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When Buying an Existing Business Is Less Expensive Than Starting One Up

When Buying an Existing Business is Less Expensive Than Starting One Up

When it is more cost effective to buy an existing business

Buying an existing business is often much less expensive than creating one from scratch.  We have lots of examples that show this is the case, however every business scenario is different. It’s important to know that one rule cannot fit all circumstances.

We want to debunk the popular myth that starting a business from scratch is the most cost effective way to go. On the SBA.gov website, for example, it states “Purchasing cost may be much higher than the cost of starting a new business,” but neglects to say that many times the opposite is true.

Three Scenarios to Demonstrate our Point

We have pulled data from one particular company (going unidentified for confidentiality reasons) and compared it from where the original owner started it up and then compared the same company’s financial performance after was sold. We used data from a startup franchise we worked with sometime back. Where we could, we took exact figures such as  the actual start up costs, the actual earnings, and the Seller’s Discretionary Earnings (SDE).

We used the likely selling price, herein set at 2.5 times the SDE, based on the multiples of several similar business sales. We used growth in profitability at 3% annually when we made assumptions of future years. Please note that this business continues to rise at a rate much higher than 3% and has never had a year where it earned less than a prior year. We kept things simple where we could to focus on illustrating the value in buying an existing business.

Scenario 1

In the first scenario, we assumed the Original Owner keeps the business for the first ten years following its startup. The Original Owner actually came to us when it was earning (SDE) about $85,000 but in the scenario below we made a calculation as if the Original Owner kept it for ten and then sold at 2.5 times the SDE of the tenth year. Its cash flow looks something like the cash flow in Figure A:

 Invest

  $          (250,000.00)

Year 1

  $            (82,000.00)

Year 2

  $            (39,000.00)

Year 3

  $              37,000.00

Year 4

  $              49,000.00

Year 5

  $              85,000.00

Year 6

  $              95,000.00

Year 7

  $            103,000.00

Year  8

  $            105,000.00

Year 9

  $            108,150.00

Year 10

  $            111,394.50

 Sold

  $            278,486.25

Figure A – Start Up, Keep 10 Years, Sell

We see the Original Owner spent about $250,000 to startup, and lost money the first two years.

Scenario 2

In the next scenario, we see that someone buys this same business just after the business earned (SDE) $85,000. The New Owner pays 2.5 times that SDE. The New Owner pays $212,500 in cash and begins making a profit immediately.

 

 Invest

  $   (212,500.00)

Year 1

  $        95,000.00

Year 2

  $        97,850.00

Year 3

  $      100,785.50

Year 4

  $      103,809.07

Year 5

  $      106,923.34

Year 6

  $      110,131.04

Year 7

  $      113,434.97

Year 8

  $      116,838.02

Year 9

  $      120,343.16

Year 10

  $      123,953.45

 Sold

  $      309,883.63

Figure B – New owner Acquires for All Cash and Sells in Year 10

Scenario 3

In the third case, we look at the New Owner buying for the same price and conditions as in Figure B, but the New Owner gets an SBA loan,  contributes only 20% down and finances the rest at 6% over ten years.

 

Invest

  $     (42,500.00)

Year 1

  $       79,816.76

Year 2

  $       82,666.76

Year 3

  $       85,602.26

Year 4

  $       88,625.83

Year 5

  $       91,740.10

Year 6

  $       94,947.80

Year  7

  $       98,251.73

Year 8

  $     101,654.78

Year 9

  $     105,159.92

Year 10

  $     108,770.21

 Sold

  $     309,883.63

Figure C – New Owner Gets an SBA Loan (Only 20% and 80% financing plus fees)

Note that the Selling Price for Figure B and Figure C are the same since when calculating the SDE, one adjusts for the interest and loan payment which goes away end of term and financing may or may not exist for the Next Buyer.

Scenario Comparison

Here is a summary, where the Net Present Value for each of the scenarios is calculated. Note that the Original Owner actually sold this existing business after the year she made $85,000. The following year the business netted $95,000. For all future years, we estimated at 3% increase. We also calculated the first 10 years as if the Original Owner had decided to keep the business for 10 years and then sell. We assumed the New Owner would keep the business for 10 years and then sell at 2.5 times SDE. We used an Annual Discount Rate of 12% for these calculations.

 

Figure A

Actual

Figure B

Figure C

Invest

 $ (250,000.00)

 $  (250,000.00)

$ (212,500.00)

 $ (42,500.00)

Year 1

 $   (82,000.00)

 $  (82,000.00)

 $  95,000.00

 $ 79,816.76

Year 2

 $   (39,000.00)

 $ (39,000.00)

 $ 97,850.00

 $ 82,666.76

Year 3

 $    37,000.00

 $  37,000.00

 $ 100,785.50

 $  85,602.26

Year 4

 $    49,000.00

 $  49,000.00

 $ 103,809.07

 $   88,625.83

Year 5

 $   85,000.00

 $  297,500.00

 $ 106,923.34

 $ 91,740.10

Year 6

 $   95,000.00

 $  110,131.04

 $  94,947.80

Year 7

 $  103,000.00

 $  113,434.97

 $  98,251.73

Year 8

 $ 105,000.00

 $  116,838.02

 $  101,654.78

Year 9

 $ 108,150.00

 $ 120,343.16

 $105,159.92

Year 10

 $ 111,394.50

 $ 123,953.45

 $ 108,770.21

Sold

 $ 278,486.25

 $ 309,883.63

 $  309,883.63

NPV

$53,063.50

($128,019.10)

$486,085.51

$570,296.83

Other Factors to Consider

There are many other factors to consider, including various replacement costs, questionable steady growth, and changes that come with new ownership (earnings can go up or down).

So when considering business ownership, consider the many benefits of acquiring an existing business. Many times the benefits of acquiring existing businesses out way the benefit of starting new ones.  Keep in mind that every business scenario is different, so do not try to apply one rule to every circumstance.

It is important to realize that while you can grow an existing business, you can also experience a decrease in sales. All businesses have a level of risk and past performance is no guarantee of future success. However, with an existing business, you have a pretty good idea about its past and present performance.  Both Figures B and C have better Net Present Values (NPV) than that experience by the Original Owner.

Consider your options carefully and speak with experienced advisers to get proper advice and perspective.

Lastly, never overpay for your business acquisition. Remember the Legacy Rule: “Buy based on potential, but pay based on performance”.

If you have further questions regarding buying an existing business, start ups, or franchises, please feel free to visit our website at www.BuyBizUSA.com or call 833-Buy-Biz1 (833-289-2491).

Thank you!

Brian A. Stephens, MBA, CBI