buying a business

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If you’ve ever been interested in working for yourself, or starting a small business, you’ve heard the statistic that most small businesses fail within the first 5 years. Why is that?

The most common reasons given are:

  1. Lack of experience
  2. Being under-capitalized (running out of money before you achieve profitability)
  3. Poor location
  4. Poor inventory management (Not having enough of an item, or having too much which may suck up all your capital)
  5. Poor money management (poorly structed business loans, co-mingling of finances)

But I think the most basic one is lack of any business sense whatsoever!

I went to get a smog check for my car registration and I called up several smog check test centers within a 10 mile radius. I got quotes that ranged from $37 to $70.  The fact that the highest quote was 89% higher than the lowest quote was quite interesting.

I decided that instead of driving 9.5 miles to pay $37, I could drive only 2 miles and pay $39.95. That’s a good compromise between time spent and money saved (especially in Los Angeles where it takes forever to get anywhere).  However, I decided to stop at the first one I saw and ask if they’d do a price match, especially since the store was completely devoid of any customers. I asked them how much it would cost and was quoted a price of $65. I told them the store down the street quoted me $40 and the manager said that he knew the owner of that place and they indeed offer a $40 price, but he could afford to offer that price because they did a higher volume and made money on repairs too.  The best he could offer was $55.

I tried arguing with him that they probably did higher volume precisely because the price was lower, and that his costs were fixed and the marginal cost of performing an additional smog check were significantly lower than $55 or $40 or even $20. When you consider that you have idle staff and idle machinery, the cost of running a machine for 20 minutes is just the cost of electricity which couldn’t have been more than a dollar. By price matching price-conscious customers, you’re engaging in a perfectly legal form of price-discrimination which allows you to attain your optimal profit levels. After wasting 3 minutes, I realized he wasn’t going to budge and he was perfectly happy to see me go 1/2 mile down the street to his competitor, which incidentally seemed to be running at 75% capacity.

So if you’ve ever wondered why some small businesses fail its because they’re run by incompetent morons who lack knowledge of finance, marketing, consumer behavior or sometimes just plain common sense.

A friend approached me over the weekend asking for advice on buying a Cold Stone Creamery.

We went over the numbers. They looked okay. The Seller was selling 5 of his stores for 1 times gross revenue [about 4 times net profit] or approximately $350-$400k each. He was willing to finance with only 20% down plus $20k franchise transfer fee which is a great way to get into it if you don’t have the money, or enough to qualify for an SBA loan.

The stores were located in good neighborhoods with 80,000+ people living in a 2 mile radius and in retail business centers doing over $1 billion worth of sales per year. The company requires a population of only 20,000 in a 2 mile radius and an average income of atleast $35k, but I don’t think these are enough to sustain the business. You want a LOT of people stopping by the store and they shouldn’t be too rich. Rich people live in population spare neighborhoods, have fewer children and are less likely to walk to the icecream store every night in summer since they’re out travelling the world. They’re kids are also less likely to work for $7 per hour so finding cheap manpower might be tough.

Apparently the seller claimed he was selling the stores because his brother was supposed to be doing the marketing and wasn’t pulling his weight. So he was getting rid of them. He said that there was minimal supervision required by the owners and it was ideal for absentee owners. I find that a little hard to belive that someone would sell 5 stores pulling approximately $100k each that required minimal supervision. Doesn’t matter how rich you are, $500k/yr is always a good chunk of change. I warned my friend that it could turn into a 2nd job that he wouldn’t be able to quit.

I advised calling up the Area Development Managers and asking them to have existing owners talk to them. They’re usually pretty honest about the requirements and efforts required to keep the stores operating successfully.

followup:

I kind of got interested in the deal and thought about partnering with my friend on it.

I had my CPA look at the numbers. Since I’ve referred him a ton of business and got him in some good investments, he doesn’t charge for this kind of stuff. He looked at the financials and said 2 things.

  1. Don’t pay more than 2.5 to 3 times the net income.
  2. He’s not making the $100k per store that he’s telling you.

So I passed on the deal. My friend was still interested and he got a potential partner who’s already in the business but was outside the area. But as soon as he found out who the seller was he said that guy’s a crook and bailed. So we both ended up bailing on it.

Doesn’t matter what franchise you’re buying, always show the financials to a competent CPA and try find out the background of the seller.

If you’d like to see listings of various retail businesses for sale, be sure to check out my business & investment store.

Update: As it so happened, after I posted this, a couple from Hawaii contacted me and told me how they had gotten fleeced by a seller of a Cold Stone Creamery. They over-paid for it based on fraudulent numbers and had both bought themselves low-paying jobs (minimum wage for 11 hours a day) that they couldn’t quit.


related post:

What To Look At When Buying A Dry Clearer Business