Module 13 Alternatives to Starting a Business PDF

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MODULE 13 ALTERNATIVES TO STARTING A BUSINESS

INTRODUCTION and LEARNING OBJECTIVES To this point the discussion has focused on starting a business from scratch. Buying an existing business and franchising are two alternatives to starting from scratch. This module outlines both options and discusses the advantages and disadvantages of each. Franchising also represents a potential growth or expansion strategy and the module outlines the pros and cons of this strategy from the franchisor’s perspective. On completion of this module students should: 1. Recognize that buying an existing business and franchising may be appropriate alternatives to business start-up; 2. Understand the advantages and disadvantages of buying an existing business; 3. Identify issues and opportunities related to buying a business; 4. Understand the importance of conducting due diligence; 5. Be aware of the advantages and disadvantages of getting started in business as a franchisee; and 6. Recognize the advantages and disadvantages of franchising as a growth strategy; and 7. Be able to compare and to assess various alternatives to starting a business and make appropriate recommendations with supporting rationale.

SUGGESTED READINGS Buying a Business Buying a Business: The Safer Alternative http://entrepreneurs.about.com/od/buyingabusiness/a/buyingabusiness.htm How to Buy a Business http://www.entrepreneur.com/startingabusiness/startupbasics/article79638.html Twelve Laws of the Business Buying and Selling Jungle http://entrepreneurs.about.com/gi/o.htm? zi=1/XJ&zTi=1&sdn=entrepreneurs&cdn=money&tm=15&gps=174_358_1008_508&f= 00&tt=14&bt=1&bts=1&zu=http %3A//www.businessbookpress.com/articles/article148.htm How to Negotiate When Buying a Business http://www.inc.com/guides/201101/how-to-negotiate-when-buying-a-business.html

Franchising (Franchisee Perspective) Pros & Cons of Buying a Franchise http://sbinformation.about.com/cs/bestpractices/a/aa011203a.htm 10 Common Mistakes of Prospective Franchisees http://www.inc.com/articles/2000/01/14880.html Franchising (Franchisor Perspective) The Advantages of Franchising for Franchisors http://www.ehow.com/list_6403169_advantages-franchisingfranchisors.html Surviving as a New Franchisor http://www.allbusiness.com/franchises/franchising-yourbusiness/13815327-1.html

BUYING A BUSINESS As discussed throughout the course there are significant challenges and risks associated with starting a business from scratch. Failure rates can be extraordinarily high depending on the type of venture, with estimates ranging as high as 80-90% in the first five years. In addition, it is anticipated there will be a large number of businesses for sale over the next three to five years as many entrepreneurs struggle with the challenge of identifying appropriate successors. As a result, buying an existing business represents an alternative to starting your own business. As with other entry strategies there are advantages and disadvantages to buying an existing business as follows. Potential Advantages of Buying a Business 1. Reduced start-up risk – established businesses have overcome many of the obstacles faced by new start-ups and as a result risks to the buyer may be significantly reduced, especially if proper due diligence is conducted on the condition of the business. 2. Shorter time to break even – assuming the venture is in good financial condition, buying offers the distinct advantage of reaching break-even and potential profitability in a shorter period of time. 3. Elimination of a competitor – buying an existing business eliminates one competitor, especially if the alternative is to start a new one in the same industry. 4. Established customers – one of the major challenges faced by a new venture is building clientele. An existing business offers the advantage of an existing customer base, hopefully one that includes repeat customers. 5. Established suppliers – similar to the customer perspective an existing business has established suppliers, thereby mitigating the challenges associated with building credibility and relationships. 6. Existing name and reputation – closely related to established customers, an existing business has developed a positive reputation, again contributing to successful operations. 7. Buying employees – finding qualified and experienced employees is a significant challenge facing most businesses; an existing business addresses this need. 8. Location – depending on the nature of the business, location can be a critical success factor. As with the elimination of a competitor, buying an existing business affords the opportunity to acquire an established, productive location. 9. Easier to finance – many of the challenges outlined previously associated with access to finance are addressed by the existing business since it has established relationships with financial institutions. Potential Disadvantages of Buying a Business 1. Old equipment and building – tangible physical assets deteriorate over time. As a result, there is the risk that fixed assets may be in need of repair and/or replacement.

