****Evaluating Business Models When Buying a Business

Tips for Buying a Business

Evaluting Business Models When Buying a Business
Buying a business? Of all the things to consider when buying a business, a thorough evaluation of the business model is the most important consideration.

When buying an existing business, it's important to thoroughly evaluate the business model.
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In essence, when evaluating a business model, you must ask three questions:

• How does the company I am about to buy currently make money?
• Can I continue to make money after I buy this business using the existing business model?
• Is there something I can do to change the business model to greatly improve the potential of this business?

How Does the Business Model Make Money?

At first blush, this question would not seem to be very illuminating:

How does a Subway franchise make money? Well, they sell sandwiches. Duh.
How does a local drycleaning business make money? They take in clothes, dry clean them, and get paid to do that. Duh.
How does a PR firm make money? They get clients to pay them money to get media placements. Duh.
How does a website development firm make money? They build websites and get paid to do so? Duh.
How does a lawn mowing service make money? They mow lawns and get paid to do so. Duh.
How does a telecomm value-added reseller make money? They sell businesses T1 lines and other telecomm services and get paid to do so. Duh.

To evaluate the business model, you have to ask probing questions that take the discussion up a notch. Here are a few sample questions to ask when evaluating a business to buy and that company's business model:

Is the business dependent on individual talent or can it still do well even when existing employees are replaced with new employees? In the case of a Subway franchise, the business is systematized and existing employees can be replaced. However, in the case of the PR firm, the customers may have been buying the skills and relationship of a single individual. If that individual is not there, the business model may not perform as well.

Is their repeat business and a recurring revenue stream? A lawn mowing service can sign up clients for an entire summer, and have repeat revenues from customers every week. In contrast, a website development company might only be earning money while working on a specific project. In that respect, the website company is like a taxi driver. No fare, no income. A telecomm value-added reseller locks into a growing recurring revenue stream because they are typically compensated by the provider (e.g. MCI, Sprint, etc.) as long as their client keeps the service. Hence, in the fifth year of business, they are still earning revenues from companies they signed up five years ago, four years ago, etc.

Is the value proposition unique and can a competitor steal the business away? A dry cleaner could lose a lot of business if a comparable business opened up across the street and offered the same services at half the price. The key to a strong business model is some sort of unique positioning that cannot be easily replicated by competitors.


Can I Continue to Make Money With the Current Business Model?

Just because the current owner is making money with the existing business model, doesn't mean you will be able to continue to make the same amount of money in the future.

In the case of the PR firm mentioned above, will those existing clients all stick with you? Will you be able to service clients well? Will you be able to attract new clients? The answers to these questions have a direct impact on how your business model will do for you.

At the end of the day, business models are not abstractions. They are personalized entities that succeed or fail. One person may do very well with a given business model, while another fails miserably.

So don't ask: is this a good business model? Instead, ask: Can I make money with this business model?

Can the Business Model Be Improved Upon?

This is where the real money is made.

If you simply plan on buying the existing business model and running it as is, then you will, in most instances, have to pay a price commensurate with what the business m model will generate.

However, if you can change the business model in a way that improves it, you can transform the price you paid for buying a business into a much higher value.

For example, maybe you buy the lawn service and transform it into a lawn service and landscaping company that also shovels sidewalks and driveways in the winter. You get a bigger share of your customer's wallet and you are well-positioned to grow the business because you have improved the value proposition.

Maybe, you buy the website development company and convert the model from a one-time contract business to a business that has upfront contracts but also has ongoing maintenance contracts. By doing so, you lock into recurring and predictable revenue streams that the previous owner never had.

You get the idea. When buying a business from an existing business owner, you need to look for the opportunities that the previous owner was never able to capitalize on.

Those subtle shifts in the business model are what can allow you to make buying an existing business the best decision you ever made.

Related Articles

Want to learn more about this topic? If so, you will enjoy these articles:

http://www.gaebler.com/Recurring-Revenue-Business-Models.htm
Recurring Revenue Business Models

http://www.gaebler.com/Evaluting-Business-Models-When-Buying-a-Business.htm

How to Buy a Business: Valuation Process

How to Buy a Business

Valuation Process
Written by Bobby Jan for Gaebler Ventures

Buying a business? If so, defining how much a business is worth is very important. This article will help you by breaking the valuation process into five easy steps.

