Bank Alfalah | SME Toolkit

Home Based Business

Provided by My Own Business, Content Partner for the SME Toolkit

Objective:

In the past, jobs provided most everyone with a dependable pay envelope and long range security – but not anymore. An alternative is to go into business, yet most people don’t have the confidence to start a full-time business. This session will review the dos and don’ts of operating a home-based business, how to pick the right business, and the common pitfalls. You will realize that these businesses still require business skills just like any other business.

  • What Have You Got to Lose Gain?
  • What Are the Special Benefits of a Home Based Business?
    • Minimum investment
    • Maximize communication technologies
    • Start small and grow by compounding
    • A built-in organizational structure: all in the family
    • Open to all ages and walks of life
    • A productive activity for the out-of-work
  • Approaches to a Home Based Business
    • Moonlight business (part-time)
    • Full-time home business
  • Picking the Right Business is Crucial
    • Specialization works best
    • One that will not conflict with your employment
    • Appropriate for “all in the family” participation?
  • Common Pitfalls
    • Failure to compartmentalize
    • Failure to limit financial risks
    • Physical limitations
  • Top Ten Do’s and Don’ts
  • Business Plan
  • Session Feedback and Quiz

You know the business

In many ways buying an existing business can offer advantages over internal expansion. You already know where the pitfalls and opportunities lie. You can “ad on” a business without any learning process and can make improvements based on your own operations.

Economies of scale

Acquisitions of companies in your own business will strengthen your buying power and spread your fixed costs over a high level of sales. Waste Management is a good example of successful growth through acquisitions. This multi billion dollar enterprise was built by acquiring hundreds of companies in the waste business.

Profit centers are already in place

Acquiring businesses is inherently less risk than starting from scratch. Everything is already in place: the sales, earnings and organization. All these are uncertainties when starting an operation from scratch.

Expand geographically

Geographic expansion increases your customer base and therefore sales. It also opens up potential for more potential advertising media that would be inefficient in a limited area.

Better positioned to evaluate intrinsic value

Placing an accurate value on an acquisition will be crucial when investing your retained earnings. We recommended that calculating intrinsic value be used as the basic tool. Operating companies with a history of earnings plus good prospects of future earnings will make the calculation of its intrinsic value more accurate. See “evaluation methods” later in this session.

Vertically integrate

On the supply side, vertical integration includes acquiring sources of supply in order to lower your costs and insure quality standards. On the operating side it might mean acquiring an IT firm to establish your own Internet technology department. On the marketing side it may mean acquiring a distributor in your marketing chain. Vertical Integration article will furnish complete information on the advantages, risks and how to evaluate vertical integration.

If you are manufacturing golf clubs, would it be appropriate to also sell golf bags and other golf equipment? Here are two examples of “add on” acquisitions:

  • Quaker Oats’ acquisition of Snapple in 1994 became a textbook example of what can go wrong in an “ad on” merger. The corporate cultures were altogether different. Quaker Oats upset the distribution network, let go the sales force, redesigned packaging and advertising campaigns, all with disastrous results. Quaker Oats sold Snapple three years later at a loss of approximately 400 million dollars.
  • Proctor and Gamble’s acquisition of Natura Pet Products in 2010 is an example of a positive “ad on” acquisition where P and G’s existing lines of pet foods will be broadened to include the holistic and natural segment of the market. The localized business of Natura will also be scaled up to world-wide marketing opportunities.

Maureen Costello

Wholesale Distributor
Is buying a business easier than starting one from scratch?

Personally I think that buying a business is a lot easier than starting a business from scratch. When you start a business from scratch you have to do everything. You have to have to reinvent the wheel in many instances. When you purchase a business it’s already operating. There are already pieces in place and then you can improve upon them and move them around. So I believe it’s easier to purchase an existing business. You know more about it, there’s more information, more history and the best business to buy is one that you’re already operating. I purchased a business I was already operating. I knew everything about it, I didn’t have any surprises. And a lot of people get into a business and don’t get into owning a business by purchasing the business they are already working for.

Lincoln Watase

President, Yum Yum Donut Shops, Inc.
What were the ingredients that made Yum Yum Donut’s acquisition of Winchell’s a success?

Yum Yum’s acquisition of Winchell’s was unique in that Yum-Yum and Winchell were so similar; the same types of products the same general locations of stores. As far as advice, in looking back I know the VP of Operations and I personally went and visited every store, took the time to meet with and take to each manager. We thought that was important because we wanted to let the folks in the stores know we cared about them and appreciated and knew how much work it was to manage a store so we wanted to send that message. In addition we deliberately minimized changes if possible to allow for a smother transfer of the acquisition. If there was something we have to change we erred on the side of not having to make that change. Just the sear fact that we were doing this acquisition that was plenty of changes for the employees of Winchell’s to be dealing with. So as a general rule we did try and minimize changes and we also in for the planning of the acquisition we tried to think of any and every possible thing that could go wrong so we would be prepared for just about every contingency in the hopes there would never be any surprises given to us. And lastly we used experts. We know how to run donut shops but in doing a large acquisition by all means attorneys that deal with these things on a regular basis as well as consultants, tax attorneys, you know we weren’t hesitant to recognize where we really didn’t have the expertise and go out and get expert advice.

Branding mistakes

Purchasing a company whose product is highly regarded poses the question: “Should we change their branding to our own?” Most acquiring firms take great pride in their own brand names and generally will change an acquired name to their own. This can be either a good or bad idea depending on the circumstances. Here are examples:

  • Do you think an acquirer of Hershey Chocolate would change the name from Hershey to their own brand? Probably not…an easy decision.
  • Building a brand name is expensive and takes a lot of time.
  • In 2004 Yum Yum Donuts acquired Winchell’s Donuts, a famous name in doughnuts. Yum Yum’s management resisted the temptation to change the name to Yum Yum. Why discard a great reputation and name that had taken generations to build?

Integrating the business

There will always be challenges when integrating an acquired business. For example labor issues may need to be resolved or operating cultures, spending disciplines, and lines of authority. In your due-diligence process, make a check-list of all issues in which the cultures and business practices of you and the acquirer differ and work out all potential problems before closing.

Failure to clear seller’s potential liabilities

Any company you acquire will have some problems and possibly unrecorded liabilities. Usually the seller will be anxious to disclose undocumented problems because if they don’t, non-disclosure could expose them to potential of later litigation. So whenever the seller discloses any unrecorded liabilities or problems, slow down and be careful to take the time to have them fully resolved.

Inadequate evaluation of retaining the management

It would be a mistake not to carefully analyze whether or not to retain the management of the acquired firm. Here are some considerations:

Retain the management

  • In some businesses that are relationship-driven, retaining managers and their client networks would be crucial to the success of the business.
  • You may not be able to, or desire to, supply management. You will need to have a clear agreement that management will stay on.
  • In some cases the seller may be a great manager and getting great satisfaction from the challenges of the job.

Install your own management

  • You may be able to install your own managers with no loss to the business.
  • Enhancement of the business by replacing poor management could become part of your acquisition strategy.
  • A review of “Getting Your Team in Place” can provide a business plan outline for operation of an acquired business.

The seller’s suppliers may not want to sell to you

Let’s assume you are purchasing a competitor. Part of the reason is your wish to add their highly desirable “widget” line of goods to your own line. You will need to get assurance from the company making “widgets” that they will continue to sell to you. If you close your purchase without this assurance and “widget’ company declines to sell to you, you have wasted what you paid to get the line.

Over leveraging

The biggest risk in expanding or making acquisitions is incurring too much debt, either from the seller or other sources of financing. Business leverage refers to the use of borrowed funds to accelerate growth and increase the rate of return on an investment such as purchasing a business. For example, if an acquired business can generate a 20% annul return and the cost of the borrowing is 5%, the potential earnings are magnified.

But leverage is a double-edged sword that is a powerful tool during good times but can quickly become your worst enemy during bad times. The world-wide financial collapse of 2008 was squarely due to leverage. You may encounter temptations to over-leverage when purchasing a business. If you are offered favorable financing from a seller, keep in mind he may not be too concerned with your risk because if you can’t make the payments he will put you in default and take the business back.

Whenever you hear about companies going into bankruptcy, there will almost always be the same reason cited: “Our revenues dropped because of the bad economy.” But if you investigate closely you will probably find that the company had launched a capital project or acquisition by borrowing money and were unable to pay it back….nothing to do with a bad economy. In bad times companies without debt can simply continue to reduce cost to maintain a balanced cash flow.

The worst part of incurring a high level of borrowing lies in the fact that if for any reasons, including unexpected business downturns, you are unable to service, replace or renew the debt, you will run the risk of losing your company. You could be betting the company that unforeseen external or internal adversities will not occur.

So as you grow, you have choices:

  • Don’t borrow at all. Build through the use of retained earnings.
  • Restrict borrowing within two very conservative limits:
    • Restrict the annual debt service to a small fraction of your conservative annual cash flow.
    • Borrow long-term and pay off short term. If you plan to repay in 3 years borrow for 6 years (but pay off in 3 years).

Inadequate accounting controls

It is possible that your existing accounting system and internal controls are not adequate to manage the larger organization. Review the overall needs with your accountant before closing and have necessary systems and people in place.

Your acquisition program should include having your annual financial statements audited. This highest level of accounting scrutiny is expensive but can be invaluable in an acquisition program:

  • To secure financing from your bank who will most likely require it.
  • To gain your seller’s confidence in providing seller financing.
  • To give assurances to any other involved parties.

Maureen Costello

Wholesale Distributor
Is buying a business easier than starting one from scratch?

Personally I think that buying a business is a lot easier than starting a business from scratch. When you start a business from scratch you have to do everything. You have to have to reinvent the wheel in many instances. When you purchase a business it’s already operating. There are already pieces in place and then you can improve upon them and move them around. So I believe it’s easier to purchase an existing business. You know more about it, there’s more information, more history and the best business to buy is one that you’re already operating. I purchased a business I was already operating. I knew everything about it, I didn’t have any surprises. And a lot of people get into a business and don’t get into owning a business by purchasing the business they are already working for.

Stan Henslee

President, Yum Yum Donut Shops, Inc.
What experiences have you had when acquiring an accounting practice?

Yes, I was part of a team that worked on the acquisition of accounting practices to merg them into our firm. And there were several factors that we looked at in trying to make a decision or to make an offer for an acquisition. The first one, we looked at the customer’s target base. Were their clients the type of client that the new firm or our firm would be able to serve and retain? Were the employees properly trained and skilled and would they fit into our model of accounting practice? Would we be able to keep the owner involved in the targeted practice for at least a short time to help with the transition into the new firm? Fourthly, what type of management requirements would it make on our parent firm? Would we be able to manage the transition of the target? And then just as a general rule, you’d want to look at how the deal was structured. Would it create a debt service that the target company would not be able to generate enough cash to meet some type of a return on our investment and be able to meet the debt service to the seller.

