Finance & Grow Your New Business. Angie Mohr
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solutions to both businesses and residences. Craig hadn’t given much thought to the concept until now, but suddenly realized the benefits to both business owners and homeowners.
The next morning (several hours after the lights came back on), Craig called Green Power Inc. to find out more information. Craig met with the owner that afternoon and, two weeks later, Craig was presented with an offer to buy into a new offshoot of Green Power Inc. aimed at the residential market. Craig would have a 50 percent ownership stake in the new business with Gordon, the current owner of Green Power. Craig’s responsibilities would be those of the general manager; he would run the day-to-day operations and would head up all strategic and operational planning. For this, he would be paid a salary of $67,000 plus would receive dividends as an owner of the company.
Craig spent the following week with his accountant, analyzing the offer and the potential return. He compared it to the cost of starting up his own alternative energy company and determined that the cost of starting from scratch would outweigh the additional profit from owning the entire business. He would not only have to invest in all of the marketing materials, but he would have to develop the necessary expertise in alternative energy. Craig’s best opportunity would be to buy into the new offshoot of the existing company.
You will most likely open your doors before you take in the first dollar in revenues, and you will take the enormous leap of faith that customers will actually want what you are selling the way you had it laid out in the plan.
It sounds scary but designing and building the business that exists in your head can be an extremely fulfilling and gratifying experience. So much so, that many successful entrepreneurs design and build businesses, then sell them once they’re up and running. Then they start all over again and build another one.
Here are some of the pros of building a business from scratch:
• You can design internal systems the way you want them to work right from the beginning.
• It can be less expensive than buying an existing operation.
• There is no risk of acquiring the previous owners’ liabilities or having to satisfy pre-existing warranties.
• You can manage staffing needs more carefully (i.e., you don’t inherit employees that are sub-par and/or difficult to fire).
There are some cons to building a business from scratch:
• It can be more difficult and expensive to attract investors. Because the venture doesn’t exist yet, it will be riskier for them.
• It can take longer to generate profits than with an existing business.
• It can take a long time to build name recognition and goodwill with customers.
• There is a much greater risk of failure than with a business that has a proven track record.
Buying an Existing Business
Buying an existing business is, in general, less of a risk for you as the major investor. You have the opportunity to watch the business in action and you will be able to access the historical financial information to determine patterns such as growth rate, profitability, and solvency. You know that you will be able to generate a return on your investment almost immediately as well as be remunerated for your management role in the business (and perhaps also your operational role).
You may also choose to buy a business if you want to quickly introduce a new product to an existing customer base before there are too many competitors in the market. For example, if you have developed a brand new print-on-demand self-serve book station, you may want to have instant access to a thriving bookstore’s customers before copycats come on the market.
Here are some of the pros of buying an existing business:
• It can be easier to obtain external financing than if you build a business from scratch because the business has a track record.
• You can market your existing products to a new customer base.
• It is easier to manage an existing business model and fine-tune it than build it from the ground up.
• You can generate profits right from the purchase date.
• You can continue the business with the existing goodwill and name recognition.
There are some cons to buying an existing business:
• You may be inheriting the hidden headaches of the previous owner.
• You may be inheriting “negative goodwill” if the business had a bad name in the community.
• It may take as long to reshape the business the way you want it as it would to have started a new business from scratch.
• The customers you are “buying” may have only been loyal to the former owner and may choose not to stay on as customers when you take over.
Financial Considerations in the Build-versus-Buy Decision
Once you have taken into consideration your personal goals and your tolerance of risk, the decision to buy versus build a business comes down to a financial one. There are many ways to analyze a purchase decision, but we will look at the most common: the discounted cash flow method.
Discounted cash flow analysis (DCF) helps us to look at a purchase decision and figure out at what point our cash inflows (revenue) match and then exceed our cash outflows (operating and financing costs). DCF takes into consideration the important fact that the timing of the inflows and outflows of cash are different. A dollar received three years from now is worth less than a dollar that we have to spend today. This is called the time value of money and is the basis of DCF analysis. For more information on cash flows, please refer to Financial Management 101, the second book in the Numbers 101 for Small Business series.
Let’s look at an example to see DCF in action:
You have been offered the opportunity to purchase a sign-making company for $225,000. You have already talked to your bank manager and she is willing to finance $175,000 but you will have to use $50,000 of your own savings to finance the rest. You have been thinking about starting up a similar type of company for some time and you want to compare the cash flows of purchasing an existing business versus building one from scratch.
Considering a start-up business
You have put together a cash flow projection for the proposed start-up company. The five-year cash flow projection is shown in Sample 1.
Sample 1: Cash Flow Projection for a Start-Up Business
In this start-up company, you would be investing $50,000 of your own money in order to finance the start-up costs of $18,860 and the cash shortfalls in years one and two ($17,060 and $7,250 respectively). By year three, the company is projected to have a cash surplus, which grows annually up to year five.
You can see that before you even open the doors, you will have to invest $18,860 into the company. Most of that money goes towards buying the sign-making equipment and inventory. Further investments in equipment will have to be made every year as the company starts increasing sales.
How can we evaluate whether or not this option would be a sound investment? There are many methods of decision analysis. The method we’ll consider here is to look at discounted cash flows. This method allows us to come up with an annualized return on investment. Remember that you will invest $50,000 into this venture. You could have taken that $50,000 and put it in the stock market or invested it in bonds. Both of those activities would have generated a return. In the same manner, we can look at the return from this start-up business.
The annualized return on investment is simply the