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STREET SMARTS

Caveat Emptor

CEO Brodsky explains why it's riskier for a first-time entrepreneur to purchase an existing business than it is to build one from the ground up.

Norm Brodsky is a veteran entrepreneur.

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Street Smarts

As risky as it is to start a business, buying somebody else's is even riskier. Even if you're careful, it's all too easy to get sucked into a bad deal

A lot of people will tell you that you're better off buying a business than starting one from scratch. They say you can reduce your risk, save money, and achieve your goals faster if you take over a company that's already up and running.

Don't believe it. For most first-time entrepreneurs--especially those who've never run a company before--the chances of surviving are much greater if you build the business yourself, from the ground up.

Why? There are a number of reasons. For one thing, it's harder to learn a business if you haven't been with it from the start. You miss out on all the trial-and-error education that happens in the early stages. You don't understand key relationships in the business. You don't know what to do in emergencies. You make mistakes that are much costlier than they would have been back when the company was smaller and struggling to get off the ground.

No matter how fast you learn, moreover, you're likely to find that the challenges are greater than you bargained for when you bought the business. Listen, acquisitions are very tricky. You can do as much due diligence as you please, and you still won't know exactly what you're getting until you've already paid for it--at which point it's usually too late to go back. Even experienced businesspeople often get burned. As for inexperienced buyers, they're usually at the mercy of the seller, or the seller's representative, or the business broker (if there is one), all of whom have one thing in mind: getting the deal done. If you're not careful, you could easily wind up buying a pig in a poke.

That's what almost happened to Josh, a young fellow in his early thirties who sent me an E-mail after reading one of my columns. He said he was getting ready to buy his first business, and he needed my help. He had a meeting scheduled in a few days at which he was supposed to sign some papers and put down a $100,000 deposit on the business, 60% of it nonrefundable. His father, a Canadian business owner, thought he was making a mistake but said Josh could go ahead if he got someone with more experience to sign off on the deal. Josh wondered if I'd be willing to look it over and give him my opinion. I agreed.

It turned out that the company he wanted to buy was a small packager of herbal lotions, which it sold through independent sales representatives to specialty stores and chains. The current owner had been running the company out of her home. She'd been in business three or four years and had done fairly well, or so it appeared from her financial statements. Now she was pregnant and wanted to cash out. She was asking for $250,000.

The company seemed to be just what Josh was looking for. It was in his price range. It had plenty of growth potential. And although it was still fairly new, it was already turning a good profit. According to the financial statements he'd received, the business had generated pretax earnings of $40,000 on sales of $201,000 in 1997--a return of almost 20%. That was a significant improvement over 1996, when the company had earned $17,000 on sales of $175,000. In 1995 it had lost $10,000 on $79,000 in sales.

So the numbers were moving in the right direction. Josh figured he could maintain the momentum and build a substantial business of his own--something he'd dreamed about doing for years. He could hardly wait to get started. He sent me copies of all the material the seller had given him and, a couple of days later, showed up at my office with a draft of a confidentiality agreement he'd received from the seller's lawyer. He said he had an appointment to sign the agreement--and pay the deposit--the next morning.

I told him to call the lawyer and cancel the meeting.

"What do you mean?" he said. "They want to move fast. They have another buyer in the wings."

I said, "Josh, you're not ready to sign anything. Tell the lawyer you'll get back to him in 48 hours."

The problem was that he didn't have nearly enough information to answer the most basic question in any acquisition, namely, what are you buying? He thought he was buying a company with a good product line. But there was no way to tell how good the product line really was--or whether the price was even in the ballpark--because he didn't have any information about what was happening in the market.

He didn't know, for example, who the top 10 customers were or what percentage of sales each of them accounted for. He didn't know how their purchases changed from year to year. Were the same customers coming back, or did the company have to keep finding new customers to replace the ones who left? Did one or two customers account for a disproportionately large percentage of sales, and if so, why?

And what was going on with the sales representatives? The company was supposedly paying them each a 15% commission on sales. So why did total commissions amount to 15% of sales in 1995, 12% in 1996, and 7% in 1997? Were sales reps leaving, turning their customers into "house accounts," or was there some other explanation? How many reps did the company have, anyway? How much business did each of them bring in, and how much were the biggest producers earning?

That was only the beginning, of course. There were dozens of other questions Josh would have to get answered before making a commitment to buy the company. But I didn't see any point in going forward until we at least got a breakdown of sales by customer and by sales representative for the past two or three years. Those numbers would show us whether or not the company did, in fact, have a product line that customers wanted to buy and sales reps wanted to sell. Without that information, it wasn't worth it for Josh to spend time investigating a possible deal, let alone hand over his money.

Josh contacted the company's owner, requesting the additional information. She responded that she wouldn't give him the names of her customers and sales representatives without a signed agreement. I told him, "Fine. She can label the customers 1, 2, 3, 4, and the sales reps A, B, C, D, but you need to see those numbers before signing anything."

I also advised him to insist that the agreement be amended so that his deposit would be completely refundable at his whim within three weeks. Why shouldn't he be free to change his mind for any reason, as long as he acted expeditiously? The lawyer agreed and redrew the papers, but as it turned out, the change was unnecessary.

A few days later Josh received the additional information he'd asked for. It painted quite a different picture of the company. For one thing, only 15% of its customers, representing about 30% of its sales, were returning from year to year. In other words, Josh would have to replace 85% of the customers, and 70% of the sales, just to stay even. What's more, he'd have to do it with a new sales force: the company was turning over sales representatives at a rate of more than 50% a year.

It was hard to see what Josh would gain by acquiring the company. The products couldn't be all that great, or more customers would be reordering them. An established name? It couldn't be very strong. A dedicated sales force? He was going to have to build one anyway. As for the formulas he might need to get started, he could hire a laboratory to come up with some for a lot less than $250,000. The truth was, if he really wanted an herbal-lotions company, it made more sense for him to start his own.

In the end, Josh decided he'd had his fill of herbal lotions. He told the seller he wasn't interested in pursuing the deal. He wasn't happy about letting it go, but he couldn't argue with the numbers.

So now he's searching for another business to buy. I'll probably advise him on that deal as well. Maybe one of these days he'll take my advice and begin looking for a business to start.

Norm Brodsky is a veteran entrepreneur whose six businesses include a former Inc. 100 company and a three-time Inc. 500 company. This column was coauthored by Bo Burlingham.

Last updated: Aug 1, 1998

NORM BRODSKY | Columnist

Street Smarts columnist and senior contributing editor Norm Brodsky is a veteran entrepreneur who has founded and expanded six businesses.

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.



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