Description of the model

Warren Buffett’s remarkable success as chairman of Berkshire Hathaway provides a potential acquisition strategy for some entrepreneurs. It requires expert judgment in evaluating acquired management and the intrinsic value of potential acquisitions. The overall strategy is to acquire businesses with high intrinsic values at attractive prices where the sellers wish to stay on as operating managers.

Acquisition criteria

Some important considerations:

  • You, as the acquiring firm, will control all capital allocations including use of the acquired company’s retained earnings to purchase other companies.

Management roles

Your firm must be very good at two distinctly different management skills:

  • The oversight and nurturing of the acquired companies.
  • Making wise decisions in the allocation of capital.

Warning label

Warren Buffett is one of the most brilliant businessmen in history. In other words, be warned that this is a difficult growth model to emulate. It requires uncommon abilities in the evaluation of businesses and their managers.The three key external players will be your lawyer, accountant and banker. Both your lawyer and accountant should be engaged in acquisition practice and tax laws. You should also bring in your key department heads such as your marketing manager, chief financial officer and any key advisors.

Stan Henslee

President, Yum Yum Donut Shops, Inc.
What mistakes have you seen people make when buying a business?

There are two basic mistakes; the first is a lack of doing the proper due diligence in looking at the business before negotiating the purchase. You want to find out the true reason the seller wants to sell his business. You want to find out what type of customers he has and try and estimate how many of those customers you will be able to serve. You want to find out what the labor situation is for that business and the technical qualities the employees must have and how readily available are such employees. You want to find out what the situation is for the facilities, are they leased? How long a lease will you be able to get and how favorable will the terms be? The second big mistake is not having adequate capital going into the business. Many times it can take up to two years before the business starts to generate enough money to support you. So you’ve got to have to have about two years of savings that you can live out of. Many times I have seen people buy a business and the debt service is so high that it takes a lot more than two years to get the business turned around to where it will support you.

Establishing the price

In any purchase transaction (and buying a business will be a big one) you will need to establish that the price you pay is justified. If you are already in the business that you are acquiring, your evaluations should be better qualified than the estimates of outsiders.

To follow the desirable rule “buy low sell high” you should buy a business for less than its valuation and sell it for more than its valuation…but you must know how to establish “valuation!” There are three guidelines to keep in mind:

  • It is better to buy a great business at a fair price than a fair business at a great price.
  • It is better to be approximately right than absolutely wrong in your pricing evaluation.
  • It is better to buy a great business with bad management than a bad business with great management.

Placing a value on a business can be determined in a number of ways. In order to lessen the risk if being absolutely wrong in pricing, we recommend that you establish valuation by more than one or two methods. Here are methods available to you:

Sales

The standard valuation of a donut shop is weekly sales. As weekly sales increase, the bottom line earnings increase more rapidly because fixed costs are already covered. For example once a fixed cost such as rent is paid for, higher sales will produce an even higher percentage of profit. Earnings of a PKR20,000 per week shop will be more than twice that of the PKR20,000 store and experienced buyers will pay more than twice as much for the PKR10,000 store.

Earnings

The earnings of a business can sometimes be hard to determine. This could result from inadequate accounting records. Accounting transactions might be erroneously booked as earnings. Or some cash sales (and therefore earnings) may not be recorded at all. It may be necessary to stand by the cash register for an extended period of time to determine real sales and make an estimate of earnings.

Return on capital

Return on capital is sometimes referred to as return on investment or ROI. This is a mathematical equation: net earnings divided by the rate of return establishes the valuation. If you are buying a business earning PKR100,000 per year after taxes and expect to receive 20 percent return, your purchase price could be around PKR500,000. ROI will vary widely in different industries. So it will be helpful to learn what the norm is for the business you are interested in.

Intrinsic value

When you buy a business, what you are really paying for is the present value of the sum of all of its future earnings. Intrinsic value is a mathematical calculation which converts all future earnings into their present value. One method is to create a ten year spreadsheet of the estimated future year-by-year earnings and convert each of these, along with a residual long-term value, to an overall present value. This becomes the “intrinsic value” of the business. Search engines may offer programmed solutions to determining intrinsic value and we strongly recommended you become familiar with this important tool. Here’s a free resource that makes the calculations for you: http://www.moneychimp.com/articles/valuation/buffett_calc.htm

Growth potential

The measurement of a growth potential situation can be numerically measured by the intrinsic valuation calculation because your future projections will include your estimates of growth. Of course the result will be a reflection of your accuracy in projecting future numbers.In small business sales, the seller is usually the source of part of the financing. Unless you have a strong banking relationship, the seller will be your number one source for financing. But don’t be tempted to buy a business because of a seller’s willingness to finance the purchase. Stay within the leverage limitations referred to earlier in this session under “Risks”.

  • Outline to your seller exactly how you plan to repay his loan including your anticipated debt-to earnings ratio.
  • Sometimes sellers will look for a personal guarantee or additional security based on assets outside your business.
  • If you secure financing from both your bank and the seller, the seller’s financing will most likely be subordinated to the bank loan.
  • Your lawyer and accountant can strategize with you to design the overall financing package.

The topic of taking you company public is covered in “Public Ownership” article. It will cover the following advantages of being publicly owned when buying a business:

  • You are in a much better position to raise money for acquisitions through the sale of your securities.
  • Your higher profile as a public company will put you at an advantage over other bidders for a company you would like to acquire.
  • Participation in ownership of stock or stock options can be a strong incentive for the management of your acquired company.

  • Unless you are also buying the property, the lease is probably the most important document you will evaluate. Review “Location and Leasing” session. The following are the most relevant lease items:
    • The term or length of the base lease.
    • Options to the base lease term.
    • A rent that is affordable and competitive.
    • How often and how much are the adjustments to the base rent?
    • NNN charges.
    • Assignment provisions.
    • The Landlord’s contributions to the improvements, if a new business.
  • What is the quality of the improvements and fixtures: will they need replacement?
  • What is the quality and size of the inventory: is it overstocked with obsolete items?
  • What is the condition and amount of the receivables: are they collectable?
  • If I am to buy the payables, how current are they and what is the accurate total?
  • Is there an order backlog?
  • How strong are customer relationships: the goodwill you will pay for?
  • Is the primary marketplace stable or changing?
  • Does the business have, or can it obtain, all necessary government approvals and licenses? Are there any exorbitant fees?
  • Is the seller motivated or anxious?

Screening of franchisees

A franchised company is only as good as the quality of their franchisees. It is a good investment to retain the service of a professional to assess potential franchisees. They can be found under the heading “franchisee employee assessment” in search engines.

Don’t be misled into zealous growth because you find a lot of potential franchisees clamoring for your offering. There are lots of entrepreneurially minded people seeking to operate franchised businesses. Your challenge will be to install filters when interviewing potential franchisees so that selected candidates all demonstrate integrity, intelligence and energy as well as the intention to become active operators. As Warren Buffett has said, “People with integrity are predisposed to perform; people without integrity are predisposed not to perform. It is best not to get the two confused.”

Real estate development

Real estate development plays a key role in franchising. These functions include:

  • Creation of the design and working drawings of stores including equipment and fixtures.
  • Negotiation of store leases in shopping centers or other appropriate locations Normally the franchisor will be the lessee and the franchisee the sub-lessee.
  • Securing building and occupancy permits.
  • Build-out of store premises including fixtures and equipment.
  • Participate in store opening process.

Site selection is a key factor in the success of a franchised chain. Each business has its own individual site criteria. For example a donut shop should be on the side of the street going to work and a liquor store should be on the side going home. Through research and experience you need to create a “Site Model” that will provide a measurable, non-emotional, objective way to evaluate potential locations.

You can create your own “Site Model” by assigning different values to the factors that are most important for your particular business. Then each location can be numerically evaluated and compared against these measurements. The following example form will give you a methodical approach for evaluating the strengths and weaknesses of each potential location. Here are the steps:

  • Evaluate your site location for each factor on a scale of 1 to 10, Number 10 being the highest.
  • Decide the importance of each factor to your particular business on a scale of 1 to 5, number 5 being the most important.
  • Multiply the grade by the weight to determine the points for each factor. Add up the points to get a total score. Repeat this process for each site to gain an objective, comparative analysis.

Site Criteria Table
Factors Grade 1-10 Weight 1-5 Points
Traffic count: Cars or pedestrians
Visibility access
Proximity to competition
Zoning
Parking (include off-street parking)
Condition of premises
Proximity to customer generators
Income level of neighborhood
Population density
Ethnic make up of neighborhood
Age factor
Directional growth of area
Area improving or deteriorating
Crime/shoplifting rates
Availability of qualified employees
Labor rates of pay
Supplier proximity
Terms and rental rates
Adequacy of utilities, gas, & water
Transportation accessibility
Total Points

Some things to keep in mind in site selection:

  • There’s no such thing as the “last good location.”
  • Copycatting your most successful competitor’s site criteria can help you avoid making mistakes.
  • If you are building a chain of stores, never sign a lease on your second location until your first location is profitable and proven.
  • It is better to pay fair rent on a great location than pay great rent on a fair location.
  • Don’t rely on leasing agents to make your site decisions.
  • Driving streets and walking neighborhoods is a good way to scout for locations.

You will need to decide whether to build an in-house store development department which will be responsible for all aspects of site location and leasing or to outsource to commercial real estate brokers. A drawback to using brokers is the risk of conflict of interest issues.

Specialized legal council

Your legal council will be responsible for approval and compliance with all documentation including the offering circular, the franchise agreement and the sublease agreement. It is important that your legal council be experienced in corporate work and experienced in franchising law. If you are interested in an international franchising program, global expansion will require special skills. Please visit International Franchising in the Global expansion session in Business Planning section.

Training and operations management

You will need franchisees that are well trained, well motivated and well supervised. Your mission should be to emphasize consistent operations procedures, service, quality and cleanliness.

Area supervision

Ongoing oversight will be required to maintain consistency in quality and adherence to procedures. In the food service business it is correctly stated that “you are only as good as your last meal served”. Area supervisors also provide valuable feedback.

Do’s

  • Create an acquisition team including outside professionals.
  • Create a due diligence checklist.
  • Consider vertical integration prospects.
  • Acquire businesses that you understand.
  • Compliment your existing product line.
  • Evaluate whether or not to keep the seller’s management.
  • Resolve all disclosed and undisclosed potential problems before closing.
  • Learn the basics of how to calculate intrinsic value.
  • Use intrinsic value and ROI to establish valuation.
  • Gain economies of scale such as purchasing power.

Don’ts

  • Over leverage by borrowing too much.
  • Combine different corporate or labor cultures.
  • Dismiss the value of acquired brand names.
  • Make optimistic assumptions.
  • Forego assurances that seller’s suppliers will continue to sell to you.
  • Fail to have additional accounting controls in place.
  • Fail to evaluate receivables.
  • Buy a business that will take more money to keep competitive.
  • Be afraid to walk-away
  • Overlook your consultants when structuring financing.

