began offering extended warranties. Thus, the target market was both saturated and shrinking.
There are businesses that succeed primarily on the basis of the owner’s contacts, capabilities, and/or charisma. The fact that the seller signs and abides by a noncompete does not guaranty that the customers will continue to be yours. The fact that the seller had loyal customers reflects well on the seller, but those loyal customers have no reason not to take calls from your competitors once you own the business. If the owner has driven the success, you need to determine whether you have the same attributes and, furthermore, whether those attributes will be sufficient.
Many people put in money and think that their losses are limited to that amount. For example, most franchisees do not realize that their franchise agreements provide that they have to continue to pay a royalty even if they go out of business. There is usually a formula for what your royalties should be, so don’t think you can escape liability by arguing that you can’t owe royalties when you don’t have income. Similarly, people who buy businesses and don’t protect themselves may end up paying for warranty repairs, uncompleted contracts, or other things.
Another source of ongoing liability is rent. Most new business owners have to sign personal guaranties on leases, and that obligation does not go away if the business closes. In the franchise context, the franchise agreement generally gives the franchisor the right to take over the lease. Many franchisees mistakenly see that as a positive because they believe the franchisor will take over if they fail. Unfortunately, the language generally gives the franchisor the option to take it over, but it does not give them the obligation. If the location fails under your management, it is not that likely the franchisor will want it.
This can often be very difficult to predict, but most people spend very little time on it. Some ideas seem so bad that it is difficult to believe someone thought they would work. Other times, there are things that seem obvious in hindsight. Occasionally, something happens that nobody would have predicted, but a wise investor will try to take into account the fact that something bad will happen, even though the specifics cannot be predicted.
One of the patently worst investment ideas ever was a client in the 1990s who was persuaded to buy pay-phones. The company that manufactured them and sold them would also provide the location, the contract with the telephone company, and the collection services, pursuant to which it would pay a percentage of the income to the owner. The fact that cellphones were already ubiquitous should have been the first warning sign. The fact that the manufacturer of the phones was giving others the opportunity to make allegedly large returns should have been another. The costs of soliciting and servicing hundreds or even thousands of investors is very high. If this was such a good deal, the manufacturer would have kept the phones for itself or, at a minimum, found large investors to take large blocks.
On the other hand, a client had the misfortune of investing in Gloria Jean’s coffee right before the Starbucks craze. Gloria Jean’s focus was the retail sale of products designed to make coffee at home. Frankly, before Starbucks and Caribou took off, few would have predicted that stores selling high-priced coffee drinks could succeed at the level they have. It is hard to fault anyone for what happened.
If you have addressed these questions and want to move on, there are several things to keep in mind as follows:
If you are getting a bad vibe from the seller, don’t think it will be behind you once the deal is closed. The best lawyer in the world drafting the most air-tight documents in the world cannot protect you from the pains associated with entering into a transaction with the wrong party. The lawyer may be able to maximize the likelihood that you will prevail in the end, but it will rarely be worth it.
A client bought a marketing business from sellers he did not trust, but was so in love with the transaction that he convinced himself that they would be out of the picture before long. In fact, there is considerable doubt that the sellers ever left the business or honored their noncompetes. The buyer might win a lawsuit for the breach, but that is of little comfort if it is not collectable and if the distraction of litigation otherwise hurts the business.
A large percentage of new businesses or businesses with new owners fail in the first year and the reason is almost always a lack of working capital. The ones that make it generally have few unforeseen developments and/or the financial resources to weather the storms. Most of the failures believe they would have succeeded in the long run with more time.
A client invested in a tanning franchise and was so intrigued that he signed up for more than one location. Shortly thereafter, the franchisor decided to upgrade to offer more spa services. In the abstract, that was probably a good idea. The client, however, had to use up its financial cushion if it wanted to follow suit. While it is not certain the venture would have succeeded anyway, it failed a lot quicker than it would have otherwise.
There is a tendency of people who are in trouble to not seek professional help because of the belief that it will just be a further drain on resources. That fear is definitely well founded, as there are a lot of consultants who will gladly take fees without delivering anything of value. While some lawyers also fall into that category, you need to make sure you protect and preserve whatever legal rights you have. If you wait until the situation deteriorates further, you may limit your options and your leverage.
A client bought a business on installments, and there was a covenant that the assets could not be encumbered other than by the existing bank lien. Because of changes in bank regulations, the loan was called and the client paid it off. Under the terms of the deal, the client was not allowed to encumber the assets with any other liens and was not, therefore, able to set up a new line of credit. Rather than satisfying the loan, the client should have arranged to purchase the loan and the lien rights. Ideally, the client could have found new financing and transferred the lien rights to the new lender. At a minimum, the client would have been in first position with respect to the assets. Even if that did not work, there were legal arguments available as a result of changed circumstances outside of the client’s control. The client declined to seek help, however, and tried without success to resolve legal issues on its own.
There is a tendency for buyers not to consult with attorneys in advance because of a belief that lawyers are too focused on what might go wrong. While there is probably some truth to that, there are a lot of people who end up wishing they had made the investment in legal advice in advance. While an attorney generally does not make decisions for clients on business issues, a good business attorney can help assess the deal by getting the client to consider the risks. If the client chooses to ignore the advice of others or the advice in this article, at least remember this: If it seems too good to be true, it probably is.