How systems influence how much equity is in a business (and help you decide what kind of business you should start.)

Many people dream of owning a business because they envy the Lifestyle, the Income, the Freedom and the Equity- L.I.F.E.™ – that successful business owners enjoy. Yet the majority are too afraid to choose the entrepreneurial life, conjuring up scary visions of 80 hour workweeks, sleepless nights, and possible failure. Certainly, depending how you set up your business and how prepared you are as an entrepreneur, starting and owning any business is not easy. But like any career, no one is born knowing how to run a business and most of us start our business career like we do any other career: by becoming savvier and more skilled overtime. As the business grows, we grow, and vice versa. In owning a business, your skill-set and success are entirely up to you, and by how much continuous learning you invest in time and money. Even those who have had successful careers in the corporate world should not underestimate the challenges of becoming a small business CEO of even of one person company. 

There is one framework that, when applied with discipline, makes the business owner’s life, and their success, easier and faster and that hugely contribute to an abundant life. Well-known but actually surprisingly ignored by many small to midsize business owners are business systems. A system is a set of procedures that are repeatable, documented, and enforced with the intent of creating consistency, save time, money and increase predictability. Every aspect of a business can use a system, from the simple act of greeting customers, to building a marketing plan, to growing a team, developing new products or services, etc. Even the building of systems should be a system. There is one other less obvious advantage to building a well-oiled machine of business systems, besides giving the owner more time to pursue other activities such as time with family or for hobbies. And that is how much equity good systems can create and that the owner will be able to cash in when they exit the business. Here we examine how systematization contributes to building equity and how taking it into consideration, in the early stages of your research of the right business to start for you, can help you make a better decision on what type of business path you should take: an independent business startup, a turn-key concept, or the acquisition of an existing business. 

Independent Business Startup.

In an independent startup from your idea, everything needs to be created from ground zero, often resulting in time-consuming trials and errors. This means that the ramp-up of your business model to profitability stretches farther in time. Depending on your entrepreneurial style, the task of building systems might be an exciting prospect or a dreadful one. Especially with a startup, the ramp-up time should be estimated in advance in order to plan for adequate working capital. Working capital in starting a business allows you, the entrepreneur, to pay your bills and “keep the lights on” in your business and in your life. This is even more important if yours is a brick and mortar business with fixed recurring costs such as rent. The good news is that with an independent startup you have a great opportunity to build equity that can be cashed-in once you exit the business. Building systems also helps you to successfully hire and train employees, which in turn will allow you to scale your business beyond your role as an individual contributor generating revenues. A key element to building equity in a business is that the business should not depend on the owner to be a producer of revenues. Otherwise, once the business is for sale and the original owner leaves, revenues will be diminished and so will the value of the business, hence its equity. Not having solid systems will also limit your pool of potential buyers.

Turn-Key Concept:

In turn-key businesses, for example franchises or business opportunities, systems are the life and blood of their growth, allowing them to scale domestically and internationally. The good news for a new business owner developing a franchise unit: systems are already in place and the concept is proven, thus avoiding a costly trial and error timeframe.  If you are exploring investing in a new franchise, your consultant if you have one, should emphasize validating the quality of the systems and training provided by the franchisor. After all, that is why you are paying $20K to $40K in franchise fee: having access to established and proven systems and training. In a good turn-key business the one time franchise fee will be worth it as building systems in a startup can cost several times a franchise fee. Keep in mind though that a franchisor will require any new owner (franchisee) to follow the established systems and procedures as is stipulated in the agreement signed by both parties. So be sure that this requirement fits your entrepreneurial style. Proven systems should result in shorter time frame for ramp-up, break-even point, profitability, and ultimately greater equity potential. Your franchise consultant should also guide you in determining how long the ramp-up will be necessary before you break-even and so you can budget the working capital accordingly. However, be sure to evaluate how much equity you might be able to obtain in any business model. If a turn-key business you are considering looks like it could produce $100K per year in net income and the seller’s discretionary earnings (SDE), which is net income +/- adjustments is about $110 K it means that you will most likely be able to resell it down the road for around that price as long as you are not the main revenue producer in the business.  If you target to earn multiples of the SDE in equity, a business should demonstrate well above $150K in SDE. Certainly the equity gained will depend on the business’ sector of industry, the type of buyer, and the state of the economy when you are exiting your business. Let’s take for example a franchise that cost $300K in startup investment. If could be a small gym, a hair salon, an ice cream shop, or even a small restaurant depending on the cost of leasehold improvements in your geographic area. Generally, if your objective is to eventually cash-in multiple of that initial investment at exit, find out during your early research stage that it is actually feasible with the business you are choosing, by doing your due diligence in assessing that the potential SDE in that business has a chance to support your goals in equity. 

Acquisition of business for sale

If you choose to acquire a business that is for sale, the good news is that the business is already cash flowing – unless you are considering one that’s losing money and that you want to turn around. However, the premium you are paying for a cash flowing business represents the equity that the seller has built over the years and that they have earned. Which means that if the business is mostly optimized, i.e. resources of time and space are fully utilized or almost, you are probably not going to increase much more value in the business overtime. For example, a restaurant, a spa, or gym that has an occupancy rate of 70%, meaning the tables or rooms or space are occupied 80% of the time, doesn’t have a lot of room to increase revenues. You can however recover your initial investment when you are ready to exit, which is still positive since you bought it as an immediately cash flowing business. A way to increase equity overtime beyond the original investment, would typically require that you scale up by investing additional capital, ie. for greater space, more efficient equipment, or developing an entirely new stream of revenues. If you are considering acquiring a business that has few business systems in place you could have greater negotiating power on the price you pay. That could also be your opportunity to build better ones and increase the value of this business overtime when you are selling.

With either a startup, a turn-key, or an acquisition, having solid business systems that you continuously create, improve and enforce with discipline can really give you L.I.F.E.™ Lifestyle, Income, Freedom and the Equity that many wish they could have. The best time to think about systems and the equity you might want to build is before you choose a business. Begin the process by having clarity on your priorities and your objectives to create a life you love via business ownership. That will help you determine the best path to business ownership path for you. Then, you can continue your due diligence with other aspects of business ownership such as which sectors of industry, full time or absentee models, brick and mortar or home-base businesses, and chose a business that capitalize on your strengths, your skills and your personality.

Author’s note: 

What are your thoughts? Feel free to comment or ask your questions. If you are interested in learning more about how to choose the right business for you, consider attending my next webinar or contact me at pb@openforbusinesslab.com to discuss your path to business ownership.