Ten Questions to Ask Before Buying a Small Business
Personal Lessons from a Side Hustle
Prior to becoming a venture capitalist in 2019, I had already been the owner of several brick and mortar businesses that I had acquired in the interest of generating semi-passive income and an outsized ROI compared to stocks, bonds, real estate, and other traditional forms of investment. I purchased three separate franchise locations of Elements Massage, a national chain of membership-based therapeutic massage services. Each location was already operational and owned by different individuals when I acquired them in 2017, 2018, and 2019, respectively. I have learned many lessons from this experience. As a result, I have often been asked questions about this from friends who have expressed a desire to either “be their own boss” or find opportunities to generate passive income through acquiring an existing business. Here are the top ten questions that I would advise anyone to think about as they consider the upsides and risks of pursuing such a goal. I will devote a separate future blog to the topic of owning a franchise business specifically.
What is your motivation for buying a business? Are you doing this because you are genuinely passionate about being a business owner, but don’t want to take the risk of starting something new? Is it because you see a great opportunity to buy and expand a specific existing business or invest into an emerging industry? Is it because you see an opportunity for ROI that you couldn’t achieve through other means? Or something else? This is going to be a significant endeavor and you should start by being honest with yourself about what is the goal and are you mentally prepared for the long-term personal and professional commitment that will be required.
Do you wish to be hands-on, semi-passive, or fully passive as an owner? It is critical to understand upfront what kind of business owner you will be. Do you wish to be a hands-on owner-operator? Do you prefer to work part-time and oversee only the most vital elements of the business operation? Or do you wish for this to be a completely passive income-generating activity? The latter sounds appealing, but it comes with risks that are likely greater than many other forms of “alternative investing” (i.e. investing outside of traditional stocks and bonds). All of these possibilities come with pros and cons that must be carefully considered. The more passive you are, the more you must be willing to delegate responsibility. This means potentially loss of operational decision-making power, as well as the added cost of hiring general managers.
What type of business best suits your interests and personality? Are you pursuing a business that you have a personal passion for? Have you identified a specific market opportunity? Will this business thrive under your leadership? It is generally helpful to enter a business in which you have prior experience as an operator or, at the very least, a customer or client. What kind of lifestyle will be required for you to operate this business and does that fit in your current stage of life? This question requires some very deep introspection if you are becoming a first-time business owner or are stepping into an industry in which you have minimal prior experience.
What kind of owner/manager are you? Are you planning to be a hands-on, “roll up your sleeves” type of owner? Do you enjoy managing day-to-day issues and solving problems as they arise? Most of the challenges that businesses face come down to “people issues” in one way or another. How do you feel about being a boss and can you manage the daily grind of balancing being both an inspirational leader and also maintaining discipline and standing firm when times require that? Can you also apply the same to your customers and suppliers, who may not always see the world as you do?
Will you be able to hire and retain the right quality and quantity of talent? Many first-time business owners are making a career switch, typically from a professional office-based role. It is very common for corporate managers to feel they are burned out by their office job and decide to become their own boss. However, as a business owner, you may very well face the task of hiring and managing staff who do not necessarily look or act like the type of people you’ve grown accustomed to having as coworkers. For example, many retail and service-based businesses are staffed by individuals with limited secondary education or perhaps vocational or technical skills in lieu of the college educated graduates who tend to populate most office jobs. This can lead to conflicts of personality and misunderstanding about expectations. Think hard about what you will do in such situations. As a dry run, you could think about becoming a salaried “manager” in the type of business you hope to enter before taking the vastly more significant leap in responsibility of becoming an owner.
