Aspiring small business owners flying blind

Many small businesses are only spending a small amount of time undertaking due diligence

Inattention to due diligence means many prospective new small businesses owners are failing to ask the right questions.

According to recent research by Griffith University’s Asia-Pacific Centre for Franchising Excellence, a large percentage of prospective small business and franchise owners are not aware of what due diligence is and of those that are, many are only spending a small amount of time undertaking due diligence.

The issue is important to aspiring small business owners as due diligence is the process of ensuring that investors are getting what they think they are buying and that what they are buying is worth what they are paying. It is also important to the economy as in Australia alone, there are currently over two million small businesses, employing over 4.5 million workers.

The 12-month research by Griffith University Asia-Pacific Centre for Franchising Excellence in conjunction with University of New South Wales and funded by CPA Australia’s Global Research Perspectives Program was conducted in two phases, the first of which involved interviews with 60 independent business owners and franchisees. The results of this phase, which were released mid-2015, showed an underlying naiveté by many in regards to business due diligence before starting or buying a venture.

The just-released results of the second phase, based on an online survey with 610 current and former small business operators, adds a quantitative context to the previous findings.

A major new finding is that the pre-commitment of investors to carrying out due diligence is driven by four key factors:

  • level of awareness
  • budget
  • appetite for risk
  • whether the investment is a stand-alone operation or franchise.

According to Asia-Pacific Centre for Franchising Excellence director, Professor Lorelle Frazer, 42 per cent of respondents were not aware of what due diligence is, or the resources available to help them conduct it. Some 39 per cent said they have some understanding of it, with just 19 per cent expressing a clear comprehension.

“We found that on average, people spent 28 hours investigating a business before committing to buy and one-fifth said they spent no time at all on research,” Frazer says.

“With such a big decision to make, more time should be spent sourcing and then weighing up information, and considering different options.”

However, not everyone skimps. One fast-food restaurant franchisee said due diligence “took probably 12 months from enquiry: looking at figures and documents, going through the different stages, seeing a solicitor and accountant, reviewing business plans and so forth”.

Although the amount of time both independents and franchisees devote to due diligence is relatively low, prospective franchisees tend to consult more widely than independents, who even when they do conduct due diligence, largely do so without professional input.

Entering into a franchise arrangement – or any small business venture – demands objective and dispassionate due diligence before a commitment is made.

Certainly the majority appear reluctant to invest in the exercise. Only around one-third consulted with an accountant, lawyer or other advisors prior to making a commitment.

“On average people spent $2000 on due diligence,” Frazer reveals. The average spend by franchisees was $2500 to $2700, dropping to $1500 and $2290 among owners of independent businesses.

Some felt they didn’t have any money to spare. One retail franchisee noted: “It cost me $240,000 to buy the franchise. There was no way I could afford to spend money on a lawyer or accountant. I was totally stretched.”

Report co-author, Assoc Professor Jenny Buchan from UNSW Australia, attributes the propensity of new franchisees to invest slightly more in due diligence to Australia’s Franchising Code of Conduct, which requires a franchisor to provide a pre-contract disclosure document.

As a result, prospective franchisees may have a better appreciation of the value of obtaining professional advice prior to start-up than independent small business operators, she says.

The study demonstrated that there is some link between due diligence, subsequent business performance and overall operator satisfaction. Again, the business performance and satisfaction levels of franchisees exceeded independents. Further research is however needed on the link between due diligence and performance.

Notably, however, franchisees were more likely to regret the extent of their diligence, with more than half wishing they had done more research before buying a franchise.

Entering into a franchise arrangement – or any small business venture – demands objective and dispassionate due diligence before a commitment is made. Unfortunately, the study reveals, due diligence is conducted far less than should be.

One current auto-repair franchisee summarised: “It’s the work you do prior to signing on the dotted line that helps to ensure you’re not buying a lemon, setting up in the wrong location, or even just investing in the wrong type of equipment.”

KEY FINDINGS

The two-phase research report, titled “The effectiveness of undertaking due diligence prior to starting up or purchasing a small business or franchise”, was supported by CPA Australia. It found:

  • A need for greater education and support for aspiring small business owners during the decision-making process prior to starting or purchasing a small business.
  • Widespread unfamiliarity with the term “due diligence”, how to conduct it effectively, and differences in both the type and amount of due diligence undertaken by independent small business owners and franchisees.
  • Less than one-fifth of franchisees and independent small business owners believed they had a clear understanding of due diligence before they purchased or established their business.

A free online pre-entry franchise education program offered by Griffith University in collaboration with the Australian Competition and Consumer Commission is available at: Asia-Pacific Centre for Franchising Excellence

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