Session Feedback and Quiz

Copyright © 1993, 1997-2016, My Own Business, Inc. All Rights Reserved.

Growth by Duplication

Provided by My Own Business, Content Partner for the SME Toolkit

Objective:

Duplication of a successful store concept requires management in a number of business disciplines unrelated to the operation of the stores themselves. Failure in any one of them could become a stumbling block. This session covers what you need to know before you expand by duplication.

  • What is growth by duplication?
    • Definition of duplication
    • Small scale duplication
    • Large scale duplication
  • Examples of growth by duplication
    • Businesses with questionable potential
    • Businesses with good potential
  • Importance of a successful pilot operation
  • Management skills required
    • Financing skills
    • Create profit centers
    • Management selection
    • Accounting oversight
    • Supervision oversight
  • Real estate development functions
    • Creating a site model for your locations
    • Architecture and construction
  • Leasing issues
    • Rule number one
    • A potential conflict of interest
    • Recommendations
  • Legal issues
  • Top ten do’s and don’ts
  • Session Feedback and Quiz

Definition of duplication

Growth by duplication is taking your present business and duplicating it in other locations. It’s also called a “cookie-cutter” approach because as with a cookie cutter, identical cookies can efficiently be stamped out in either small or large numbers.

There is a margin of safety in pursuing this method of growth because your expansion does not take you outside your already proven circle of competence. You are sticking to what you know best and what you have already proven to be successful. This approach does however require some management skills beyond those required for operating a single location.

Growing the business that you have learned to do well in doesn’t mean that you should not always be trying to improve it. More often than not, good ideas for making improvements can come from outside your own operations. The best places to learn will be from your most successful competitors.

Small scale duplication

Assume you have a profitable business that is appropriate for duplication and your customers are located in a ten mile radius. If you add another equally successful store outside that area (so you’re not competing with yourself) you could accomplish two goals:

  • Double your sales.
  • Potentially more than double your earnings since some fixed costs are now spread over two stores and you have greater purchasing power.

Large scale duplication

To build a really large business, you will continue to expand over an increasingly widespread area. Your long-term goals could include:

    • Franchising the concept

.

  • Public ownership.
  • Become a candidate for acquisition by a larger company.

Maureen Costello

Wholesale Distributor
Is buying a business easier than starting one from scratch?

Personally I think that buying a business is a lot easier than starting a business from scratch. When you start a business from scratch you have to do everything. You have to have to reinvent the wheel in many instances. When you purchase a business it’s already operating. There are already pieces in place and then you can improve upon them and move them around. So I believe it’s easier to purchase an existing business. You know more about it, there’s more information, more history and the best business to buy is one that you’re already operating. I purchased a business I was already operating. I knew everything about it, I didn’t have any surprises. And a lot of people get into a business and don’t get into owning a business by purchasing the business they are already working for.

Maureen Costello

Wholesale Distributor
Is it a bad idea for a pet store to operate in a supermarket shopping center?

Interestingly enough not only is that not a problem but it’s a benefit. One of the problems with any independently owned business is that it doesn’t have name recognition so it takes time to develop a reputation in the community and a lot of times independent stores a have a problem because manufactures want to put their product in these larger stores because it’s convenient for the shopper to buy them. But there is nothing more convenient for a consumer than being able to go to a pet store if it’s located in a grocery store shopping center because they are going to the grocery store anyway. I know a lot of times our retailers believe that the grocery store is their competitor and in actuality the grocery store draws people into the center and a pet lover would rather go into a pet store than. It’s more fun, they enjoy the experience and many times even if the independent store carries exactly the same product as in the grocery store because the independent store may more variety and more knowledgeable people they’ll sell more than the grocery store does. So people who are really clever about this actually locate themselves next to these grocery stores and see them as an asset rather than a liability.

Businesses with questionable potential:

  • A professional or specialized practice (where your individual expertise is the cornerstone of the business.)
  • A business that requires high investment in machinery, upkeep, working capital, keeping up with the competition or any other reason. If you have borrowed money for the opening, debt repayment will be a major obligation.
  • A manufacturing business where efficiency is based on centralization.
  • A product or service business where the owner is the sole key person.
  • Web based businesses.
  • Service businesses…but not all.

Businesses with good potential:

  • Think about most any retail chain you know.
  • Foodservices, especially fast food.
  • Franchisors. Please refer to the following session on franchising which covers how your business could become a franchisor.
  • A firm that is geographically widening its market.

One cornerstone must be in place: your initial operation (or store) must have achieved a proven record of customer acceptance and profitability. It should be in operation for a sufficient time to have worked out flaws and a high probability of ongoing profitability. This will rule out fads or styles or businesses with short life-spans due to obsolescence or other reasons. You should have experienced profitable earnings for at least a year.
Duplication requires successful management in a number of business disciplines unrelated to the operation of the stores themselves. Failure in any one of them could become a stumbling block.

Financing skills

Opening a new store location will cost a lot of money. Assuming you are leasing the location, costs will include fixtures, equipment, tenant improvements, inventory, signage, lease deposits, working capital and other expenses. Your sources of funding will come from retained earnings or borrowing or both.

  • When you borrow, if you can pay back in three years, then ask for a five year loan…and not the other way around.
  • Your cash flow projections should show sufficient cash flow to cover debt payments by a stated margin of safety. For example you cash flow might be a multiplier of your debt service.
  • Your cash flow projections should show sufficient cash flow to cover debt payments by a stated margin of safety. For example you cash flow might be a multiplier of your debt service.

Create profit centers

Incentive plans will vary according to the business, but one essential component will be a system based on frequently calculated profit and loss statements for each individual store. Reasons include:

  • The only way to truly evaluate a store is how it contributes to overall company earnings.
  • Profit sharing provides the most powerful incentive for a store manager.
  • The best managers want the incentive to reflect their individual successes, not on overall company results.
  • A frequent, more imminent reward is more powerful than one sometime in the future.
  • You need to know the financial results of each individual store in order to pinpoint weak ones. Losing store should either be corrected promptly or spun off by sale or sublease.

A case study on a profit based incentive plan:

Company “A” decided to vertically integrate by getting into the manufacture of its line of retail goods. An outstanding manager with all the qualifications was available but asked for 10% of the company’s stock. Instead, a profit sharing plan was created for the profit center he was to run, giving him a 10% share in the profits. Over time he made a great deal of money and flew his own plane. The company was delighted: it still received nine out of every ten dollars of earnings the manager produced.

Management selection

The success of your growth will depend a great deal on how skilled you and your human resource (HR) management is in selecting the best managers to run your stores. Mistakes made in this process can result in a huge drain on earnings. Here are some recommendations:

  • Have a very highly qualified HR manager.
  • Set up a standard process to screen applicants.
  • The process should include testing that is specific to each position.
  • Do not take any short-cuts in reference checking. Make sure the candidates have accomplished what they claim.
  • Ask candidates the same questions so you can compare answers
  • Consider retaining a HR consulting firm that can customize the search process to your specific needs.


Our overall recommendation on hiring managers is quoted from Warren Buffett:

“In looking for someone to hire, you look for three qualities: integrity, intelligence and energy. But the most important is integrity, because if they don’t have that, the other two qualities, intelligence and energy, are going to kill you.”

Accounting oversight

Your accounting system will require a system of preparing frequent income statements on a store-by-store basis. Profit sharing payments should be disbursed to managers at the same time the profit and loss (P & L) statements are prepared. This will require your accounting department to develop procedures to accomplish this including inventory accounting. Some chains prepare P & L’s every week. In cases where weekly is not practical, P & L statements should be published monthly.

Supervision oversight

Once you have opened your second store you are now a chain and will require some controls in place.

  • A training manual in place for each job description.
  • An operations manual so that each procedure is standardized.
  • Central control of SKUs (stock keeping units).
  • Central purchasing and distribution to stores. Store managers place their purchase orders with your central distribution facility.
  • Central control of pricing, merchandising plans and advertising.
  • A feedback procedure so that store managers have free access to central management.
  • A supervisory plan so that stores are adequately monitored.
  • Regular meetings with store managers to gain feedback and discuss strategies.
  • Rigid disciplines as to service, handling complaints, uniforms, menus, etc.

Maureen Costello

Wholesale Distributor
What problems are encountered when running a chain of retail stores?

I think when you have a chain of retail stores especially if the first ones are very successful. You end up every once in a while opening up a store that is not successful. And there is a tendency not to want to acknowledge that you made a mistake in picking the location and you want to think that if I just work a little harder at it I can turn this into a profit. But in reality what you end up doing is spending so much time doing is trying to fix a loser that you really don’t do the best you can with your winners and some of them become losers too. So I think retailers who are expanding their chains need to be really honest with themselves, be willing to cut their losses if that’s what it takes to get rid of something that’s not making money or sometimes you can turn lemons into lemonade and you can sell a loser to somebody else. You can make money or at least get yourself out of it and not take a loss and then you can go back to operating your successful stores.
If you continue to add more stores, you will also be in the real estate development business. Some of these functions include:

Creating a site model for your locations

We recommend you establish a site model for your particular business. Each business is different. The site model will establish an objective way to evaluate the various factors which make up a good location.

Demographics, especially population mix, will be important.

In some cases, copying the location criteria of a really successful competitor will be of value.

Architecture and construction

  • In order to secure necessary permits you will need an architect to prepare working drawings for the store including the tenant improvements.
  • You will need a contractor to build out the store (assuming it is free standing) or construct the tenant improvements if it is in a shopping center. The landlord may be responsible for the tenant improvement build-out.

Lincoln Watase

President, Yum Yum Donut Shops, Inc.

After you took over as CEO of Yum Yum – Winchell’s, what benefits were gained from your store refurbishment program?

Well we felt when we refurbished a store sales went up. It became very clear it was a positive thing to do. In addition we found that employee moral seem to improved. We think that’s because since the store was nicer and customers were complimenting the store, you know the employees feel better about being in the store and pride in working at that store. So all in all that was a very good program to put in place.

Rule number one:

It is better to pay fair rent for a great location than to pay great rent for a fair location.

A potential conflict of interest

In the early stage of growth you will probably outsource your site location responsibility to a commercial real estate broker who will act as your “site” person. But be aware of the conflict of interest which will exist when the agent’s compensation is derived from leasing commissions. For example, the agent may strive for a 20 year lease instead of a 10 year lease with one 10 year option.

Any lease you sign for a second store will probably create the largest liability in your business. If you sign a 10 year lease for PKR10,000 per month with a 10 year option, over ten years, come what may, you will owe the landlord PKR1,200,000. For a leasing checklist please refer to our session “Location and Leasing” in the Operations section.

Recommendations

  • Never enter a lease negotiation without your real estate lawyer.
  • Never agree to a lease negotiated by either your leasing agent or the landlord’s leasing agent.
  • Require a right to sublet which shall not be unreasonably withheld.
  • Better to sign a 10 year lease with a 10 year option than a 20 year lease.
  • Negotiate for the landlord to provide tenant’s improvements.
  • Negotiate a go-dark clause in the event the anchor tenant leaves.
  • Don’t scatter your locations to make distribution, supervision and advertising difficult. Build-out one marketing area at a time.

