When buying an existing business, it's important to thoroughly evaluate the business model.
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In essence, when evaluating a business model, you must ask three questions:
- How does the company I am about to buy currently make money?
- Can I continue to make money after I buy this business using the existing business model?
- Is there something I can do to change the business model to greatly improve the potential of this business?
How Does the Business Model Make Money?
At first blush, this question would not seem to be very illuminating:
- How does a Subway franchise make money? Well, they sell sandwiches. Duh.
- How does a local drycleaning business make money? They take in clothes, dry clean them, and get paid to do that. Duh.
- How does a PR firm make money? They get clients to pay them money to get media placements. Duh.
- How does a website development firm make money? They build websites and get paid to do so? Duh.
- How does a lawn mowing service make money? They mow lawns and get paid to do so. Duh.
- How does a telecomm value-added reseller make money? They sell businesses T1 lines and other telecomm services and get paid to do so. Duh.
To evaluate the business model, you have to ask probing questions that take the discussion up a notch. Here are a few sample questions to ask when evaluating a business to buy and that company's business model:
- Is the business dependent on individual talent or can it still do well even when existing employees are replaced with new employees? In the case of a Subway franchise, the business is systematized and existing employees can be replaced. However, in the case of the PR firm, the customers may have been buying the skills and relationship of a single individual. If that individual is not there, the business model may not perform as well.
- Is their repeat business and a recurring revenue stream? A lawn mowing service can sign up clients for an entire summer, and have repeat revenues from customers every week. In contrast, a website development company might only be earning money while working on a specific project. In that respect, the website company is like a taxi driver. No fare, no income. A telecomm value-added reseller locks into a growing recurring revenue stream because they are typically compensated by the provider (e.g. MCI, Sprint, etc.) as long as their client keeps the service. Hence, in the fifth year of business, they are still earning revenues from companies they signed up five years ago, four years ago, etc.
- Is the value proposition unique and can a competitor steal the business away? A dry cleaner could lose a lot of business if a comparable business opened up across the street and offered the same services at half the price. The key to a strong business model is some sort of unique positioning that cannot be easily replicated by competitors.
Can I Continue to Make Money With the Current Business Model?
Just because the current owner is making money with the existing business model, doesn't mean you will be able to continue to make the same amount of money in the future.
In the case of the PR firm mentioned above, will those existing clients all stick with you? Will you be able to service clients well? Will you be able to attract new clients? The answers to these questions have a direct impact on how your business model will do for you.
At the end of the day, business models are not abstractions. They are personalized entities that succeed or fail. One person may do very well with a given business model, while another fails miserably.
So don't ask: is this a good business model? Instead, ask: Can I make money with this business model?
Can the Business Model Be Improved Upon?
This is where the real money is made.
If you simply plan on buying the existing business model and running it as is, then you will, in most instances, have to pay a price commensurate with what the business m model will generate.
However, if you can change the business model in a way that improves it, you can transform the price you paid for buying a business into a much higher value.
For example, maybe you buy the lawn service and transform it into a lawn service and landscaping company that also shovels sidewalks and driveways in the winter. You get a bigger share of your customer's wallet and you are well-positioned to grow the business because you have improved the value proposition.
Maybe, you buy the website development company and convert the model from a one-time contract business to a business that has upfront contracts but also has ongoing maintenance contracts. By doing so, you lock into recurring and predictable revenue streams that the previous owner never had.
You get the idea. When buying a business from an existing business owner, you need to look for the opportunities that the previous owner was never able to capitalize on.
Those subtle shifts in the business model are what can allow you to make buying an existing business the best decision you ever made.