2. Obsolete inventory – as with fixed assets, inventory may be potentially outdated and not in saleable condition. 3. Overstated accounts receivable – as with fixed assets and inventory, it is incumbent on the buyer to scrutinize the firm’s accounts receivable to ensure they are current and fully collectible. 4. Difficult price negotiations - buying a business is not unlike making any major purchase. The process involves one of negotiation and the buyer and seller often have very different views of the value of the business, which can potentially result in conflict. 5. Buying goodwill increases initial capital needs – goodwill essentially represents the value of the purchase price that exceeds the value of the physical, tangible assets. This premium or goodwill must be financed just as the other assets must be financed. 6. Difficult to find – notwithstanding the predictions of increased business opportunities for sale in the near future, if the entrepreneur has identified a particular opportunity to start a business, the same type of venture may not be for sale at the moment. 7. May be in poor financial health – one of the most important aspects of conducting due diligence on the business being offered for sale is to determine why the owner wants to sell. It could be because the owner wants to retire and has no one to succeed her or him. Or it could be because the business is in poor financial condition and facing potential closure. Issues to Consider When Buying a Business While buying a business offers may advantages and can help overcome many obstacles associated with starting a business from scratch, it should not be viewed as a shortcut to success. It is still necessary to engage in self-assessment to determine if this is the right business for you. Similarly, it is important to examine industry structure and to determine sustainable competitive advantage. As has been noted already, buying a business involves a process of negotiation. It is essential to recognize the potentially divergent goals of the buyer and seller; at the same time being prepared to negotiate in good faith and with the objective of reaching mutual agreement. From the buyer’s perspective, the importance of conducting due diligence cannot be overestimated. The importance of due diligence to establishing the condition of buildings, equipment, inventory and accounts receivable has already been pointed out. However, there are other areas where it is essential to investigate business circumstances, such as employee morale, customer reputation, any existing legal disputes, lease terms, and the commitment of management. The latter can be an extremely important dimension of transitioning to the new owners. Does existing management have the right skill set and will they stay and work with the new owners. In a similar light, is the seller willing to stay involved to assist in the transition process? Further, due diligence should also focus on determining the real reason why the business is for sale. As noted previously, there are legitimate reasons that don’t negatively impact on the success of the venture. On the other hand, the owner may be selling because the

business is in financial difficulty. The buyer needs to recognize this. Remember, while it is useful for the buyer to picture the venture in the future under new leadership, you don’t want to pay the seller for anything other than past results. There are also a number of issues around valuation and approaches to buy-out that deserve consideration. First, as indicated previously, value is not an “absolute”; it is a negotiated outcome that should reflect a variety of approaches to estimating the worth of the business, including asset-based and earnings-based valuations. Second, the buyer needs to decide what s/he is purchasing, shares or assets. Buying shares means buying the whole package, assets and liabilities. On the other hand, buying assets allows the purchaser to be more selective, buying only those assets of interest. Third, approaches to buy-out can range from immediate cash payment to a negotiated pay-out over time. A leveraged buy-out refers to the unique situation where the business is determined to have undervalued assets and the purchaser borrows against those assets using the cash flow from the business to make the payments on the debt. Finally, the possibility of retaining the present owner(s) is one that may be an attractive option to the buyer and deserves consideration, particularly when combined with the seller helping to finance the purchase. As mentioned previously, involving the present owners can help with the transition to the new owners, providing valuable introductions to key customers and suppliers. If payment occurs over time (and especially if the seller has helped to finance the purchase this way), they will continue to have a keen interest in the future success of the business. FRANCHISING According to the Canadian Franchise Association (www.cfa.ca) “franchising is a business relationship where a franchisor (a company or individual who owns the franchise system) grants a licence to a franchisee (a company or person who contracts to use the franchise system) the right to use the franchisors trademark, brand and operating system for an initial fee (initial franchise fee). In return the franchisee provides a share of the income back to the franchisor (a royalty). The licence is contractual and is usually for a fixed period of time, often five, 10, or 20 years. The franchisor selects candidates to become strategic-partners in implementing the business plan and selling products and services to the franchisor's customers using the proven franchisors business model and/or their proprietary products.” The most prevalent type of franchise is known as a “format” franchise, whereby the franchisee operates according to a proven business format (method of operating) provided by the franchisor. The franchise agreement is usually very restrictive, requiring the franchisee to follow established rules and regulations governing everything from hours of operation, to product and service offerings, store location and layout, to just about every aspect of business operations. As a result, franchising has often been referred to as entrepreneurship for people who are not particularly entrepreneurial. The sample franchise agreement below includes typical contents and questions/issues that need to be resolved.

Franchise Agreement Sample Contents

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Issue

Questions to Resolve

Franchise fee Royalties Quality control Advertising Offerings Equipment Location Operations Reporting Disputes Termination

Amount? One time? Per unit? Amount? Percent of net or gross? Sliding scale? Quality specs? Monitoring? Rewards? Sanctions? Fee? Local budget? National? Intensity? Messages? Product line? Product mix? Requirements? Alternatives? Required? Additional? Financing? Site selection? Franchisor aid? Financing? Signs? Hours? Maintenance? Décor? HR policies? Types? Frequency? Auditing? Sanctions? Resolution methods? Equity of resolution process? Timing? Causes? Sanctions? Recourse?

According to Franchise Canada, the franchise industry in Canada represents over $100 billion in sales annually and continues to grow. Statistics provided by Franchise Canada (http://www.franchiseek.com/Canada/Franchise_Canada_Statistics.htm) further indicate the impact of franchising on the Canadian economy as follows:  Approximately 1 out of 5 consumer dollars are spent on good and services at a franchise;  Approximately 76,000 individual franchise operations do business in Canada under 900 different brand names;  Franchising employs over 1 million people in Canada or 1 out of every 14 working Canadians is employed by a franchise;  A Canadian franchise opens every 2 hours 365 days a year;  Average franchise fee: $23,000;  Average franchisee investment: $160,000;  Although the hospitality industry continues to be the largest single sector, comprising almost 40 per cent of franchised brand names, the franchise industry is active in over 30 business, service and retail sectors;  Franchising is the preferred Canadian small business expansion model; and  Of all the franchises opened in Canada within the last 5 years, 86% are under the same ownership and 97% are still in business. As with buying a business, starting a business under the franchise method offers both potential advantages and disadvantages as follows. Potential Advantages to the Franchisee 1. Buying a name/reputation – established franchises offer the distinct advantage of a proven name and reputation, significantly reducing the time required to build a customer base.