Be sure that the name, logo, slogans and artwork you have selected have been cleared by your intellectual property attorney as being available.

Do’s

  • Stay in the business that’s within your circle of competence.
  • Stay within geographical limits you can service well.
  • Prove profitability and systems before expanding.
  • Bring in your lawyer for all real estate transactions.
  • Build out one market area at a time.
  • Verify that your name, logos and slogans are available.
  • Compartmentalize your P & L’s to individual stores.
  • Calculate P & L’s frequently for each store.
  • Establish a real estate site model.
  • Pay fair rent for a great location.

Don’ts

  • Over borrow. Maintain 3-5 times cash flow to debt service.
  • Pay great rent for a fair location.
  • Risk duplication if you are the sole key person.
  • Be in a hurry…instead proceed with great caution.
  • Overlook the importance of operating manuals.
  • Let leasing agents negotiate your leases.
  • Overlook the importance of demographics.
  • Be vulnerable to Website-based competition.
  • Don’t give stock to managers: share the profits instead.
  • Sign a lease without including recommended deal points.

Session Feedback and Quiz

Copyright © 1993, 1997-2016, My Own Business, Inc. All Rights Reserved.

Buying Businesses

Provided by My Own Business, Content Partner for the SME Toolkit

Objective:

Buying an existing business can offer advantages over organic expansion. In this session you will learn how to evaluate the opportunities and risks associated with expansion through acquisition.

  • Advantages of buying companies in your own business
    • You know the business
    • Achieve economies of scale
    • Profit centers are already in place
    • Expand geographically
    • Better position to evaluate intrinsic value
    • Vertically integrate
    • Complement or fill out your product line
  • Risks
    • Branding mistakes
    • Integrating the businesses
    • Failure to clear up seller’s potential liabilities
    • Inadequate evaluation of retaining the management
    • Seller’s suppliers may not want to sell to you
    • Over leveraging
    • Inadequate accounting controls
  • The Berkshire Hathaway acquisition model
    • Description of the model
    • Acquisition criteria
    • Management roles
    • Warning label
  • Your acquisition team
  • Evaluation methods
    • Establishing the price
    • Sales
    • Earnings
    • Return on Capital
    • Intrinsic value
    • Growth potential
  • Leverage with seller financing
  • Advantages of your being publicly owned
  • Due diligence checklist
  • Top ten Do’s and Don’ts
  • Session Feedback and Quiz

You know the business

In many ways buying an existing business can offer advantages over internal expansion. You already know where the pitfalls and opportunities lie. You can “ad on” a business without any learning process and can make improvements based on your own operations.

Economies of scale

Acquisitions of companies in your own business will strengthen your buying power and spread your fixed costs over a high level of sales. Waste Management is a good example of successful growth through acquisitions. This multi billion dollar enterprise was built by acquiring hundreds of companies in the waste business.

Profit centers are already in place

Acquiring businesses is inherently less risk than starting from scratch. Everything is already in place: the sales, earnings and organization. All these are uncertainties when starting an operation from scratch.

Expand geographically

Geographic expansion increases your customer base and therefore sales. It also opens up potential for more potential advertising media that would be inefficient in a limited area.

Better positioned to evaluate intrinsic value

Placing an accurate value on an acquisition will be crucial when investing your retained earnings. We recommended that calculating intrinsic value be used as the basic tool. Operating companies with a history of earnings plus good prospects of future earnings will make the calculation of its intrinsic value more accurate. See “evaluation methods” later in this session.

Vertically integrate

On the supply side, vertical integration includes acquiring sources of supply in order to lower your costs and insure quality standards. On the operating side it might mean acquiring an IT firm to establish your own Internet technology department. On the marketing side it may mean acquiring a distributor in your marketing chain. Vertical Integration article will furnish complete information on the advantages, risks and how to evaluate vertical integration.

If you are manufacturing golf clubs, would it be appropriate to also sell golf bags and other golf equipment? Here are two examples of “add on” acquisitions:

  • Quaker Oats’ acquisition of Snapple in 1994 became a textbook example of what can go wrong in an “ad on” merger. The corporate cultures were altogether different. Quaker Oats upset the distribution network, let go the sales force, redesigned packaging and advertising campaigns, all with disastrous results. Quaker Oats sold Snapple three years later at a loss of approximately 400 million dollars.
  • Proctor and Gamble’s acquisition of Natura Pet Products in 2010 is an example of a positive “ad on” acquisition where P and G’s existing lines of pet foods will be broadened to include the holistic and natural segment of the market. The localized business of Natura will also be scaled up to world-wide marketing opportunities.

Maureen Costello

Wholesale Distributor
Is buying a business easier than starting one from scratch?

Personally I think that buying a business is a lot easier than starting a business from scratch. When you start a business from scratch you have to do everything. You have to have to reinvent the wheel in many instances. When you purchase a business it’s already operating. There are already pieces in place and then you can improve upon them and move them around. So I believe it’s easier to purchase an existing business. You know more about it, there’s more information, more history and the best business to buy is one that you’re already operating. I purchased a business I was already operating. I knew everything about it, I didn’t have any surprises. And a lot of people get into a business and don’t get into owning a business by purchasing the business they are already working for.

Lincoln Watase

President, Yum Yum Donut Shops, Inc.
What were the ingredients that made Yum Yum Donut’s acquisition of Winchell’s a success?

Yum Yum’s acquisition of Winchell’s was unique in that Yum-Yum and Winchell were so similar; the same types of products the same general locations of stores. As far as advice, in looking back I know the VP of Operations and I personally went and visited every store, took the time to meet with and take to each manager. We thought that was important because we wanted to let the folks in the stores know we cared about them and appreciated and knew how much work it was to manage a store so we wanted to send that message. In addition we deliberately minimized changes if possible to allow for a smother transfer of the acquisition. If there was something we have to change we erred on the side of not having to make that change. Just the sear fact that we were doing this acquisition that was plenty of changes for the employees of Winchell’s to be dealing with. So as a general rule we did try and minimize changes and we also in for the planning of the acquisition we tried to think of any and every possible thing that could go wrong so we would be prepared for just about every contingency in the hopes there would never be any surprises given to us. And lastly we used experts. We know how to run donut shops but in doing a large acquisition by all means attorneys that deal with these things on a regular basis as well as consultants, tax attorneys, you know we weren’t hesitant to recognize where we really didn’t have the expertise and go out and get expert advice.

Branding mistakes

Purchasing a company whose product is highly regarded poses the question: “Should we change their branding to our own?” Most acquiring firms take great pride in their own brand names and generally will change an acquired name to their own. This can be either a good or bad idea depending on the circumstances. Here are examples:

  • Do you think an acquirer of Hershey Chocolate would change the name from Hershey to their own brand? Probably not…an easy decision.
  • Building a brand name is expensive and takes a lot of time.
  • In 2004 Yum Yum Donuts acquired Winchell’s Donuts, a famous name in doughnuts. Yum Yum’s management resisted the temptation to change the name to Yum Yum. Why discard a great reputation and name that had taken generations to build?

Integrating the business

There will always be challenges when integrating an acquired business. For example labor issues may need to be resolved or operating cultures, spending disciplines, and lines of authority. In your due-diligence process, make a check-list of all issues in which the cultures and business practices of you and the acquirer differ and work out all potential problems before closing.

Failure to clear seller’s potential liabilities

Any company you acquire will have some problems and possibly unrecorded liabilities. Usually the seller will be anxious to disclose undocumented problems because if they don’t, non-disclosure could expose them to potential of later litigation. So whenever the seller discloses any unrecorded liabilities or problems, slow down and be careful to take the time to have them fully resolved.

Inadequate evaluation of retaining the management

It would be a mistake not to carefully analyze whether or not to retain the management of the acquired firm. Here are some considerations:

Retain the management

  • In some businesses that are relationship-driven, retaining managers and their client networks would be crucial to the success of the business.
  • You may not be able to, or desire to, supply management. You will need to have a clear agreement that management will stay on.
  • In some cases the seller may be a great manager and getting great satisfaction from the challenges of the job.

Install your own management

  • You may be able to install your own managers with no loss to the business.
  • Enhancement of the business by replacing poor management could become part of your acquisition strategy.
  • A review of “Getting Your Team in Place” can provide a business plan outline for operation of an acquired business.

The seller’s suppliers may not want to sell to you

Let’s assume you are purchasing a competitor. Part of the reason is your wish to add their highly desirable “widget” line of goods to your own line. You will need to get assurance from the company making “widgets” that they will continue to sell to you. If you close your purchase without this assurance and “widget’ company declines to sell to you, you have wasted what you paid to get the line.

Over leveraging

The biggest risk in expanding or making acquisitions is incurring too much debt, either from the seller or other sources of financing. Business leverage refers to the use of borrowed funds to accelerate growth and increase the rate of return on an investment such as purchasing a business. For example, if an acquired business can generate a 20% annul return and the cost of the borrowing is 5%, the potential earnings are magnified.

But leverage is a double-edged sword that is a powerful tool during good times but can quickly become your worst enemy during bad times. The world-wide financial collapse of 2008 was squarely due to leverage. You may encounter temptations to over-leverage when purchasing a business. If you are offered favorable financing from a seller, keep in mind he may not be too concerned with your risk because if you can’t make the payments he will put you in default and take the business back.

Whenever you hear about companies going into bankruptcy, there will almost always be the same reason cited: “Our revenues dropped because of the bad economy.” But if you investigate closely you will probably find that the company had launched a capital project or acquisition by borrowing money and were unable to pay it back….nothing to do with a bad economy. In bad times companies without debt can simply continue to reduce cost to maintain a balanced cash flow.

The worst part of incurring a high level of borrowing lies in the fact that if for any reasons, including unexpected business downturns, you are unable to service, replace or renew the debt, you will run the risk of losing your company. You could be betting the company that unforeseen external or internal adversities will not occur.

So as you grow, you have choices:

  • Don’t borrow at all. Build through the use of retained earnings.
  • Restrict borrowing within two very conservative limits:
    • Restrict the annual debt service to a small fraction of your conservative annual cash flow.
    • Borrow long-term and pay off short term. If you plan to repay in 3 years borrow for 6 years (but pay off in 3 years).

Inadequate accounting controls

It is possible that your existing accounting system and internal controls are not adequate to manage the larger organization. Review the overall needs with your accountant before closing and have necessary systems and people in place.

Your acquisition program should include having your annual financial statements audited. This highest level of accounting scrutiny is expensive but can be invaluable in an acquisition program:

  • To secure financing from your bank who will most likely require it.
  • To gain your seller’s confidence in providing seller financing.
  • To give assurances to any other involved parties.

Maureen Costello

Wholesale Distributor
Is buying a business easier than starting one from scratch?

