Buying A Business - What You Need To Know
By Richard Parker: President of The Business Buyer Resource Center and author of How To Buy A Good Business At A Great Price©
The Bad News
According to industry statistics, over 90% of the people who begin the search to buy a business fail to ever complete a purchase. Even worse, the average person looks at business for sale listings for 18 months and still, they never buy one!
This article will discuss some of the reasons why this happens, how to avoid this fate, and the fundamental issues any prospective buyer must be aware of in order to be the successful.
Why so many failures? Part of the problem is that most businesses listed for sale are overpriced and have plenty of problems. There were also several common reasons given by those who failed to realize their dream of business ownership, or worse, ended up buying a bad business.
Most were first-time buyers and they admitted to having totally underestimated just how much was involved with each stage of the buying process. They felt overwhelmed and ill-equipped to handle all of the new situations and major decisions they encountered.
Common Questions Buyers Face Which They Are Not Sure How To Answer
- What type of business should I buy?
- How can I tell if the seller has “cooked the books”?
- What can I do to protect myself if the business declines after I take it over?
- Where can I find the really good potential businesses for sale?
- The seller claims there is a lot of “cash business” – how do I know if it’s true?
- Why don’t business brokers reply to my inquiries?
- What is the business worth - how to I properly value it?
- How do I finance the deal?
- Will the customers still buy from me?
- Will the key employees stay?
- What is the real reason they are selling?
- Is the seller hiding anything that can haunt me later on?
- Am I crazy to be buying a business now?
- There are no hard assets in the business – what am I really buying?
There are specific methods to address and answer these questions however, without the necessary knowledge they will remain unanswered which, in turn, causes a buyer to not have enough comfort or confidence to complete a transaction.
If you're going to buy a business, the old expression - "If you fail to prepare then be prepared to fail" - is so true.
The business you buy will determine your financial future. When you buy a good one the rewards will be incredible. But don't take anything for granted. You cannot guess your way to success. It takes "know how" to be successful in this endeavor. When you have the right information, it's easy to make good decisions. But without the knowledge, you'll end up with a huge financial mess!
As an example, the average small business purchase typically involves
- 36 critical questions you must ask every seller
- 200 individual points to investigate
- 54 specific clauses to negotiate
- 73 key issues to review in every business for sale listing
What Exactly Are You Buying?
It can be difficult to understand what you are actually “buying” when you purchase a small business. Most do not have a lot of hard assets; they are typically service-type companies, so what are you really getting?
First and foremost you want to buy a business that can generate an income stream. The entire concept behind buying a business versus starting one is to have one that the can start paying you immediately, or, in the very near term. You want to avoid the pains of a startup which generally entail months or years of working without any significant compensation.
Second, you must buy a solid business that you can apply your skills and experience to in order grow it and build value and to also provide you with the lifestyle you want.
Making Sure The Business Is Sustainable
Most importantly, you must be certain through detailed analysis and a comprehensive review, that the business can sustain its prior levels after you purchase it. In other words, it must be one that will transition well to YOU as the new owner without any major hiccups.
Your research has to dictate that you have the necessary skills to operate the business and grow it. A good business bought by the wrong person will quickly decline. Similarly, there are a ton of good businesses not being run by the right people and these can be phenomenal opportunities.
The Business Must Be Right For You
This is definitely the BIG ONE! Further to the points above, there is no single more important aspect to buying a business than making sure the business is the right one for you. The business has to fit your greatest strengths. You do not want to be forced to learn on the job the most critical aspects of what it takes (took the prior owner) to make the business successful.
Whatever it is that you do best must be the single most important driving factor of the revenues and profits of any business you consider purchasing. You need to take a diligent and realistic approach to this and be brutally honest with yourself. This is NOT the time to try to make yourself into something you are not.
Finding the Right Business
There are hundreds of thousands of businesses listed for sale online. Only about 1/3 of them will ever sell. Most are either overpriced or laden with problems. These issues, coupled with not necessarily knowing what type of business is right for you can therefore present some challenges.
There are four important things to consider:
- If you are not absolutely certain about the type of business to buy, assemble a few general categories. Often, it is easier to rule some out (i.e. gas stations, hair salons, restaurants make up the bulk of listings so if you have no interest in those your search immediately becomes more focused).
- Pick 3-4 general categories and find 4 or 5 in each. Contact and meet with the sellers. After an initial review of these twelve to twenty businesses you will begin to gain some clarity. Then, narrow it down again and complete the same exercise.
- Once you narrow it down to 1 or 2 industries, subscribe to the email alerts on the various websites so you will see new listings in your categories as soon as they hit the market.
- Do not restrict your search to only those businesses listed for sale online. There are a ton of really good businesses that get sold yet never get listed in the public view. You should be doing direct solicitations to companies (use the sample letter in our guide). However, this should only be done once you have a clear sense of the type of business you want to buy.
How To Accurately Value A Business
Valuing a business requires a detailed exercise and one thing is certain: whatever a seller thinks their business is “worth” rarely has anything to do with its value. Plus, of course, a business is only worth what a buyer is willing to pay and a seller willing to accept.
Valuing a business is not a science; it’s an art.
The valuation exercise can use a few different methods however, the key component of valuations is to determine with as much certainty as possible how much the business will generate in Owner’s Benefits in order to pay you a salary, service any debt, and have ample excess to grow the business.
Many buyers incorrectly focus on the company’s assets while compiling a valuation. While assets are important of course, they play a far less important role than many believe. After all, assets are strictly a mechanism for the company to generate revenue and profits. If a company is asset-rich but can generate a [profit, is it worth buying? Focus on the bottom line profits generated in the past and what you can do to sustain and build them.
