In a previous post I mentioned my reasons for owning a small business. In this post I am going to review my preferred way of getting one. Many people believe that to become an entrepreneur one must start a business. This is not true. There is another option: buying it. I’ve done both. I’ve bought small businesses and also have started a couple. I prefer buying a small business instead of starting one because it is less risky and less costly than starting one.
Buying an existing business is less risky because:
1) The startup growing pains are over.
2) There is a proven business model. The business is up and running.
3) The business is producing cash flow. The existing cash flow lowers your opportunity cost.
Growing pains are over
The most risky period of a business is the beginning. Most businesses fail in the first year of operation. It takes a lot of work, planning, dedication and “luck” to start a business. If you look at history, the French tried to create a canal thru the Isthmus of Panama. They failed after spending $234MM, eight years of work and lives lost. The Americans bought the French out for $40MM and learned from their mistakes. The rest, as they say, is history. The U.S. constructed the Panama Canal which started operating in 1914. The same happens at the small business level. Do you want to be the one trying to start a new business like the French canal?
Proven business model
What is safer? Buying an existing McDonald’s restaurant or starting your own burger joint from scratch? When you buy an existing business you get to see its track record. You can easily tell if the business is sound or not. Does the restaurant have consistent traffic of clients? Is the service good? Is the food good? When you start a restaurant, you start out with no client traffic. You must have a marketing and advertising plan. The survival of the new business is less certain than the existing one.
I always try to buy businesses that are profitable. The acquired business is already producing a nice stream of cash flow. This is much better than starting a business which would put you in a negative cash flow situation. Having cash flow gives you flexibility. You can allocate this cash to expand the business or to distribute to yourself. It also lowers your opportunity cost versus the startup. For example, let’s say an acquired business can generate $100K the first year versus a startup that would lose ($80K). If you could get a job paying $100K that acquired business covers your opportunity cost immediately. In the start-up scenario, you are not only giving up your potential $100K job but you also have to contribute $80K to fund the business losses. Hence, you would be losing ($180K). That’s why if you currently have a high salary (opportunity cost), it is less expensive to buy a business than starting one.
You are probably thinking that you’ll need money to buy the business. In a future post I’ll review how to obtain the money to buy a business. By the way, it is easier to finance an acquisition than a startup.
Please ask any question about this post in the comment section.
Have a great eclectic investing day!