Personally I think that buying a business is a lot easier than starting a business from scratch. When you start a business from scratch you have to do everything. You have to have to reinvent the wheel in many instances. When you purchase a business it’s already operating. There are already pieces in place and then you can improve upon them and move them around. So I believe it’s easier to purchase an existing business. You know more about it, there’s more information, more history and the best business to buy is one that you’re already operating. I purchased a business I was already operating. I knew everything about it, I didn’t have any surprises. And a lot of people get into a business and don’t get into owning a business by purchasing the business they are already working for.

Stan Henslee

President, Yum Yum Donut Shops, Inc.
What experiences have you had when acquiring an accounting practice?

Yes, I was part of a team that worked on the acquisition of accounting practices to merg them into our firm. And there were several factors that we looked at in trying to make a decision or to make an offer for an acquisition. The first one, we looked at the customer’s target base. Were their clients the type of client that the new firm or our firm would be able to serve and retain? Were the employees properly trained and skilled and would they fit into our model of accounting practice? Would we be able to keep the owner involved in the targeted practice for at least a short time to help with the transition into the new firm? Fourthly, what type of management requirements would it make on our parent firm? Would we be able to manage the transition of the target? And then just as a general rule, you’d want to look at how the deal was structured. Would it create a debt service that the target company would not be able to generate enough cash to meet some type of a return on our investment and be able to meet the debt service to the seller.

Description of the model

Warren Buffett’s remarkable success as chairman of Berkshire Hathaway provides a potential acquisition strategy for some entrepreneurs. It requires expert judgment in evaluating acquired management and the intrinsic value of potential acquisitions. The overall strategy is to acquire businesses with high intrinsic values at attractive prices where the sellers wish to stay on as operating managers.

Acquisition criteria

Some important considerations:

  • You, as the acquiring firm, will control all capital allocations including use of the acquired company’s retained earnings to purchase other companies.

Management roles

Your firm must be very good at two distinctly different management skills:

  • The oversight and nurturing of the acquired companies.
  • Making wise decisions in the allocation of capital.

Warning label

Warren Buffett is one of the most brilliant businessmen in history. In other words, be warned that this is a difficult growth model to emulate. It requires uncommon abilities in the evaluation of businesses and their managers.The three key external players will be your lawyer, accountant and banker. Both your lawyer and accountant should be engaged in acquisition practice and tax laws. You should also bring in your key department heads such as your marketing manager, chief financial officer and any key advisors.

Stan Henslee

President, Yum Yum Donut Shops, Inc.
What mistakes have you seen people make when buying a business?

There are two basic mistakes; the first is a lack of doing the proper due diligence in looking at the business before negotiating the purchase. You want to find out the true reason the seller wants to sell his business. You want to find out what type of customers he has and try and estimate how many of those customers you will be able to serve. You want to find out what the labor situation is for that business and the technical qualities the employees must have and how readily available are such employees. You want to find out what the situation is for the facilities, are they leased? How long a lease will you be able to get and how favorable will the terms be? The second big mistake is not having adequate capital going into the business. Many times it can take up to two years before the business starts to generate enough money to support you. So you’ve got to have to have about two years of savings that you can live out of. Many times I have seen people buy a business and the debt service is so high that it takes a lot more than two years to get the business turned around to where it will support you.

Establishing the price

In any purchase transaction (and buying a business will be a big one) you will need to establish that the price you pay is justified. If you are already in the business that you are acquiring, your evaluations should be better qualified than the estimates of outsiders.

To follow the desirable rule “buy low sell high” you should buy a business for less than its valuation and sell it for more than its valuation…but you must know how to establish “valuation!” There are three guidelines to keep in mind:

  • It is better to buy a great business at a fair price than a fair business at a great price.
  • It is better to be approximately right than absolutely wrong in your pricing evaluation.
  • It is better to buy a great business with bad management than a bad business with great management.

Placing a value on a business can be determined in a number of ways. In order to lessen the risk if being absolutely wrong in pricing, we recommend that you establish valuation by more than one or two methods. Here are methods available to you:

Sales

The standard valuation of a donut shop is weekly sales. As weekly sales increase, the bottom line earnings increase more rapidly because fixed costs are already covered. For example once a fixed cost such as rent is paid for, higher sales will produce an even higher percentage of profit. Earnings of a PKR20,000 per week shop will be more than twice that of the PKR20,000 store and experienced buyers will pay more than twice as much for the PKR10,000 store.

Earnings

The earnings of a business can sometimes be hard to determine. This could result from inadequate accounting records. Accounting transactions might be erroneously booked as earnings. Or some cash sales (and therefore earnings) may not be recorded at all. It may be necessary to stand by the cash register for an extended period of time to determine real sales and make an estimate of earnings.

Return on capital

Return on capital is sometimes referred to as return on investment or ROI. This is a mathematical equation: net earnings divided by the rate of return establishes the valuation. If you are buying a business earning PKR100,000 per year after taxes and expect to receive 20 percent return, your purchase price could be around PKR500,000. ROI will vary widely in different industries. So it will be helpful to learn what the norm is for the business you are interested in.

Intrinsic value

When you buy a business, what you are really paying for is the present value of the sum of all of its future earnings. Intrinsic value is a mathematical calculation which converts all future earnings into their present value. One method is to create a ten year spreadsheet of the estimated future year-by-year earnings and convert each of these, along with a residual long-term value, to an overall present value. This becomes the “intrinsic value” of the business. Search engines may offer programmed solutions to determining intrinsic value and we strongly recommended you become familiar with this important tool. Here’s a free resource that makes the calculations for you: http://www.moneychimp.com/articles/valuation/buffett_calc.htm

Growth potential

The measurement of a growth potential situation can be numerically measured by the intrinsic valuation calculation because your future projections will include your estimates of growth. Of course the result will be a reflection of your accuracy in projecting future numbers.In small business sales, the seller is usually the source of part of the financing. Unless you have a strong banking relationship, the seller will be your number one source for financing. But don’t be tempted to buy a business because of a seller’s willingness to finance the purchase. Stay within the leverage limitations referred to earlier in this session under “Risks”.

  • Outline to your seller exactly how you plan to repay his loan including your anticipated debt-to earnings ratio.
  • Sometimes sellers will look for a personal guarantee or additional security based on assets outside your business.
  • If you secure financing from both your bank and the seller, the seller’s financing will most likely be subordinated to the bank loan.
  • Your lawyer and accountant can strategize with you to design the overall financing package.

The topic of taking you company public is covered in “Public Ownership” article. It will cover the following advantages of being publicly owned when buying a business:

  • You are in a much better position to raise money for acquisitions through the sale of your securities.
  • Your higher profile as a public company will put you at an advantage over other bidders for a company you would like to acquire.
  • Participation in ownership of stock or stock options can be a strong incentive for the management of your acquired company.

  • Unless you are also buying the property, the lease is probably the most important document you will evaluate. Review “Location and Leasing” session. The following are the most relevant lease items:
    • The term or length of the base lease.
    • Options to the base lease term.
    • A rent that is affordable and competitive.
    • How often and how much are the adjustments to the base rent?
    • NNN charges.
    • Assignment provisions.
    • The Landlord’s contributions to the improvements, if a new business.
  • What is the quality of the improvements and fixtures: will they need replacement?
  • What is the quality and size of the inventory: is it overstocked with obsolete items?
  • What is the condition and amount of the receivables: are they collectable?
  • If I am to buy the payables, how current are they and what is the accurate total?
  • Is there an order backlog?
  • How strong are customer relationships: the goodwill you will pay for?
  • Is the primary marketplace stable or changing?
  • Does the business have, or can it obtain, all necessary government approvals and licenses? Are there any exorbitant fees?
  • Is the seller motivated or anxious?

Screening of franchisees

A franchised company is only as good as the quality of their franchisees. It is a good investment to retain the service of a professional to assess potential franchisees. They can be found under the heading “franchisee employee assessment” in search engines.

Don’t be misled into zealous growth because you find a lot of potential franchisees clamoring for your offering. There are lots of entrepreneurially minded people seeking to operate franchised businesses. Your challenge will be to install filters when interviewing potential franchisees so that selected candidates all demonstrate integrity, intelligence and energy as well as the intention to become active operators. As Warren Buffett has said, “People with integrity are predisposed to perform; people without integrity are predisposed not to perform. It is best not to get the two confused.”

Real estate development

Real estate development plays a key role in franchising. These functions include:

  • Creation of the design and working drawings of stores including equipment and fixtures.
  • Negotiation of store leases in shopping centers or other appropriate locations Normally the franchisor will be the lessee and the franchisee the sub-lessee.
  • Securing building and occupancy permits.
  • Build-out of store premises including fixtures and equipment.
  • Participate in store opening process.

Site selection is a key factor in the success of a franchised chain. Each business has its own individual site criteria. For example a donut shop should be on the side of the street going to work and a liquor store should be on the side going home. Through research and experience you need to create a “Site Model” that will provide a measurable, non-emotional, objective way to evaluate potential locations.

You can create your own “Site Model” by assigning different values to the factors that are most important for your particular business. Then each location can be numerically evaluated and compared against these measurements. The following example form will give you a methodical approach for evaluating the strengths and weaknesses of each potential location. Here are the steps:

  • Evaluate your site location for each factor on a scale of 1 to 10, Number 10 being the highest.
  • Decide the importance of each factor to your particular business on a scale of 1 to 5, number 5 being the most important.
  • Multiply the grade by the weight to determine the points for each factor. Add up the points to get a total score. Repeat this process for each site to gain an objective, comparative analysis.

Site Criteria Table
Factors Grade 1-10 Weight 1-5 Points
Traffic count: Cars or pedestrians
Visibility access
Proximity to competition
Zoning
Parking (include off-street parking)
Condition of premises
Proximity to customer generators
Income level of neighborhood
Population density
Ethnic make up of neighborhood
Age factor
Directional growth of area
Area improving or deteriorating
Crime/shoplifting rates
Availability of qualified employees
Labor rates of pay
Supplier proximity
Terms and rental rates
Adequacy of utilities, gas, & water
Transportation accessibility
Total Points

Some things to keep in mind in site selection:

  • There’s no such thing as the “last good location.”
  • Copycatting your most successful competitor’s site criteria can help you avoid making mistakes.
  • If you are building a chain of stores, never sign a lease on your second location until your first location is profitable and proven.
  • It is better to pay fair rent on a great location than pay great rent on a fair location.
  • Don’t rely on leasing agents to make your site decisions.
  • Driving streets and walking neighborhoods is a good way to scout for locations.

You will need to decide whether to build an in-house store development department which will be responsible for all aspects of site location and leasing or to outsource to commercial real estate brokers. A drawback to using brokers is the risk of conflict of interest issues.

Specialized legal council

Your legal council will be responsible for approval and compliance with all documentation including the offering circular, the franchise agreement and the sublease agreement. It is important that your legal council be experienced in corporate work and experienced in franchising law. If you are interested in an international franchising program, global expansion will require special skills. Please visit International Franchising in the Global expansion session in Business Planning section.