2. Established markets – closely related to the first point, the franchisee benefits from access to markets that have been developed through the combined efforts of the franchise network. 3. Technical/management expertise – can be extremely beneficial to those who have limited experience. 4. Standardized procedures – developed by the franchisor ensure consistency in the delivery of products and services by the franchisees. 5. Quality standards – developed by the franchisor also ensure high quality products and services, thereby maintaining the credibility of the franchise network. 6. Selection of location and facility design – choosing the right location can be of critical importance to the success of some businesses and the franchisor has developed significant expertise with both site selection and layout that is provided to franchisees. 7. Quicker cash flow – the combined result of established customers, proven products/services, standardized operating procedures, and franchisor support is a reduction in risk and an increased likelihood of success. Potential Disadvantages to the Franchisee 1. Loss of independence – as noted previously, the franchise agreement dictates how the franchisee has to operate. As a result, entrepreneurial and managerial freedom is significantly reduced. 2. High initial fees – the initial fee for a well known, well established franchise can be quite high, thereby contributing to increased investment and financing on the part of the franchisee. 3. High royalties and advertising allowances – reduce the share of profits that flow to the franchisee. 4. Contractual restrictions – as noted the franchise agreement can be very restrictive for example dictating sources of supply, operating territory, renewal provisions and general operating procedures. 5. Inapplicable advertising – franchisees contribute o an advertising pool that is used to the benefit of the network. In some cases, the advertising methods may not be appropriate to a particular geographic region. 6. Termination clauses – as with contractual restrictions, termination clauses frequently favour the franchisor. 7. Not receiving promised help – one of the potential benefits is the technical and managerial assistance provided by the franchisor. Unfortunately, in a few cases franchisors have not delivered assistance as indicated. 8. Unsuitable products – franchisors determine the product/service mix and in some cases new products are introduced that are not appropriate to all markets. 9. Lack of competitive advantage – the combined offerings of the franchisor should translate into competitive advantage to franchisees. Failure to deliver across the full range of services governed by the franchise agreement can diminish expected competitive advantage.

Issues to Consider When Buying a Franchise As with buying a business, franchising should not be viewed as a shortcut to starting a business. Potential franchisees need to engage in the full due diligence process beginning with the usual self-assessment to determine if the franchise opportunity is the right fit for them. Similarly, there is no substitute for conducting standard industry and competitive analyses. In addition, the due diligence process should include an investigation of the franchisor and their disclosure and offering documents. Discussions with existing franchisees and retaining legal counsel are highly recommended. From the franchisee’s perspective there are a number of things to look for as follows:         

Proven operating locations Credible top management Skilled field support staff Established trade identity A proprietary operations manual Effective training programs Plans for advertising, marketing, PR and promotion A communication system Sufficient capital The Franchisor’s Perspective

At the outset of this module, it was noted that franchising also represents a potential growth or expansion strategy. In fact, Franchise Canada indicates franchising is the preferred Canadian small business expansion model. The following potential advantages to the franchisor explain in part why many small businesses use franchising as a growth strategy. Potential Advantages to the Franchisor 1. Faster growth - franchising enables faster growth than would otherwise be possible. 2. Lower capital requirements - franchising provides financing to support growth, thus reducing capital requirements. 3. Motivation – utilizing independent owners as franchisees increases motivation compared to employing company managers. 4. Control – the franchise agreement ensures considerable control over locations. 5. Revenue stream – fees from initial payments and royalties provide sources of revenue. There are also potential disadvantages to the franchisor as follows: 1. Reduced control – notwithstanding the franchise agreement, participation by franchisees can reduce franchisor control. 2. Profit sharing – profits are shared with franchisees through royalty payments.

3. Operating support – the franchisor must provide a greater commitment to operational support as required by the terms of the franchise agreement. 4. Problem franchisees – not surprisingly there will be some franchisees that are difficult to deal with, potentially resulting in conflict and strained relationships with the franchisor. SUMMARY This module has outlined two alternatives to starting a business from scratch – buying a business and franchising. Both options have advantages and disadvantages. Both also give rise to issues that need to be addressed by entrepreneurs considering these strategies. In particular, entrepreneurs need to assess personal fit, industry structure, and competition just as for starting a business. Similarly, the entrepreneur must engage in due diligence in both cases to minimize the risks and to maximize the likelihood of success. Finally, it was noted that franchising is a proven, and in many cases, chosen method of expansion for small firms. As a result, it is important to consider franchising from the franchisor’s perspective and to assess its appropriateness as a growth strategy....