The following article was written by Tuck Aikin, a former colleague of mine, several decades ago, but it is as true today as it was then. I hope you enjoy it.
It’s probably not surprising that the continuing flow of local layoffs has resulted in a spurt of interest by those who have lost their jobs in buying an existing small business. We’re not talking about the recently reported $1 million SBA loan types of businesses here, but small businesses that would require $20,000 to $40,000 “down” (equity) and prospectively offer an annual income of $35,000 to $45,000 or higher for the new owner/operator.
It’s also understandable that in considering such a purchase, the prospective buyer’s primary motivation is often to be “in control” of his or her destiny rather than be subject to the inevitable economic fluctuations that are characteristic of a market-driven economy. Nonetheless, it would be wise for a prospective buyer to proceed cautiously before taking on such a challenge. Business ownership for the inexperienced involves much greater financial and personal risk than is usually appreciated. Further, there are at least three more important criteria that should be met to justify buying an existing business, such as prospects for growth, profitability (return on investment), and income replacement.
Growth
We’ve often heard prospective buyers say that they don’t care about building the business into a bigger operation; they just want a steady, predictable income that delivers a modest standard of living. Unfortunately, businesses rarely exist in a static environment. Markets expand and contract constantly and are usually driven by competition and innovation. To disregard opportunities for growth, then, means to allow a competitor to fill the need, a dangerous stance to take that can lead to failure.
Normally, business growth is necessary just for survival, and to grow means to take on more risk, more work, and most likely more debt! With that much energy going into the enterprise, then, why settle for mediocrity? Besides, if your business isn’t taking advantage of growth opportunities, its value is substantially diminished, which will make it much more difficult to sell and consequently allow you to retrieve your investment.
Small businesses, too, usually don’t provide retirement benefits, so the only way to achieve financial independence at or before retirement is to sell your business for a price that, after taxes, will achieve that goal. If you are going to buy, then make sure there are prospects for growth.
Return on Investment
Another criterion that should be satisfied is that the purchased business should offer a realistic opportunity to earn a return on the money you and any partners have invested. This means cash invested, not borrowed money. Because such investment is, in essence, “sunk capital,” that is, can’t be withdrawn until the company is sold, a high rate of return is usually required.
A common standard under such conditions is usually 20%. So, if $100,000 is invested in the business, it should earn a $20,000 minimum profitability each year of operation. And don’t forget, profitability does not include the salary the business pays you for your work, as long as that salary is set the same as that which the business would need to pay a non-owner to do your work. Such a salary, incidentally, is the final important criterion that should be met before buying the small business offered for sale. If the business is unlikely to be able to pay you adequately for the work you perform or someone else you might hire to run the business, then you should consider another candidate business.
Income Replacement – Salary/Wages
In the final analysis, then, if the business you’re considering buying can’t meet all three of these criteria – growth, return on investment, appropriate salary – give it the boot and follow the reverse of the Nike ad: “Just don’t do it!”.
Tuck Aikin was a former SCORE colleague of mine for many years until his retirement. Tuck is a prolific writer and wrote small business-themed articles for the Colorado Springs Gazette for many years. As a co-mentor, Tuck was my inspiration for me starting this blog. The preceding post is reproduced with permission from the author.