Training and operations management

You will need franchisees that are well trained, well motivated and well supervised. Your mission should be to emphasize consistent operations procedures, service, quality and cleanliness.

Area supervision

Ongoing oversight will be required to maintain consistency in quality and adherence to procedures. In the food service business it is correctly stated that “you are only as good as your last meal served”. Area supervisors also provide valuable feedback.

Do’s

  • Create an acquisition team including outside professionals.
  • Create a due diligence checklist.
  • Consider vertical integration prospects.
  • Acquire businesses that you understand.
  • Compliment your existing product line.
  • Evaluate whether or not to keep the seller’s management.
  • Resolve all disclosed and undisclosed potential problems before closing.
  • Learn the basics of how to calculate intrinsic value.
  • Use intrinsic value and ROI to establish valuation.
  • Gain economies of scale such as purchasing power.

Don’ts

  • Over leverage by borrowing too much.
  • Combine different corporate or labor cultures.
  • Dismiss the value of acquired brand names.
  • Make optimistic assumptions.
  • Forego assurances that seller’s suppliers will continue to sell to you.
  • Fail to have additional accounting controls in place.
  • Fail to evaluate receivables.
  • Buy a business that will take more money to keep competitive.
  • Be afraid to walk-away
  • Overlook your consultants when structuring financing.

Session Feedback and Quiz

Copyright © 1993, 1997-2016, My Own Business, Inc. All Rights Reserved.

Franchising Your Business

Provided by My Own Business, Content Partner for the SME Toolkit

Objective:

A well executed franchise program can expand a sound business concept into a world-wide organization. In this session you will learn how to franchise your business and what to look out for when doing so.

  • Franchising potentials
  • Advantages of franchising
    • Franchising provides expansion capital
    • Avoids employee related problems
    • Accelerates expansion over wide area
    • Franchisee operators are motivated to succeed
  • Disadvantages of franchising
    • Sharing profits
    • Loss of absolute control
    • Lawsuits with unprofitable and/or difficult franchisees
    • State and federal franchise disclosure laws
  • Prove profitability first in company operated stores
    • Start with company-owned stores
    • Requires profitability for both franchisor and franchisee
  • Importance of conservative growth rate
  • Should master leases be with the franchisor or franchisee?
  • Importance of operating franchisees
    • Avoidance of investor franchisees
  • Special business skills required
    • Screening of franchisees
    • Real estate development
    • Specialized legal council
    • Training and operations management
    • Area supervision
  • Escrowing of franchise fees until unit opening
  • Disclosure requirements
    • Offering circular, franchise agreement and lease
    • Audited financial statements
    • Profit and loss statements from franchised stores
    • Pending litigation with franchisees
    • Contact information on past and present franchisees
  • Top Ten Do’s and Don’ts
  • Session Feedback and Quiz

A well executed franchise program can catapult a sound business concept into a world-wide organization. 7-Eleven© operates over 36,000 stores in 20 countries. Subway© is operating over 33,000 shops in 91 countries.

If you are operating a business with multiple locations you may have a good model for franchising. Growth can be accomplished by utilizing the capital and motivated management provided by franchises.

But franchising can be a double-edged sword. Mistakes made in a faulty franchising program can turn a successful business into a disaster. The strategies outlined here come from hands-on experience and will help minimize your mistakes.

Franchising provides expansion capital

The need of capital to grow is largely eliminated. The franchise fee paid by the franchisee will normally cover expenses such as fixtures, signs, rent deposits and other opening expenses. This source of cash from franchisees can reduce or eliminate one of the greatest risks of growing: financial leveraging. Instead of borrowing for growth, you franchisees can furnish the capital.

Avoids employee related problems

In a company-operated store the manager and employees are on the company payroll. In a franchised unit, they are employed by the franchisee. This relieves the franchisor of the escalating headaches related to employees, workers compensation insurance and other labor related issues.

Accelerates expansion over a wide area

The franchisor is thus free to expand geographically at a rate that eliminates the three big issues of money, managers and employees. Using Internet technology communication tools, international expansion becomes more feasible.

Franchisee operators are motivated to succeed

Some years ago a chain of doughnut shops switched from operating as a company-owned chain to a franchised chain. In most all cases the company managers stayed on as franchisees. The results of the transition were apparent the very next day. The stores were cleaner, the sales went up, and the donuts were bigger and better. The difference was that instead of managers the stores were taken over by proud owners.

Sharing profits

Your store concept will need sufficient volume, pricing and lasting power for both you and the franchisee to earn profits over a long period of time. This will rule out commodity products where sales go to the lowest cost provider or to fad based products.

Loss of absolute control

You will no longer have absolute control of how your stores are operated. Instead you will be dealing with a partner who has agreed to operate the store by following your training and instructions.

Lawsuits with unprofitable stores or uncooperative franchisees

If a franchisee is unable to make money or has any other reason to be disgruntled, you can be in for a lawsuit. If even as few as 5% of your franchisees instigate litigation, your loss of reputation and litigation costs can be very damaging.

State and federal franchise disclosure laws

Franchisors are regulated by both federal and state laws. You will need a franchising lawyer to draw up your franchise disclosure documents including a franchise offering circular. The documents will include a franchise agreement and will require disclosure of your company’s financial and other information.

Dr. Dan Nathanson

Anderson Graduate School of Business UCLA
What did Ray Kroc do differently when he started McDonalds?

And what did Ray Kroc the founder of McDonalds do differently than everybody else when he started? He made franchising a name. He created systems. He didn’t see himself as flipping hamburgers or making the best French fries. He thought of himself as selling his entire business to franchisees; people who wanted a system of doing business. And he went about creating a system to do this business and because if he was going to have to have many many establishments he couldn’t be in any every one of those establishments. He had to have somebody else running it. So he created a system that no longer needed him. He created a business that no longer needed him. So I suggest you don’t have to go out and franchise your business. But I suggest the orientation of looking at your business as a business and not being the product and thinking: What do I have to do to have a business in which I can come and go as I please and one that no long needs me? It means I have to get the right system and people in place so I can come and go and that’s a totally different orientation.

Start with company owned stores

Selling franchises is the least difficult problem in starting a franchise chain. There are always eager entrepreneurs ready to buy franchises. But it would be a mistake to start a franchise operation without first establishing a completely proven operating model and system. Most concepts will take two to five years to prove out. Without a profitable operation in place to begin with, you could be betting your company’s future because a failed concept can result in an avalanche of franchisees’ lawsuits.

Require profitability for both franchisor and franchisee

Your pilot plant stores, operating before you franchise, must demonstrate sufficient pricing power to satisfy both you as franchisor and also the franchisee. This would eliminate commodity type products where there is no pricing power other than selling at the lowest cost. Generally speaking pricing power can be defined as the power to increase your prices without lessening the demand for your product. The lack of sufficient pricing power can result in franchisees failing through burn-out and overlong hours.
While your growth rate may seem only limited by your ability to sell franchises and open stores, there are important reasons to carefully restrict growth rate, especially in the early years of development. A new franchise offering that projects hundreds of store openings in three to five years should be considered a high risk. Rapid early growth creates the following problems:

  • Compromises are made in the selection of store locations. The famous three qualities to consider in selecting real estate are true: location, location, and location. Finding good locations is like finding gold nuggets: you have to turn over a lot of rocks. And the success or failure of each franchisee will be largely tied to the quality of his or her location.
  • Too often compromises are made in lease terms. Issues such rent, term, options, cost of living adjustments, non-compete provisions, go-dark provisions, signage and common charges all need to be carefully negotiated with terms that will produce profitable stores. While it is the franchisees who takes on the lease obligations, their defaults become your bigger problems in the form of franchisee lawsuits and tarnished public image.
  • Risk of cannibalization and over saturation. Stores that are placed too close together end up competing for the same customers.
  • It takes time and experience to build up the overall infrastructure necessary to support a growing chain. Responsibilities such as franchisee training, area management, store accounting, store supervision, product development, real estate development all need to mature through experiences learned during early growth years.
  • Growth should be focused on developing specifically designated marketing areas to enable the clustering of stores and gain the benefits of cost effect advertising, supervision and delivery systems. But clustering must be disciplined so that franchisees do not overlap.

There are two ways a franchisor can structure the leases covering store locations.

Franchisees lease from landlords.

Franchisors have the franchisees sign leases directly with shopping center owners. A standardized lease form is furnished for submittal to prospective landlords. In this approach the franchisor usually takes on the responsibility of selecting and sometimes negotiating locations.

Some franchisors use this approach in order to not be obligated for the lease payments. The liability of a 20 year lease at PKR5,000 per month is PKR1,200,000. This is a huge number to burden the franchisor’s balance sheet. But there are two big problems associated with this approach:

Since the franchisor does not control the site, an unhappy franchisee is far more likely to walk away from the franchisee agreement.
Landlords who control good locations do not want to sign leases with “non-credit” tenants. They want to deal with the more financially responsible franchisors.

  • Since the franchisor does not control the site, an unhappy franchisee is far more likely to walk away from the franchisee agreement.
  • Landlords who control good locations do not want to sign leases with “non-credit” tenants. They want to deal with the more financially responsible franchisors.

The franchisor controls the real estate.

In this approach, the franchisor locates, negotiates and signs the leases for the stores and subleases the premises to franchisees. This puts power in the hands of the franchisor to evict franchises who are not meeting franchise agreements or for other reasons and releasing to new franchisees. Exposure for the huge rent liabilities is mitigated by use of a sub-let clause which permits franchisors to re-lease premises to other franchisees or to non-franchised tenants.

As a franchised operation grows in size and financial strength, it can borrow money much less expensively than paying rent to landlords. Most all well-seasoned franchisors control their locations either by being the underlying tenant in leased spaces or by owning locations and leasing them to franchisees.

Avoidance of investor franchisees

Most successful franchisees operate their stores and are not absentee investors. An investor adds a third party to the profit pool (along with the franchisor and the store manager) that is usually hard to support. Potential investor-franchisees should be screened out early in the application process.

Under some circumstances matured franchised companies will negotiate “area” franchisees where the franchisee is responsible for a geographical area and multiple stores. For example this plays a more important role in franchising overseas where an area or even a country franchise may be appropriate.

Phil Holland

Founder, My Own Business
What are some of the advantages and disadvantages of becoming a franchisor?

To begin with if you feel that your route to expansion can be handled by franchising there are some things you might want to think about. First of all it’s important that the vehicle that you have, the retail concept is sufficiently proven both in terms of durability and earnings to be satisfactory to generate enough profits for you and your potential franchisees. There are some good and bad aspects about your becoming a franchisor. Covering the good things; the investment in capital to expand your chain will no longer be coming from your retained earnings but will be coming from your franchisees who will be supplying the capital to open stores including rent deposits, equipments, fixtures. This will allow you to expand much more rapidly and also geographically. The other benefits of being a franchisor is that there is one huge benefit that you are no longer are engaged with the employment difficulties of having employees. Because remember now the employees and management running your stores will no longer be on your payroll but will be on the payroll or your franchisees. There’s some potential problems in becoming a franchisor. One risk you face is that you’re now dealing with essentially with franchise partners and there is a risk of people being unhappy or being unprofitable or even over-working to make money. Many of these instances can these instance can result in litigation. And it has been experience that franchisors who have as little as five percent of their franchisees in litigation is usually a signal that the franchise is not successful nor would it be successful in the future.

