Do *not* pay for "blue sky"
Posted: Thu May 17, 2018 4:59 pm
Someone in a thread I started with a question recently asked why anyone should continue to answer all of my questions if I was never going to offer anything else. So here goes. Before moving to Cambodia I was a professor of Economics for fifteen years and, before that, I worked in the field of Economic Development for ten. This is the career field within which persons are tasked with attracting new business to a town, retaining and expanding the businesses the town already has, and getting people started with their business ideas -- in which capacity I had many opportunities to counsel individuals who wanted to buy someone else's existing business.
And here's the thing I learned about that: Effectively nobody who owns and operates a business is capable of fairly assessing its resale value, for the understandable reason that they are far too intimately invested in that very question. In particular, business owners *always* expect a prospective buyer to pay for not just the assets of the business, but for the "fact" of the existing customer base as well. "I've built this dingy little storefront into a $700/day retail trade," so the logic goes, "so now someone has to pay me for that accomplishment."
In my former profession this is known as "blue sky" and, as hard as it may be for some folks to accept or believe, it is *utterly* valueless.
If you are thinking of acquiring a business, you must never, ever, *ever* pay for blue sky. The value of any business takes the form of the assets being offered, net of unpaid liabilities. And in the rented-storefront-retail space, that amount is, I'm sorry to say, almost, *always* zero.
For starters, note that the existing owner is asking you to pay for his or her expertise -- *but*, hang on a minute, the whole *point* of the sale is that his or her expertise is disappearing, right? I mean, it's not like the seller is planning to sign on as an employee after you've bought them out. So in order to believe that the existing customer base is actually worth money, a person would have to cynically view the general public as so blinded by the logo on the sign that they don't even notice that the place is under new management. That might be true if we were talking about a McDonald's franchise, but it ain't even remotely true if we're talking about a sole-proprietor restaurant, retail boutique, or bar. No, in those cases, as soon as the present owner is gone, the value of the existing customer base drops to zero, precisely because there's no rule that says they ever have to come back.
But it's even worse than that, because the idea that a buyer should pay for someone else's blue sky ignores the alternate strategy available to any aspiring entrepreneur -- namely to open the exact-same business right next door. If the existing entrepreneur really was successful in building up a trade, that trade would be geographically centered on that location, but NOT beholden to that specific front door (again, excepting cases of franchise-driven brand loyalty). All the prospective buyer would have to do is say, "Oh, okay, thanks for your time," shake hands with the seller, walk right next door and rent the storefront that shares a long wall with the one for sale, and the customers would all be right there anyway.
I had this lesson remembered to me by the very nice and personable owner/operator of "The Flicks" movie theaters. As many of you know, he's been trying to sell the theaters for quite some time now, and part of his rehearsed presentation is to offer to "show you all of his books for the past three years." And that's just the perfect example of someone expecting you to pay him for his blue sky: The books mean *n*o*t*h*i*n*g*, at least on the revenue side, the instant the seller flies back to his outfitters' business in Nairobi. They might be useful for drawing up your own cash-flow projections and budgeting for your debt service, but as an actor on the fair value of the theaters they are useless. And once you strip that aspect of his presentation, all you're left with is three leases (fair purchase price by someone else = $0 by the way), three projectors (pretty close to ditto), a movie collection, an outdoor sign or three, and a couple of popcorn machines. You could open right next door to the guy and call it "Flicks 4" for less than $3,000 in start-up costs. You could even use the exact same typefaces and color scheme in your signs and promotion materials. And there wouldn't be a thing he could do about it.
Do, not, pay, for, someone, else's, blue, sky, ever, period.
And here's the thing I learned about that: Effectively nobody who owns and operates a business is capable of fairly assessing its resale value, for the understandable reason that they are far too intimately invested in that very question. In particular, business owners *always* expect a prospective buyer to pay for not just the assets of the business, but for the "fact" of the existing customer base as well. "I've built this dingy little storefront into a $700/day retail trade," so the logic goes, "so now someone has to pay me for that accomplishment."
In my former profession this is known as "blue sky" and, as hard as it may be for some folks to accept or believe, it is *utterly* valueless.
If you are thinking of acquiring a business, you must never, ever, *ever* pay for blue sky. The value of any business takes the form of the assets being offered, net of unpaid liabilities. And in the rented-storefront-retail space, that amount is, I'm sorry to say, almost, *always* zero.
For starters, note that the existing owner is asking you to pay for his or her expertise -- *but*, hang on a minute, the whole *point* of the sale is that his or her expertise is disappearing, right? I mean, it's not like the seller is planning to sign on as an employee after you've bought them out. So in order to believe that the existing customer base is actually worth money, a person would have to cynically view the general public as so blinded by the logo on the sign that they don't even notice that the place is under new management. That might be true if we were talking about a McDonald's franchise, but it ain't even remotely true if we're talking about a sole-proprietor restaurant, retail boutique, or bar. No, in those cases, as soon as the present owner is gone, the value of the existing customer base drops to zero, precisely because there's no rule that says they ever have to come back.
But it's even worse than that, because the idea that a buyer should pay for someone else's blue sky ignores the alternate strategy available to any aspiring entrepreneur -- namely to open the exact-same business right next door. If the existing entrepreneur really was successful in building up a trade, that trade would be geographically centered on that location, but NOT beholden to that specific front door (again, excepting cases of franchise-driven brand loyalty). All the prospective buyer would have to do is say, "Oh, okay, thanks for your time," shake hands with the seller, walk right next door and rent the storefront that shares a long wall with the one for sale, and the customers would all be right there anyway.
I had this lesson remembered to me by the very nice and personable owner/operator of "The Flicks" movie theaters. As many of you know, he's been trying to sell the theaters for quite some time now, and part of his rehearsed presentation is to offer to "show you all of his books for the past three years." And that's just the perfect example of someone expecting you to pay him for his blue sky: The books mean *n*o*t*h*i*n*g*, at least on the revenue side, the instant the seller flies back to his outfitters' business in Nairobi. They might be useful for drawing up your own cash-flow projections and budgeting for your debt service, but as an actor on the fair value of the theaters they are useless. And once you strip that aspect of his presentation, all you're left with is three leases (fair purchase price by someone else = $0 by the way), three projectors (pretty close to ditto), a movie collection, an outdoor sign or three, and a couple of popcorn machines. You could open right next door to the guy and call it "Flicks 4" for less than $3,000 in start-up costs. You could even use the exact same typefaces and color scheme in your signs and promotion materials. And there wouldn't be a thing he could do about it.
Do, not, pay, for, someone, else's, blue, sky, ever, period.