© 2007 John Wiley & Sons Australia, Ltd

Options for going into business Chapter 5 Options for going into business

Chapter outline Issues to consider before going into business Starting a new business Purchasing an existing business Entering a franchise system Comparison of options Procedural steps when starting a business venture.

Learning objectives Explain the 3 major issues that all prospective entrepreneurs and small-business owners must consider before going into business Compare and contrast the advantages and disadvantages of starting a new business.

Learning objectives Outline the factors to take into account when assessing a business for purchase Explain the different ways of calculating a business purchase price

Learning objectives Describe how a franchise operates Use the ‘6 step’ process to organise your strategy for going into business

Business commencement options There are essentially 3 major options for going into business: Launch a new (start-up) business venture Purchase an existing firm Enter a franchise arrangement

Issues to consider before going into business Any business venture is driven by 3 forces: Personal goals and abilities of the owner/entrepreneur What resources are available to the business owner (money, staff, etc)? The nature of the business opportunity itself

Starting a new business — the advantages The owner can shape his or her own vision Flexibility — fewer constraints on owner Cost minimisation — often cheaper to start New lifestyle goals — can ensure business and personal goals are closely aligned from the outset

Starting a new business — the disadvantages Hard to raise capital Lack of an established customer base May suffer cash flow problems Requires considerable effort to learn how to operate the business effectively (‘learning curve expenses’)

Costs of a start-up venture Some costs are common to all new enterprises, such as: Licenses and permits required to operate the business Working capital Communications equipment (such as telephones, computers, fax machines) Operating plant and equipment

Costs of a new (start-up) business venture Staff recruitment expenses Insurance Raw materials (or trading stock) Rental of premises (unless working from the owner’s home) Stationery In addition, there will also be industry-specific expenses.

Purchasing an existing business Advantages: Can begin trading immediately Easier to arrange finance for the venture Established track record of the firm allows a more objective evaluation of likely future performance

Purchasing an existing business Disadvantages: May ‘inherit’ existing liabilities Less flexible than a start-up Difficult to establish purchase price

Establishing a purchase price Three major techniques used by sellers (vendors) and purchasers: 1. Market-based valuations 2. Asset-based valuations 3. Earnings-based (cash flow) valuations

Market-based valuations The going market rate method simply the ‘current market’ price for a particular type of firm Selling price = Selling price of similar firms

Market-based valuations Revenue multiplier method common ‘industry multiple’ that is used to estimate the most likely purchase price of the practice Selling price = Turnover × Standard industry multiple

Asset-based valuations Involves setting a price after examining the assets and liabilities of the business: Book value asking price is set by first calculating the worth of all the firm’s assets Selling price = Tangible assets + Intangible assets − Liabilities

Asset-based valuations Adjusted book (net asset) value simple book value method relying on the books of account

Asset-based valuations Liquidation value value of the business if it was to be broken up and sold as individual assets, rather than continuing to operate it as a going concern

Asset-based valuations Replacement value the cost of replacing all of the firm’s tangible assets (at current market costs)

Earnings-based (cash flow) valuations Return on investment based on the assumption that the risk and return of a business should be reflected in its selling price. It works on a formula which includes the estimated future profit earnings: Selling price = Net annual profit × (100/ROI)

Earnings-based (cash flow) valuations Discounted cash flows reduces (discounts) the future cash income generated by the business back to its current value Value = + terminal value

Questions to ask Why is the business being sold? Will existing staff remain if the business is sold? What debts/liabilities exist? Can all licenses and permits to operate be transferred? How accurate are the financial accounts?

Questions to ask What is the future state of the industry — is demand increasing or decreasing? Is the lease on the premises secure? What is the condition of the physical assets? Will existing customers remain loyal if business has new ownership?

Entering a franchise system An increasingly common form of business operation. An arrangement whereby the originator of a business product or operating system permits another business owner to sell these goods, and/or to use the business operations system, on his or her behalf.

Entering a franchise system A licensing arrangement: a small firm receives permission to sell a particular product from an established parent organisation, but remains legally independent of that parent.

Entering a franchise system Typically has lower failure rates than new start-ups. Good for small business owners seeking security Less suitable for entrepreneurial types.

Entering a franchise system Franchisee: The business or individual who is given contractual permission to operate a particular business franchise system or sell a product by the original owner of the same. Franchisor: A business or individual who owns the right to a particular business franchise system or product.

Entering a franchise system Product franchise: gives the small business operator the right to sell a particular commodity, or set of goods. Franchisee is a distribution mechanism for good or service; has a large measure of independence about how their business is operated.

Entering a franchise system Product franchise (cont’d): Franchisor’s role is limited to ensuring that sufficient stock is made available, and that the franchisee is selling the product at a satisfactory price.

Entering a franchise system Business system franchise: A situation where the franchisor not only supplies the product, but also gives comprehensive guidelines about how the business is run (e.g. McDonald’s). All aspects of organising and operating the business have already been investigated, pre-tested and successfully implemented by the franchisor.

Advantages of franchising The new business owner is spared the task of developing an operating system New business owner learns less ‘by mistakes’ Customers are usually attracted by the presence of an established product.

Advantages of franchising Lower failure rate Franchisors provide continuing training for franchisees Pre-organised access to raw materials and supplies Raising capital can also be easier

Disadvantages of franchising Access to these systems does not come cheaply Purchase price is often quite high Franchisees have to pay a proportion of their profits to the franchisor Franchisees are restricted to serving a set market

Disadvantages of franchising Franchisees subject to contractual arrangement, and as such have a limited lifespan

Comparison of options

Procedural steps when starting a business venture Figure 5.2: The process of going into business

Summary There are 3 factors which influence all business ventures: the personal goals, desires, experience and abilities of the owner/entrepreneur the financial, human and other resources available and the nature of the business opportunity itself.

Summary There are 3 different ways of getting into business: starting a new business buying an existing operation or entering into a franchise arrangement. Each has their own advantages and disadvantages.

Summary There are 3 main ways of setting a price: market-based valuations, asset-based valuations and earnings-based (cash flow) valuations.

Summary There are 6 steps involved in the process of evaluating business options. After these steps, the intending business owner must critically evaluate which business avenue is the best option.