Entrepreneurial Zeal--It’s Clearly Stronger Than Ever in the Southland

When Fred Powers contemplated buying Gorky’s, a downtown Los Angeles restaurant, two years ago, lower rates of interest and inflation made the cafe seem as good, or better, an investment as the high-rise buildings and apartments Powers had been investing in. “I felt that this would be something I could whip into shape in a couple of months,� Powers, 40, recalls, “and then I would return to real estate.�

It hasn’t worked out that way.

While the restaurant’s business has virtually doubled in volume, helped by Powers’ additions of a wholesale bakery, a catering division and two new basements with food-preparation facilities, Powers’ time involvement has risen incrementally. Gorky’s quickly became, and remains, Powers’ full-time job.

“I thought it would be a thousand times easier than it is,� he says.

Powers’ song is a common refrain in Southern California. Small businesses change hands at a dizzying clip in the Southland, where entrepreneurial zeal seems stronger than ever. Whenever an owner tires of the long hours and unending workload, he or she sells the business to an eager buyer and uses the often-substantial profit to buy or start another business.

On any business day in Los Angeles County, 40 businesses will typically record bulk sales transfers--a statistic equivalent to a transfer of title. That translates into 10,000 sales of companies annually, according to McCord Co., a commercial credit reporting service. On average, these companies sell for $45,000 to $115,000.

Local business brokers and acquisition specialists exult that, for every owner poised to sell, there are as many as 10 buyers lined up to purchase existing Southland businesses.

“Southern California is the mecca for small business deals,� says James McNeill Stancill, professor of finance at USC. “Smaller businesses are indigenous to California . . . and competition is high to buy.�

William C. Dunkelberg, a small business expert and Dean of the School of Business and Management at Temple University, agrees. “There are two hot areas in the United States right now--the West Coast and New England. Both of these areas have experienced a tremendous amount of in-migration. And every time you have 1,000 more people you need more support firms--a grocery store or shoe store.�

Moreover, Dunkelberg says, “the whole West Coast is a shopping center for foreign investors. . . . They started in the financial markets. Now foreign money is spilling into real assets--like businesses in Los Angeles.�

He predicts that this trend may last another decade and then run out of steam. “If we just let the demographic wheel turn, these foreign investors will stop working as hard and start living off their pensions in about 10 years, and will be liquidating their assets.�

According to Dunkelberg and other small business experts, buying an existing business is more efficient and cheaper starting from scratch--which helps explain the current popularity of buying small businesses in Southern California.

“Buying an existing business is as entrepreneurial as starting a business--and may be the best entry,� says Mack Davis, adjunct professor in the Entrepreneur Program at USC. “One reason for so many start-up failures is that there isn’t a proven concept�--a risk that’s avoided by buying a going concern.

Because Southern California is viewed as a sellers’ market for small and medium-size companies, most buyers in Southern California must turn to professionals not just to complete a deal but to find out what deals are available.

“Business brokers who advertise as ‘business opportunity’ specialists tend to handle sales of under $1 million, and they tend to be selling to people who are buying a job,� Hoods says. Buyers of dry-cleaning establishments, florists, specialty food outlets or other small retail establishments often intend to work there themselves and to employ family members, dividing up the net profit as salary.

In contrast, says Hoods, “merger and acquisition specialists tend to sell to investors who are buying a return on investment after paying someone to manage the business.�

Even in the middle market, starting at $1 million to $5 million and stretching to a $50-million price tag, some 16% of companies are sold to private individuals, with another 20% going to investor groups, according to a Geneva survey.

Fast-Food Operations

The competition for those considering the purchase of an existing business comes increasingly from foreign buyers. Some 20% of the buyers of businesses in the Geneva Co. survey were from abroad. “America is emerging as a tax haven,� Hoods said. “Next year, our corporate tax rate will be 34%, among the lowest in the world.�

The most popular existing businesses in the Los Angeles area--especially at the lower price range and among foreign buyers--are, not surprisingly, fast-food operations and other food-related service businesses where language skills are secondary to cash. But these are not the only businesses expected to be profitable through the next decade.

“A person looking for good growth potential in the next few years would do well to look at medium- to high-tech industries, or a business that would require technical skills,� advises Ed Resha, Jr., a broker at V. R. Business Brokers in Los Angeles.

Hoods pinpointed wholesale distribution firms, rental equipment companies, light manufacturers, business and financial services and computer-related businesses as all poised for growth. And the emphasis of the moment is on profits. “Here in Southern California we are not selling sick companies,� he says. “There is too big a market for healthy companies.�

Business brokers refer most typically to “multiples of sales� or “multiples of income� when they set prices for smaller businesses. But, as one seller of a beachside yogurt store glumly admits, “multipliers may not mean anything. Using such calculations my store should have sold for $175,0900. I got $120,000 after numerous buyers pointed out that that was what yogurt stores were selling for.�

“The comparable sales approach is quite common in business sales,� says one business appraisal expert. Even better, since there may not be a company that sold recently with exactly a comparable situation, are “comparable public company analyses,� which match a privately-held business with a similar, public one to set a price.

Hidden Costs

Setting a price on an existing business may be the least of the hurdles facing a would-be buyer. “The majority of sales in business opportunities are financed by the sellers, with a 30% to 50% cash down payment,� says Kathy Abbott, broker-owner of the Restaurant Broker Inc. in Buena Park.

“These are one of bankers’ least favorable loans. It’s very, very difficult to get a loan to buy a business, even a profitable one, unless you are a very strong financial risk personally.�

Moreover, Abbott warned about the hidden costs of going into business. “The inventory is separate from the cost of the business,� she observes. A buyer should include an escrow instruction placing a maximum dollar amount on the inventory, which is valued just days before escrow closes. Or, if inventory has been included in the sales price, a buyer should establish a floor to be sure a seller can’t deflate the inventory.

Other unexpected costs may include, according to Abbott, lease and security deposits; a 6.5% sales tax on that portion of the price allocated to “F,F&E;,� fixtures, furniture and equipment; escrow fees and a share of the 10% to 12% commission.

In addition, “it’s incredibly important to have a very knowledgeable attorney look into every aspect of all permits and regulations for compliance,� adds Powers of Gorky’s. “As an example, there was no certificate of occupancy posted in the restaurant. It turned out to be a nightmare where I had to involve city hall, the city councilman, the fire department and the building department.

“Six months after I was here, a city inspector walked in with a clicker and started counting people,� Powers recalls. “The previous owner said everything was in order, but I had 76 seats and he said only 49 could occupy (the cafe). It cost us roughly $13,000 in fees to the city and to architects to fix, and to have the number of seats we needed.