One area that causes many buyers to get off track with valuations is to reference the seller’s asking price as a barometer for the valuation. This is the wrong approach. Forget the asking price and don’t worry about insulting the seller. A buyer’s valuation has to utilize factual and historical financial data – the seller’s asking price almost always is a quasi-arbitrary number that sometimes is based on what they think it’s worth or what they will need for their next stage in life. This article does not allow me enough room to cover valuations in the detail it deserves. As such, I would highly recommend you read the comprehensive article we have on this subject at: http://www.diomo.com/valuing-a-business.html
Will The Customers Still Buy from You?
It is a common buyer concern and can indeed be a frightening one. How can a buyer know or be assured that the customers will continue to buy after a change in ownership? More importantly, what about businesses where a relatively few number of customers represent the bulk of the revenues?
In the latter case, you must structure a deal with an earnout component so that the seller only gets paid at a certain time in the future if the business is sustained and the key clients continue to generate sales.
For less complex businesses, where the seller is not the sole reason why customers purchase their goods or services, a new owner can be reasonably assured that unless they operate the business in an unprofessional way, clients will remain. Nevertheless, it is an aspect of the business buying process that must be investigated thoroughly!
Reviewing The Books and Records and Dealing With Unreported Income
The poor condition of many small businesses’ books and records is the single biggest reason why a business either never sells or the deal falls apart. That is why a buyer should inquire very early in the discussions about the following three items:
- Can the seller prove the numbers?
- How are they going to do it?
- Are they willing to do so? (keep in mind if a business is not recorded all of the revenues they may not want or even be able to prove them)
Even if the numbers are not in pristine order, it is possible to reconstruct the financials given other documentation such as internal P & l statements, supplier invoices, credit card receipts, payroll tax data and sales tax information. While not ideal, it can be done.
Insofar as unreported income, the advice here is: Beware! No matter how good a sales pitch a buyer gets from a seller about there being “cash sales” that are not reflected in the records, the onus is on the seller and not the buyer to prove them, And if they cannot prove them, ypou cannot pay for them – end of story!
On this note, a bit of advice after you buy a business: maintain flawless records and report all of your income. First of all not doing so is illegal. Next, funds are better left in the business to grow the company and third, having good books and records will pay you back several times when the time comes for you to sell the business.
How To Arrange Financing
Wouldn’t it be nice if you had a ton of money and could just walk into a good business , write them a check and take it over? Unfortunately, that is not reality for the vast majority of people. Moreover, even if you had the financial resources, it would be insane to do. It is simply prudent to get the deal financed.
One of the great misconceptions business buyers have is that banks are waiting with open vaults to finance small business purchases. Sorry to be the bearer of bad news but that is not going to happen.
Banks simply do not finance small business purchases to any extent. Sure some will do a very few select few, and they all advertise how they are “small business friendly” but that is simply banker talk for: “if you have 100% collateral we may lend you some money”. It’s the old adage: if you have the money already, banks will loan you some. But if you already have it, why do you need them?
Then you have the SBA-type programs. Here too they are totally misrepresented and financing under their various loan programs represent a fraction of the small business sale terms.
So where do you get the money?
Simple: get the seller to finance the deal. It has been and always will be the most popular way these deals get done. In fact, 91% of our clients arrange seller financing.
The reality is that in order to get a deal to a closing and especially when financial markets are tight, sellers have to finance the deal. The percentages vary but are generally thirty to seventy percent of the deal total.
Most importantly, seller financing is the best mechanism any buyer has at their disposal that a seller is representing the truth to them. After all, if they are financing the deal and have ”skin in the game”, it would be sheer craziness for them to misrepresent the business.
Regardless of what any broker or seller tells you, rest assured seller financing is the way to go. If a seller steadfastly refuses, wish them well. Actually, even under today’s SBA plans, lenders are requiring seller participation in the financing in addition to what the SBA lenders may underwrite.
The formal Due Diligence is the period after an agreement has been reached whereby you will have the opportunity, with a specified time limit to analyze the more confidential aspects of the business. Inexperienced buyers wrongly assume that this is the period when only the financials are reviewed in detail – BIG mistake!
You must analyze everything: the financials, the industry, competition, contracts, licenses, employees, customers, sales process and assets.
Make sure you allow yourself enough time to conduct a thorough review. Some business broker contracts limit the review period to a few days while others have clauses whereby if the numbers come within 5% the buyer is bound to the contract. Both of these examples are sheer nonsense. The type of business will dictate the time needed but don’t lock yourself in because if you don’t complete your review in a specified time, you will not be able to get to the closing table.
Insofar as the second point, what if the numbers are close but you find out that 75% of the revenues are done with one customer? Are you going to move forward with the deal? Of course not! Or, what if you discover the lease will go up by 25% or the seller is in litigation for company fraud. All of these examples are separate from the financials but on their own would cause you to walk from the deal.
One last point, your offer must contain specific language that allows you to rescind your offer for any reason before the due diligence period ends without any penalty or further obligation and the return of any deposits.
The Final Word
Buying a business is not rocket science, but it does take specific knowledge to identify a good business that is right for you and negotiate deal terms that make sense. There are a lot of important decisions to be made during the process and many of these are probably going to be new to you. Take your time to properly prepare and educate yourself for the various steps and situations you will encounter. There is a lot of helpful information on our website to help you do just that.
This article represents a fraction of what you’ll learn on this topic in How To Buy A Good Business At A Great Price© - the most widely used reference resource and strategy guide for anyone thinking about buying a business. Read a detailed listing of what you'll learn.