Screening of franchisees

A franchised company is only as good as the quality of their franchisees. It is a good investment to retain the service of a professional to assess potential franchisees. They can be found under the heading “franchisee employee assessment” in search engines.

Don’t be misled into zealous growth because you find a lot of potential franchisees clamoring for your offering. There are lots of entrepreneurially minded people seeking to operate franchised businesses. Your challenge will be to install filters when interviewing potential franchisees so that selected candidates all demonstrate integrity, intelligence and energy as well as the intention to become active operators. As Warren Buffett has said, “People with integrity are predisposed to perform; people without integrity are predisposed not to perform. It is best not to get the two confused.”

Real estate development

Real estate development plays a key role in franchising. These functions include:

  • Creation of the design and working drawings of stores including equipment and fixtures.
  • Negotiation of store leases in shopping centers or other appropriate locations Normally the franchisor will be the lessee and the franchisee the sub-lessee.
  • Securing building and occupancy permits.
  • Build-out of store premises including fixtures and equipment.
  • Participate in store opening process.

Site selection is a key factor in the success of a franchised chain. Each business has its own individual site criteria. For example a donut shop should be on the side of the street going to work and a liquor store should be on the side going home. Through research and experience you need to create a “Site Model” that will provide a measurable, non-emotional, objective way to evaluate potential locations.

You can create your own “Site Model” by assigning different values to the factors that are most important for your particular business. Then each location can be numerically evaluated and compared against these measurements. The following example form will give you a methodical approach for evaluating the strengths and weaknesses of each potential location. Here are the steps:

  • Evaluate your site location for each factor on a scale of 1 to 10, Number 10 being the highest.
  • Decide the importance of each factor to your particular business on a scale of 1 to 5, number 5 being the most important.
  • Multiply the grade by the weight to determine the points for each factor. Add up the points to get a total score. Repeat this process for each site to gain an objective, comparative analysis.

Site Criteria Table
Factors Grade 1-10 Weight 1-5 Points
Traffic count: Cars or pedestrians
Visibility access
Proximity to competition
Zoning
Parking (include off-street parking)
Condition of premises
Proximity to customer generators
Income level of neighborhood
Population density
Ethnic make up of neighborhood
Age factor
Directional growth of area
Area improving or deteriorating
Crime/shoplifting rates
Availability of qualified employees
Labor rates of pay
Supplier proximity
Terms and rental rates
Adequacy of utilities, gas, & water
Transportation accessibility
Total Points

Some things to keep in mind in site selection:

  • There’s no such thing as the “last good location.”
  • Copycatting your most successful competitor’s site criteria can help you avoid making mistakes.
  • If you are building a chain of stores, never sign a lease on your second location until your first location is profitable and proven.
  • It is better to pay fair rent on a great location than pay great rent on a fair location.
  • Don’t rely on leasing agents to make your site decisions.
  • Driving streets and walking neighborhoods is a good way to scout for locations.

You will need to decide whether to build an in-house store development department which will be responsible for all aspects of site location and leasing or to outsource to commercial real estate brokers. A drawback to using brokers is the risk of conflict of interest issues.

Specialized legal council

Your legal council will be responsible for approval and compliance with all documentation including the offering circular, the franchise agreement and the sublease agreement. It is important that your legal council be experienced in corporate work and experienced in franchising law. If you are interested in an international franchising program, global expansion will require special skills. Please visit International Franchising in the Global expansion session in Business Planning section.

Training and operations management

You will need franchisees that are well trained, well motivated and well supervised. Your mission should be to emphasize consistent operations procedures, service, quality and cleanliness.

Area supervision

Ongoing oversight will be required to maintain consistency in quality and adherence to procedures. In the food service business it is correctly stated that “you are only as good as your last meal served”. Area supervisors also provide valuable feedback. This recommendation may not be applicable to multi-national franchisors but it would be a sound policy for start-ups. The franchise fee should be escrowed and disbursed to the franchisor upon opening of the store.

An unsuccessful franchising concept will usually trigger a bankruptcy of the franchisor as well as the franchisees. If this happens and the franchisor has commingled franchise deposits, franchisees that have not yet opened stores will lose the fees they have paid. Franchisors who follow a policy of escrowing franchise fees will gain in the following ways:

  • Protect the deposits of franchisees in waiting.
  • Generate a larger pool of franchisee prospects to select from. (More will come).
  • Self-impose a healthy financial discipline.

Stan Henslee

CPA
What mistakes are made when companies franchise their business?

I think there’s two mistakes; the first mistake is that the franchisor does not vet the franchisee properly. The prospective franchisee may not have any business management experience, may not have any business experience in that particular field. They are just going to be passive investors and they’ve got some idea that all’s they do is come in Saturday morning and clean out the cash register. It just does not work. The second mistake that franchisors make is a failure to follow up on the quality control of the product that the franchisee is putting out, be it clothing, be it food, whatever it is. The franchisee may start to cut corners and put out an inferior product. That ruins the reputation of the entire chain of franchises.

Offering circular, franchise agreement and store lease

Transparency in all matters and risks will be the key in disclosures to franchisees. The three main legal agreements will be the offering circular, the franchise agreement and the store lease. It’s best to have legal council that is experienced in the franchising industry.

Audited financial statements

Audited financial statements provide the highest level of audit scrutiny. It should be considered a necessary expense of becoming a franchisor.

Profit and loss statements from franchised stores

Your prospective franchisees should have access to the P & L’s of operating stores of their selection. Disclosing P & L’s from only the best stores can lead to claims of misrepresentation.

Pending litigation including with franchisees

The quality of your franchise will be evaluated by what percent of your franchisees have filed lawsuits. Generally speaking 1% or less indicates a good record, 3% indicates further investigation and 5% or more could indicate serious problems.

You should be prepared to disclose all lawsuits including past and present ones with franchisees.

Contact information on past and present franchisees

The most important “due diligence” investigation made by a prospective franchisee will be what he or she can learn from your operating stores. So follow the principle “we have nothing to hide’ by furnishing open access to your franchisee roster.

Do’s

  • Create a location site model to evaluate locations.
  • Budget the franchise fee to cover start-up expenses.
  • Start with company owned stores.
  • Prove profitability first.
  • Understand you will no longer have absolute control.
  • Consider your franchisee as your partner.
  • Hire and retain a franchise lawyer.
  • Screen out passive investors as franchisees.
  • Retain a professional to assess potential franchisee.
  • Follow the principle “We have nothing to hide”.

Don’ts

  • Overlook your current store managers as potential franchisees.
  • Franchise a commodity product or service.
  • Start franchising without establishing a profitable and operating model.
  • Fail to create a franchisee training center.
  • Neglect ongoing oversight to maintain consistency.
  • Cherry pick P & L’s to present to prospective franchisee.
  • Commingle franchisee deposits with your business account.
  • Grow rapidly to begin with.
  • Hesitate to close an unprofitable location and relocate franchisee.
  • Withhold contact information of franchisees past and present.

Session Feedback and Quiz

Copyright © 1993, 1997-2016, My Own Business, Inc. All Rights Reserved.

Considerations for Family Succession

Provided by My Own Business, Content Partner for the SME Toolkit

Objective:

Going public is not a realistic choice for most businesses. But for a business with a growing and sustainable product or service, public ownership could become an ultimate goal. At the same time, it is a highly complex process. This session will help you evaluate whether going public is right for your business.

  • Succession is not easy
  • Planning family succession
    • Partial measures are not enough
    • Why succession planning is routinely neglected
    • Adverse consequences are preventable
  • Your succession team
    • Lawyer
    • Accountant
    • Financial advisor
    • Insurance advisor
    • Key employees who are not family members
    • Advisory board
  • Choosing your successor
    • Thoughtful planning can strengthen the company
    • Coordinating founder and first generation goals
  • Resolving sibling goals
  • Top Ten Do’s and Don’ts
  • Session Feedback and Quiz

At some point in the life of your business you should begin the process of turning your business over to others. No one likes to think about death or taxes…or creating an exit plan. But failure to take on this responsibility will not only be costly to you but also to your family, employees and can lead to unnecessary and ruinous outcomes. You will have four alternatives for an exit strategy:

  • Plan for family succession which we will deal with in this session.
  • Sell the business.
  • Liquidate the business and sell the assets.
  • If none of the first three possibilities are realistic, the last resort would be to file for bankruptcy.

If your children or other family members are interested and qualified to run your business someday, now is the time to begin establishing a strategy to implement a successful transition plan. But be warned: according to a Bank of America study, while three out of four companies say they have a succession plan, fewer than 40% of businesses have actually implemented them. And just 15% of family businesses even make it to the second generation and even fewer to a third.

So you have a choice: someone is going to end up dictating how your company’s assets are transferred. If it’s not you it will be someone who will be less invested in the outcome then you are. Instead, it’s far better to start with a solid foundation which can be built upon by your successors.

Dr. Dan Nathanson

Anderson Graduate School of Business UCLA
What succession issues should a family business be thinking about?

Family business is the most difficult and the most rewarding types of enterprises that there are. You would be surprised to learn that family business on average outperform non-family businesses and they outperform them by a significant amount in general. Now sometimes there is a lot of dysfunction, very often there is a lot of dysfunction. The difficulty with a family business is having the balance between the family, the business and the ownership of the company. And those three things interact and the biggest thing some in succession planning. Succession planning is something that just doesn’t happen last minute. It’s something that the family talks about for a long time. The most common mistakes are that the next generation, the child generation don’t get enough outside experience before they come in. So they don’t feel enough of a sense of “I could do something else but I am choosing to work in my family business”. And the family also doesn’t see this next generation as being really valuable to the needs of the business right away. So it’s a matter of perspective. There should be and most of the time there is no communication about the business until and even after the next generation is coming into the business and the expectations are; Well 10, 15 years you’ll get you’re shot and you act as employees, you sweep the floors like everybody else. Which is all fine and you start them from the bottom. But understanding the nature of the business decisions, having people understand the nature of that relationship between the family and the business is critical.

Partial measures are not enough

There is no simple answer in implementing succession.

  • It is expensive. Transferring business control and assets requires expensive, highly qualified professionals.
  • It will involve issues of management of the business, its ownership and taxes.
  • It is a process not an event: Over time you will deal with changing laws and tax rules.
  • It is not an undertaking you can accomplish piecemeal: The various aspects of the plan are all interactive with each other.
  • It will take away time from your daily business responsibilities.

