How to Buy a Small Business
Businesses are like used cars; make sure it's not a lemon
If you know what to look for and how to buy a small business, buying an existing operation can be a great opportunity to step into the company without having to start from scratch. If you buy a turnkey operation, you can skip the startup phase entirely and begin operations as soon as the sale is complete; everything is already set up and ready to go.
Unfortunately, businesses for sale are like used cars; there are lots of them out there, but some of them are lemons. To avoid getting stuck with a bad bargain, you need to fully investigate the business you’re thinking of buying. Here's how you can tell if that small business for sale is a good deal or a clunker.
Find out If It Has Been in an Accident
In other words, before you buy a business, discover the real reason the small business is for sale. Don't just take the seller's word for this. Sure, people do retire or become ill, but the real reason may be anything from a big-box retailer moving into town and taking away customers to losing a lucrative, traffic-driving contract, such as being a postal outlet.
Discover the true reason(s) the business is for sale by talking to people who are familiar with the history of the business you're thinking of buying, such as local realtors, other business people, the local chamber of commerce, and suppliers.
If the business resides in a mall, talk to other business owners in the mall about mall management, lease rates, anchor tenants, etc. A departing anchor tenant can mean a huge drop in business traffic for the mall or management may be in the process of renewing leases at a higher rate.
Find out What's Included in the Asking Price
Find out what's actually for sale and what method of business valuation is being used. If you buy a small business, what assets are you actually getting? People selling businesses often have a spec sheet prepared, listing the assets involved and an estimate of their value. Ask for details if anything is unclear. And be sure to find out if the assets listed are free and clear of debts and liens because you don’t want to buy other people’s problems.
Pay special attention to any intangible assets that may be listed, such as goodwill. Sellers tend to inflate the value of this, thinking perhaps of the potential future value of their reputation and the established customer base.
Look Under the Hood
Remember the old joke about the guy who bought the good-looking car only to discover he couldn't drive it away because it had no engine? It's only funny when it happens to someone else. Make sure you do your due diligence before buying a small business.
Study the business's past financial performance. Ask for and examine the last three years' worth of the business's financial statements, and consider enlisting the help of an experienced CPA to help. You will also want to know who prepared and reviewed the financial data. Was the final version prepared by the internal management and accounting staff of the business, for instance, or by an outside accountant?
If the company uses an outside accountant, documents should accompany the financial statements that will explain the depth of the accountant's review. An Auditor's Report certifies that a full review has been conducted, while a Review Engagement Report will present the findings of a limited review of the business. A Notice to Reader signifies that the accountant prepared the financial statements based on information provided by the business without conducting any checks.
Don't like what you're seeing or just not seeing enough of it? Ask the seller for permission to see more detailed business records that support the data in the financial statements, and get your own audit done.
Find Out What It's Actually Worth
Find out what you should actually pay for the business. When you're buying a used car, this is a simple matter of comparison shopping, but business valuation is considerably more complicated. It's common to use a few different methods of business valuation to arrive at a price. This provides a way to come at the value from different angles and typically results in a range of value, rather than one set figure.
When preparing the asset list (spec sheet), for instance, the seller could have used:
- Book Value (based on the company's balance sheet)
- Modified Book Value (book value adjusted to reflect the current market value of the assets)
- Replacement Value (based on what it would cost to replace the asset)
- Liquidation Value (based on what the asset would bring in if the business was liquidated)
They may also have incorporated some adjustments into the business valuation process to arrive at their final asking price, based on other knowledge they have of the company's current condition and its future prospects.
How Did the Seller Set Their Price
Before you buy a small business you'll want to know how the seller arrived at his estimate of the business's value and arrive at your own estimate of how much the business is worth. The important point is that a business is not worth x amount of dollars just because the seller says so.
The real value of the business depends upon the income that the company generates and how well it's been managing its sales and expenses. Examining the business's financial records should give you an accurate, or at least informative, picture of the business's gross revenues, costs, and profit. Look to buy a business based on the return on investment, not on the stated price. In other words, what you are really buying is the annual profit, and you're looking for missed sales opportunities, expenses that could be streamlined and other opportunities to operate the company more profitable than its current owner has been doing.
If you're having trouble feeling confident about what the business you want to buy is actually worth, seek advice and valuation help from a professional business appraiser.
Take It for a Spin
Before you buy a business, get an inside perspective by asking the seller's permission to sit in on the business for several days. If he or she is agreeable, this can be a great way to find out how the business you want to buy truly operates.
If he or she doesn't agree to this, it's not necessarily a bad sign. He may still be thinking of you as a "looky-loo," as you haven't made an offer yet, and he doesn't know if you're just posing as a potential buyer to steal confidential company information.
Investigate Your Financing Alternatives
Just as when you buy a car, you need to see if you can truly afford the business you want to buy. If you don't have the cash in your pocket, this is the time to see who's interested in financing the business you're buying and how much that financing help will cost. The usual small business financing sources are friends, family and traditional lending institutions (such as banks and credit unions).
You may find that said traditional lending institutions are friendlier than usual, as financing an established business is generally considered to be less risky than financing a startup.
You may also want to consider asking the seller to finance part of your purchase of the business. One common arrangement is for the seller to carry a promissory note for part of the purchase price. (Note that if you're going to approach the seller for financing, you have to make the option attractive to them. You may need to offer a rate of interest above the going rate, for instance.)
Make an Offer
Assuming that you haven't found any glaring issues with the company after your review and you still want to buy the business, it's time to make an offer and start negotiating. You make an offer and the seller makes a counter-offer. The two of you will go through a process that will hopefully see you meeting on middle ground.
Don't be surprised if you're asked to accompany your offer to buy a business with a non-refundable deposit; sellers are typically only interested in dealing with serious buyers. The usual rules apply. Always be prepared to walk away and don't get so caught up in the process that you get pulled past the price you're prepared to actually pay.
Get a Purchase/Sale Agreement Drawn Up
Once you and the seller have reached the point of agreement on terms, the details need to be specified in a contract. Because the contract needs to itemize every aspect of the sale, it should be drawn up by a lawyer.
Being Careful Is Key
Don't be afraid to buy a business that someone else has started and grown. Buying a business can truly be an opportunity to own and operate the successful business you've been dreaming of, as long as you resist the temptation to get drawn in by a shiny paint job and do more than just kick the tires before you make an offer.