If you are looking to buy a business, you are probably wondering about business valuation.
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The valuation process might seem daunting for somebody who is new to the business of buying businesses. Although this is a difficult process, we can break it down into five smaller steps.

Step 1: Defining the Valuation Assignment

First, it is important to clearly define the parameters of the problem. What business or portion of a business is being appraised? What is the goal of the valuation?

Step 2: Gathering Facts

After step 1 is well established, now it is time to gather the necessary facts. We can further break down the facts into two categories:

• facts that are directly related to the business and
• facts that are indirectly related to the business.

Some examples of directly related facts are accounting records, past performance, client relationships, liquidation value, etc. Some examples of indirectly related facts are competition, regulatory climate, and macroeconomic trends, etc.

Step 3: Analyze the Facts

This is perhaps the most demanding step in the valuation process. After the right facts has been collected, these pieces of information must fit together to help determine the value of the business. You should use many approaches and methods to analyze the facts. In fact, in this step, you might reach many different conclusions.

Step 4: Final Estimate of Value

After exploring many approaches in step three, a conclusion, however rough or precise, must be drawn. This is important set a ceiling to how much you are willing to pay for a company.

Step 5: Prepare Valuation Report

If you are appraising a business for a client, then it is essential for you to prepare a presentable valuation report. Even if you are not making a presentation, it helps to put down your ideas down on paper or be able to explain it clearly to somebody else since this will help you solidify your finding, reasoning, and conclusion.

Cheng Ming (Bobby) Jan is an Economics major at the University of Chicago who has a strong interest in entrepreneurship and investing.

http://www.gaebler.com/Valuation-Process.htm

http://www.gaebler.com/Articles-on-Buying-a-Business.htm

http://www.gaebler.com/Business-Valuation-Trends.htm

Valuing a business using PE

The best way to think about the P/E ratio: You must understand that you're buying a business when you buy a stock. Here is a real-life example to drive the point home.

Several years ago, a friend and I considered buying a sporting goods store. It was a family-run business, with virtually no debt -- or cash -- on the balance sheet. The owner wanted $100,000 for it.

What's the most important thing you'd want to know if you'd been in our situation? Right: how much money we could reasonably expect to earn over the next few years. We didn't care about the fiction of accounting earnings (point No. 1) -- we wanted to know how much in real cash profits the business could pull in.

If it were $10,000 per year, we'd be getting the company at a P/E of 10 ($100,000 / $10,000 = 10). If it were $5,000, that's a much less attractive multiple of 20.

We dived into the fundamental analysis to figure out the real earning power of the company (point No. 2). The short story is, we thought we could make the business much more efficient (improving the margins), but future revenue and earnings growth (point No. 3) seemed very limited due to several well-financed competitors in the area.

In assessing whether this was a smart purchase, we used the three points to come up with our decision. In the end, we passed on the purchase because the P/E we calculated was over 20. Using that number hand-in-hand with our analysis, we knew it would have taken too long for us to even recoup our original investment. But the exercise itself was a lesson I'll never forget.

http://www.fool.com/investing/general/2009/06/19/why-the-pe-ratio-is-dangerous.aspx

To recap:

When buying a small business:

Point 1: Past accounting earnings are a guide, but can be manipulated. More importantly is to conservatively assess the real earning power or cash profits of this company over the next few years.

Point 2: Can you increase this real earning power through improving its efficiency - the profit margins?

Point 3: Assess its future revenue growth and earnings growth. Are these sustainable?

Having assessed the quality of the business and its management, the other decisions one has to make are:

Point 4: Would you like to own or run the business of this company?

• If the answer is no, walk away.
• If the answer is yes, proceed on to next step.

Point 5: Is the seller's price attractive for you to own this company? Given your target of a certain return on your investment, what is the 'maximum' price (akin to intrinsic value) you are willing to pay to own this company?

Point 6: Can you buy this company at a discount to your price? Ask for a discount from the seller? Maybe 'wait' for a discount from the seller? Also remember, it is also alright to buy at a fair price, especially if it is a good business with good fundamentals, up for sale for various reasons.


Essentially, this is not dissimilar to our use of QVM method in assessing which companys' stocks to invest in. (Q=Quality, V=Value, M=Management)