Why succession planning is routinely neglected

Successful entrepreneurs devote all their energies to the complexities of operating their businesses. Neglect in undertaking a plan can be the result of a combination of factors working together. These could include little desire on the part of founder to give up leadership or perhaps lack of interest on the part of the children to take over. Those who neglect succession planning only do so because of lack of knowledge of the importance to them, their families and their business.

Adverse consequences are preventable

A carefully planned, documented and maintained succession plan is like maintaining insurance in place to assure the maximum potential for good fortunes for the company. Not having a plan in place is like “going naked” on insurance coverage, where you are betting the company that an adverse event will not take place.

The potential adverse tax complications in the absence of a plan are horrendous. Decades of work can be dissipated unnecessarily and preventable by having a plan in place.

John Powers

Attorney-at-Law
Cautions on family succession

We find that more often than not the younger generation that is taking over a business within the family is anxious to do so. And the most difficult for them is to have the patience to live with that business before they begin to remold that business and change the business because that level of disruption can be very unsettling to your employees which can translate into a very unsettling relationship with either suppliers or customers. So the largest caution that we can offer is patience in the transition and respect for what has been established and the history before you begin to remold and rebrand that business perhaps in your own image or vision.


Having one or more of your family members take over the business will require a collaboration of specialists dealing in taxes, legal issues, family matters, training strategies and family counseling. It is good idea to begin developing your exit strategy early and have regularly scheduled meetings of the entire team to update and reevaluate the succession plan.

In addition to an ongoing evaluation of your successor, your team should also be considering issues such as:

  • Is there adequate funding available through insurance to ensure business survival in the event of premature death of the owner?
  • How will retirement income be provided to the retiring owner?
  • What alternative strategies should be pursued in the event that there is no qualified family member to take over the business?

Lawyer

Transferring your business to other members of your family will include transfer of large assets in which taxation will play an important role. But be careful that tax planning does not become the overriding consideration when making decisions. Regardless on how qualified your tax advisors are, taxation issues should not become the deciding factors. It is better to decide what will be most appropriate for you and your family and then let the lawyers and tax specialists determine the most tax efficient way to accomplish your objectives.

The disposition of your business will require strong interpersonal skills on the part of your lawyer. Issues to be addressed will include overall estate planning as well as the succession plan of the business.

The reasons that most family succession plans are never fulfilled include unmanageable taxes incurred, no offspring being interested, and family discord. Your lawyer and accountant will help to manage these issues.

Accountant

Your accountant’s and lawyer’s joint role will be to prepare your tax defense. The succession plan will provide an opportunity that will permit you to maximize your various exemptions and shift tax burdens off your successors. These taxes are not to be ignored. You will be exposed to at least three kinds of taxes: estate taxes, gift taxes and corporate gains tax.

Financial advisor

If the plan incorporates financial payouts, your financial advisor can offer suggestions for dealing with a wide range of investment options. Once again, your succession team should work together in helping decide on a wide range of scenarios.

Key employees who are not family members

By the time you succession plan is underway, you will most likely have a nucleus of key managers who will be important to the ongoing success of the company. By including them in your succession team you can gain their support as well as key insights into operating policies as well as improving your chances of retaining them. Your customers will also gain reassurance that future business relationships are not going to be subject to surprises or unanticipated shifts in services.

Insurance advisor

Companies with multiple owners frequently use buy-sell agreements funded by life insurance to fund the transfer of ownership upon the death of a partner. In a growing business, two ongoing insurance issues must be dealt with:

  • Periodically reevaluate the company’s worth and increase the insurance coverages accordingly.
  • Don’t let the policies lapse!

Advisory board

Consider bringing your team together in the form of an advisory board that can collectively participate in planning discussions. Consider including:

  • A succession plan consultant. There are professionals and firms that specialize in succession who can facilitate working through the planning issues.
  • Members of your family.
  • Your Advisory Board should include outside business leaders who have demonstrated success in their own succession planning.

Dr. Dan Nathanson

Anderson Graduate School of Business UCLA
How should a family go about getting information on business succession?

I suggest that for many many family businesses they go and start to do some reading about family business and cases about family businesses and what works well and what doesn’t work well. And when it’s time for the next generation to leave, you know the CEO of the company, the Founder of the company; various levels of issues that come up; how can I leave my baby? I still need to be in control to make the decisions or else they run away completely. It’s just like buying a business and such, a healthy transition is often very difficult and hard to make happen. I suggest you read and go and get a consultant, family business consultants have sprouted up and talk to a few of them see who you feel comfortable with and work with them through a transition process. There are always issues in a family business, fairness issues. What happens?-and it gets into the estate planning. Well one child wants to work in the business; one child doesn’t want to work in the business. How do you split the estate? Does the child that’s not in the business get a piece of the business? Do they get voting rights in the business? Do they get compensation from the business? How does that whole thing work in terms of fairness if you’re going into the business or not? There’s a million questions like that that come up and there’s tried and true methods depending on the nature of the specific family and that can vary all over the place. So I suggest that you talk to people, be open about it and look at the best ways to work though a family business situation.

Thoughtful planning can strengthen the company

Your advisory board’s planning will strengthen the company in ways not anticipated:

  • Your planning process may provide information and expertise to evaluate potential public ownership. For example, the plan should evaluate the future growth prospects of the firm. If the growth is attained, could the company become a candidate for public ownership and enjoy the benefits that go along with it?
  • You will reassure key employees that the company is carefully planning for the future. If no first generation children are qualified, the founder might consider selling to his employees.
  • Clearly establish lines of responsibility, now and into the future.

Coordinating the founder’s and first generation’s goals

Starting early is good for a number of reasons:

  • There will be more time available for you to evaluate different options for succession as the children are growing up.
  • Over time you can evaluate your children’s qualifications and earnestness to carry the business forward. Your children can gain work experience in the business to evaluate if they wish to take over the business or to pursue other goals. An offspring can demonstrate performance ranging from exceeding your fondest expectations to the unhappy conclusion that the offspring is hopelessly unqualified to carry on the business. On-the-job training can begin in high school, or earlier, with emphasis on a start-at-the-bottom approach to experience in job responsibilities.
  • A formal business education will also be important for your family successor including a college degree in business administration including accounting and preferably going on to a masters degree in business. Simply put, the more formal training the better your offspring will be prepared to keep abreast (hopefully ahead of) highly trained business rivals.
  • You have sufficient time to ensure you have the funds needed to retire without depending on the company for ongoing income.

Get your potential successors involved in job responsibilities that will give them insights in every facet of the business. It will be important that their personal feelings and goals be considered. Evaluate the strengths and weaknesses of all potential successors, keeping in mind what will be best for the business.

While most entrepreneurs would like their business to be taken over by the children, if none have the training or interest in doing so, family succession is not a realistic option. In such cases the founding entrepreneur must look to other options including selling the business or closing it.

A successful entrepreneur built up a robust metal working business. As much as he desired to have the business taken over by one of his three sons, they all developed other interests. Two of the three went into medicine and the third into a music career. The founder’s remaining option was to sell the business, which he did to his employees.

Your succession plan will have a much better chance if your successor works in the business long before taking it over.

A chain of food shops is now run by a CEO whose father was the founder. The son started in the business during his first year of high school. He worked in food service duties including washing floors and taking out the trash. He grew to love the business and his early work experience was invaluable later on when no one could fool him on how to run a store.

Lincoln Watase

President, Yum Yum Donut Shops, Inc.
How should a company plan for family succession?

I think family planning succession is very important. And in my case I had a lot of benefits. First of all my dad kind of lead by example just in the way he approached work, the way he was a hard working guy, the way he stressed education. So also as a child my brothers and sisters and I, we saw the company grow and we always felt excited about seeing the company taking those next steps. As a result I started working for the company at a fairly young age in high school I first started out as a clerk working in the stores then as a baker then as an assistant manager then and a manager and then finally a district manager. With all that time spent at the store level it certainly gave me a lot of great experience as well as a tremendous appreciation for the folks that are working so hard in those stores. In addition once I was in more of a management position for the company I really will always appreciate my dad giving me the chance to not only to have some responsibility but to be able to make my own decisions. And some of those decisions were hindsight not always the best of decisions but that is always just a great way to learn.

The goal of a succession plan will be to accommodate each family member. But keep in mind that the objectives of family members can often differ from those of the founder. During the founder’s lifetime the business came first. Problems can result if the generation taking over the business is focused on other interests.

To avoid this problem, a common approach is to separate the business from the family assets. Family members who are not active in the business get family assets, while those who work in the company get shares. Here is an example of the role a good lawyer can play in resolving sibling goals:

A man successfully created a business and brought in one of his children, but not his wife or other children. His desire was to reward the child who is in the business to the exclusion of the others by leaving the business to the one child, but leaving his wife and other children equivalent assets.

But often there are not enough other assets to divide the estate in the manner he desires.

So the lawyer had business recapitalized to give the wife and other children notes and/or preferred stock so that the increase in value of the business will go to the child who is working and making the business grow, but requiring him to pay off his mother and siblings through the notes and preferred stock. Or, alternatively, nonvoting common stock could have been used if the father wants the siblings to share in the growth but without the right to interfere with the running of the business by the operator.

Stan Henslee

CPA
What problems have you seen in succession plans?

Well the biggest problem that I’ve seen, now in my practice I’ve seen maybe a dozen attempts at transitioning a business to children and family and only two of them have really worked very well. The two that worked well, the proprietor or the entrepreneur involved his children very early in their lives in the business and made it a part of their life as well. The instances where it did not work was where the children were brought into the business probably at college age and by then they just weren’t interested. Perhaps the most effective transition I’ve seen was where the father set up a family limited partnership. Brought the children in as limited partners with very minute interest very early in their age and were talking perhaps Jr. High School age and then each year he would gift them a very small percentage of the business and he would involve them in, they would have actual responsibilities within the business and they would work on weekends or after school, particularly during the summer. That way they were able to earn the respect of the other employees and the business became just a part of their life. And as they got older and went into college the father knew by then if the child or children were going to be interested in taking over the business. The once thing you have to do in a situation like this is that you have to have a plan B because you never know if that child your counting on may decide he is not the least bit interested in that business and if that is the case have a plan B or a way to sell the business or your estate to sell the business in the event of your death.

Do’s

  • Start your transition plan now.
  • Evaluate the interest of family members to run your business.
  • Take time from business to plan for succession.
  • Retain a professional succession advisor.
  • Document and update your succession plan.
  • Create a succession team including family members.
  • Have specialized tax and legal advice.
  • Resolve sibling’s goals and discords.
  • Look to other options if succession is not realistic.
  • Involve your successor in business long before taking over.

Dont’s

  • Put off business succession planning.
  • Assume that family members are qualified.
  • Assume that family members are not qualified.
  • Disregard the value of an advisory board.
  • Overlook planning due to lack of knowledge.
  • Ignore potential adverse tax complications.
  • Fail to keep life insurance policies updated and in force.
  • Disregard the personal goals of potential children successors.
  • Combine business assets with family assets.

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