Buying a Business Tutorial

Now is a good time to buy a business, there’s a huge selection to choose from. Baby Boomers (people born 1946 to 1964) are retiring at the rate of about 10,000 a day, a trend that will continue until the year 2029 and about 70% of all businesses are owned by that group. Wow!

Why buy an existing business instead of starting a new one? Simple, an existing business has customers, products and services, suppliers, employees and the necessary infrastructure to generate revenue whereas none of that exists when you start one from scratch. If the goal of owning a business is to better utilize your skills, control your own destiny and create a lifestyle that a corporate bureaucracy won’t permit and only 1 in 5 startups make it past the first year, then letting someone else run the first lap is the way to go.

What To Look For When Buying a Business (or Traits of a Good Business)

Beware of paralysis by analysis, there’s no such thing as a perfect business. The most important part of an acquisition is knowing what the challenges are and having a plan to manage them. Leave the decimals to someone else. 

  1. Seller’s Discretionary Earnings: It’s not the physical assets, it’s the earnings you want. Sure, you need the furniture, fixtures and equipment but what is the true financial benefit of ownership? Seller’s Discretionary Earnings (or, SDE) is net profit (before tax) plus non-cash expense (such as depreciation and amortization) plus interest plus Owner perks (such as salary, benefits and travel) plus/minus extraordinary expense (rent adjustments and expenses that are one time or non-recurring); the sum of which equals; Seller’s Discretionary Earnings. In the vast majority of cases, stable, predictable SDE are the reason to buy or not. The fact a business has historic roots or is a landmark is no reason to buy unless adequate SDE exists.
  2. Records: Are the books and records up to date? Are the internal records updated after preparing the tax return? Are the taxes filed on time? Is modern software present to keep track of sales, expenses and inventory? Answer no to any of these and you should run, not walk away as you can’t make an informed decision without good records. Accurate and current financials are critical in determining how the company fares in its industry, amongst competitors and most importantly, verifies what you’re being told by the Seller. All cars come with a key and a heater and all businesses (that are worth buying) come with good, electronic records.
  3. Depth within the Staff: A strong management team reduces risk. Can the company operate without the owner for more than a week or two? What is the average age of management? If a company’s success is reliant on capable, well-trained employees – and not the owner – it means the business will not be negatively impacted under new ownership.
  4. Customer Diversity: A broad customer base in which no single customer accounts for more than 5% – 10% of total revenue helps to insulate a company from financial hardship if a good customer does not stay after a sale. This is easier said than done for some businesses. If the nature of the business sometimes requires large customers, ensure that customer is managed by someone other than the owner. Relationships are key in small business and keeping good customers is critical. If customer concentrations exists, you can still buy but you may want to pay part of the price on a contingency basis tied to customer retention.
  5. Barrier to Entry: As mentioned, Buyers buy cash flow, not assets. Anyone can buy furniture, fixtures, equipment, vehicles and inventory and if that’s all it takes to compete with the business, someone probably will. The harder it is to get started in the business, the less likely you will have a lot of competitors. A low barrier to entry should equal a lower price. Look for customized software or apps that lower costs and increase customer awareness and satisfaction, well-defined processes, training and employee manuals, drawings or menus for continuity purposes, a solid digital presence and a strong brand, copyrights, trademarks, etc., etc. Any advantage over the competition reduces risk.
  6. Growth Potential: Future growth is the most basic covenant for acquisition and without it; there is no reason to buy. Look for new products or services that could be delivered to existing customers in the trade area. Will demand for the product or service increase as technology and population grows? What about adding capacity, can more equipment or staff increase profits? The business must be on a growth trajectory. Use caution though…If “potential” is what the price is based on; you’re paying the Seller for work and value you create in the future. Remember, if value were in potential, then rose seeds would cost more than the roses.
  7. Facility and Equipment: Are the facilities and equipment well maintained and modern? Old technology, or a disorganized facility or office could be a sign that other aspects of the business, such as financial statements, customer records and employee files may be similarly disorganized and unreliable. A good question to ask “what capacity is the facility and equipment operating at now?” In other words, how much growth can the facility and equipment accommodate? Also, watch out for Businesses where equipment used in operations is excluded. If the business needs it and the Seller want’s to keep it, that’s simply an add to the purchase price.
  8. Loyal Employees: Outside of ownership and management, is there staff that is reliable and capable? Are they considered knowledgeable for the industry? Look for opportunities where the current staff, especially management, will remain in place. You should always interview key staff before closing on a deal.
  9. Operating Systems and Procedures: Remember fax machines, file cabinets and Windows XP? If the business still uses obsolete tech, updating could be a huge undertaking. Look for cost effective business systems in place. Old technology and paper offices are expensive to maintain and the margin for error is high. Today’s business apps are inexpensive and effective, especially when compared to manual systems.
  10. Goodwill: Name recognition, customer awareness, location, history, ongoing operations, reputation, and many other factors are all part of goodwill and are what generate the earnings. They also greatly influence value. As mentioned, don’t buy assets, buy the earnings and the ability to grow the business. Even if the company does not have many hard assets, its relationships are still key and can have significant value. The fact that customers have been with the business a long time does matter. Brand recognition, service or product reliability and high customer satisfaction are distinguishing factors that add value and mitigate risk.

