© 2007 John Wiley & Sons Australia, Ltd

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

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

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)

Discounted cash flows• reduces (discounts) the future cash

income generated by the business back to its current value

• Value = + terminal value

Earnings-based (cash flow) valuations

tt

n

t r

CF

)1(1

• 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?

Questions to ask

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.