Will you need to borrow money to acquire this business and are you willing to assume associated risks and liabilities? Let’s get real. Buying a business costs money. Even if you are buying an unprofitable business that requires work to turn it around, it is likely that you will be investing a significant amount of capital to get things going. Most private companies are sold at a multiple of between two and ten times trailing twelve month (or annualized “steady state”) income, which is often referred to as “owner’s (or seller’s) discretionary cash flow.” Do you have enough cash saved to finance this on your own? Do you plan to raise capital from partners or minority equity investors? If so, it is helpful to have a network of wealthy collaborators. For bigger businesses, search funds are an option to take the time to identify and acquire the right business. However, search funds are really only used in a tiny minority of cases and can be challenging for many individual investors to organize. The most common path to financing a business acquisition is through a bank loan. In many cases, a bank will only finance through an SBA (Small Business Administration) lending program (or its non-US equivalent), which offers them more protection than a conventional loan. You should expect that the SBA will require a lien on certain personal assets as well as personal guarantees on the loans (willing to risk your kid’s college fund?). These should not be taken lightly and they frankly do put an additional burden and risk on the decision to acquire certain entities. Note to politicians: seek new ways of getting around personal guarantee requirements and you will unleash a whole new wave of entrepreneurship among lower and middle income individuals!
Why is the seller exiting the business? As part of your due diligence, do you truly understand why the previous owner is exiting the business? As a first-time business buyer, be alert to the fact that the seller is likely motivated for reasons that they might not want to be fully transparent about. It is easy to sell a good story about wanting to move on to the next thing. However, there is often something lurking in the background. Is the business actually very stressful to manage? Are there macroeconomic conditions that may work against the trends of the industry? Perhaps there is new competition or disruptive innovation that is lurking. Or is there something more nefarious, like irregular bookkeeping that could be happening that might disguise the true financial picture of the business? If someone is clearly retiring and willing to support you in a transition (financially or through an extended period of training), that is usually a promising sign. If they are simply switching out for other reasons, it is worth asking what issues have you not yet uncovered that could make the business not as exciting to be in as it may appear on the surface.
Do you plan to expand your business, either organically or through further acquisitions? Will you be happy with maintaining a “steady as she goes” approach to reap the same level of income that the business currently generates? Or are you planning to expand the business, either vertically or horizontally, or find new opportunities to grow margins? It is essential to have a realistic idea of what you wish to accomplish and what it will take to get there. If additional financing will be required, consider your capacity for raising funds from investors or the tradeoffs that will be needed to obtain debt financing.
What are the “unknown unknowns” that might keep you up at night? In my own experience of owning franchise membership-based massage studios, there have been plenty of unexpected curveballs that I could not have predicted. These have ranged from employees exhibiting erratic behavior, to clients “raising hell” about perceived grievances, to competition moving in practically next door, to perhaps the most unexpected situation of a “once in a lifetime” flood that forced the closure and reconstruction of a studio in an area that was never considered to be a “flood zone.” It is best to use your imagination about all of the worst case scenarios that might occur and have a plan to know what you’re going to do and make sure you have a financial buffer to get through such situations.
Have you had an expert play devil’s advocate to talk you out of it? Given all of the risks, both personally and financially, to becoming a small business owner for the first time, it is worth consulting multiple experts in your target industry and in business acquisition and ownership generally. Have them play “devil’s advocate” as an exercise. In the Jewish religion, there is no effort made to convert others into the faith. In fact, the opposite is true. If someone wishes to convert, they must approach a rabbi who will try three times to convincingly talk this person out of conversion. It is a test meant to determine who is a true believer with the necessary commitment to see through what is a very non-trivial, life-altering decision. The same philosophy should apply when stepping into something of this magnitude.
I firmly believe that small business ownership, which is sometimes referred to as “entrepreneurship through acquisition (ETA),” can be incredibly empowering and is a wonderful way of mitigating many risks associated with startup new venture creation. It is helpful for a capitalist economy to have a marketplace of buyers and sellers for all types of business. The profiles of business acquirers is also broadening widely and ETA is becoming a meaningful option for expanding economic opportunities with diverse business leaders (listen to my podcast with Havell Rodrigues and Kris Schumacher from New Majority Capital for more on this specific aspect). I encourage anyone who is thinking of taking such a step toward financial independence to weigh the many factors that go into such a decision. However, this should always be done with open eyes as to both the upsides and the muddy terrain that may be faced along the way. There are tens of millions of small businesses thriving across the US and hundreds of millions globally. Is one of them right for you?