How you can prepare to buy…

It’s important that you have realistic expectations about what your money will buy. A good rule of thumb is to search for a business 4-5 times your down payment ability. The SBA has good lending programs and the Seller should also assist in financing the sale. Keep in mind that many business owners have spent years building their business and it may represent the biggest financial asset they have. They’re not going to just hand it over to you because they’re getting older, it has to be a reasonable deal.

Get the Basic Facts

Get preliminary information on price, terms, revenue and earnings. There is no point in continuing the buying process if the amount of cash necessary to buy the business is more than you are willing to invest. Also, the business has to be able to meet your basic financial needs. You always expect a business to improve under your ownership, but you have to be able to meet your living expenses and make the payment on the business until you facilitate the growth.

Get Your Questions Answered

If you like the business so far, it’s time to get your questions answered. For example:

  1. How/why did the Seller start or buy the business?
  2. How long have you been trying to sell?
  3. Why are you selling?
  4. What will you do after the sale? Will you stay in the area?
  5. Will you stay on briefly to help me transition into the business?
  6. How was the price determined?
  7. How much will you carry?
  8. Experience and age of the staff? Will they stay?
  9. My background is XYZ, can I learn your business?
  10. How can I grow the business?
  11. How many hours do you work per week?
  12. Are you able to leave the business, is there someone who can step in while you’re gone?
  13. Etc., etc., etc.

Make an Offer

With your basic questions answered, make an offer subject to verification of all the information you have received and acquiring adequate financing and facility use. Negotiate ethically, there’s no set rule about splitting the difference or how many times you go back and forth. The goal is to get to the price and terms both parties can live with.

Due Diligence

With your offer accepted, you are ready to begin what is commonly called due diligence.

Due Diligence is a review, investigation and confirmation process designed to corroborate the representations of a business owner about the true status of the business with the intent to uncover material variance.

Sounds hard-core, right? Well…it is. The buyer is always the most nervous party in a transaction and by far, has the most risk. There is a legitimate need for access to accurate, timely records to help manage the risk and provide some level of assurance that the seller’s representations are materially true and correct. If the Seller is not forthcoming with information, walk away…quickly.

Close the Deal

Expect the unexpected and don’t let up, sprint across the finish line. Banks, attorneys and accountants will drive you nuts with silly info requests, a lot of which seems to be repetitive, but everything needs to be documented so you have to work through it. Each deal with have its own set of documents and the more common docs include:

  1. Asset Purchase Agreement: this is the primary, binding document that contains the terms and conditions of the deal. It’s sometimes called a PSA (Purchase and Sale Agreement) or simply Purchase Agreement. In most cases, this is signed after the LOI and the parties work toward closing per this agreement. In some cases, however, this document is not signed until closing. We see risk in signing at closing because either party could walk away or demand a change to close the transaction, so we recommend signing the formal agreement sooner rather than later. Both scenarios can work though.
  2. Bill of Sale: a somewhat simple document, usually 1-2 pages conveying everything to the Buyer.
  3. Promissory Note(s): if the Seller is carrying part of the deal, you’ll want your attorney to review this prior to closing. It will likely include a personal guarantee.
  4. Security Agreement: describes any collateral for the Promissory Note.
  5. Settlement Statement: lists the credits and debits per the agreement the parties reached. It’s a good idea to get this a day or two prior to closing if possible so you can study it in detail. It’s just as the title indicates, “settlement” of the deal.

Depending on your primary agreement, there could be other important documents as well. Again, we prefer a comprehensive Asset Purchase Agreement that encompasses the following but there are those who prefer to have separate docs for each topic. Both scenarios can work, but the more documents drafted, the more cost for each party it seems:

  • Non-Compete Agreement.
  • Due Diligence Acknowledgment.
  • Inventory Acknowledgment.
  • Transition and Training Agreement.
  • Assignment of Name.
  • Corporate Resolutions.
  • Creditor Affidavit.
  • Lien Searches.
  • Reaffirmation of Reps and Warranties.
  • Escrow Agreements.
  • Purchase Agreement Amendments.
  • Post-Closing Agreement.
  • Etc., etc., etc.

Congrats, you now own a business…better get to work!

The Bottom Line

Being in business for yourself can be a daunting prospect. There are no guarantees. At some point, after all of your investigation is completed, you will still have to make that “leap of faith” that is necessary to proceed with the purchase of the business. You will have to work hard, perhaps even “tighten your belt” a little, and perform many different jobs to be successful in your own business. But, if running your own show, making your own decisions, not having to worry about job security (remember, no one can fire you from your own business), and just being on your own are important – then owning a business is for you. After taking this leap of faith, almost all business owners will tell you that they would never go back to being an employee.

Got questions, please call, we’ll do our best to help!