Owning a company doesn’t necessarily mean starting one.
If you’re thinking about being your own and owning a business, buying a company that’s already up and running maybe easier and faster than starting from scratch.
How many times have you been in a business and noticed that the place is booming even though service is poor, then imagined what the business could be like if it were run properly?
How often have you encountered incompetent ownership or management and though, “Boy, if I owned this place, I could turn it into a booming success.”?
Or perhaps you want your own business, but the thought of spending lots of time, money and energy getting a new venture up and running holds you back. If any of these scenarios sound familiar, you may be the perfect candidate to buy a business. But keep in mind, buying a business successfully requires that you take certain steps.
Step 1: Do the Research
Shopping for a business requires the same careful planning as starting from scratch, plus it demands studying the history of the seller’s decisions and mistakes.
When you buy a business you inherit the business’s problems as well as its potential, so it is imperative that you answer the obvious question: Why is the owner selling? Some reasons:
Personal – The owner may want to retire or is in poor health. This reason would not rule our your buying the business, especially if it is doing well. There is no better combination for a buyer than a motivated seller and a good business.
Financial – The business is losing money or isn’t profitable enough. This reason wouldn’t eliminate the business from contention either. The problems might stem from poor management, the owner’s too-high salary, or unfavorable economic conditions that are due to change in the near future.
Impending doom – The seller knows something you don’t. This reason could, and probably should, kill the deal. Some examples of this are: the market is saturated and profit margins are about to collapse; a major revenue-producing contract is expiring and won’t be renewed; new, powerful competition is moving next door, such as a major electronics warehouse store opening next to a mom-and-pop operation.
Step 2: Study the Books
Just as life insurance company requires a detailed physical before insuring a person, it’s essential that you examine the books before buying a business. The books provide a snapshot of the inner workings and health of a business. Specific records that you or your expert should review include:
- Income statements from the past three to five years – income statements show expenses as well as income.
- Balance Sheets from the past three to five years – balance sheets show assets and liabilities as of a particular date.
- Income tax returns from the past three to five years.
- Loan agreements.
- Credit reports from the past three years.
- Contracts with major customers or current suppliers.
- Patents or trademarks – these allow you to be certain that the business owns what it uses and makes you aware if any valuable patent expires, the competition could sell the previously exclusive product or service for much less, thus cutting into your projected profit margin.
- Accounts receivable and accounts payable records.
- Outstanding litigation.
- Insurance policies.
- Contracts with employees or unions.
- Leases for real estate or equipment.
- Records of the age and condition of any buildings and equipment.
Obviously, red flags that are cause for concern are severe or increasing losses, unpaid tax liabilities, unsettled lawsuits against the company; unfavorable or costly contracts with the employees or suppliers; and long-term leases that are well above current market rates.
It’s especially important to check for outstanding litigation, since you will inherit any lawsuits pending against the company you buy, Check records at the county courthouse to make sure the owner isn’t withholding information about pending lawsuits.
If a seller refuses to open up all the books, get out immediately. Also, don’t believe an owner who says the books you’re seeing aren’t the “real” books because some of the profits have been skimmed and kept out of the hands of the IRS. You shouldn’t pay for any undocumented profits, and besides, it’s illegal.
Step 3: Determine the value, set a price and negotiate.
If, after completing steps one and two, you’re still interested in the purchase, it’s time to determine the price and negotiate the deal.
In some cases, you can take over a business simply by assuming responsibility for the debts, because the owner is doing all he or she can to get out from under them. This may be a good deal as long as the potential profitability outweighs, and can soon eliminate, the debt.
In other cases, you may be able to pledge the assets of the business to obtain a loan to finance the purchase price. This is preferable to using your personal assets as collateral.
There are various formulas used to determine the value and price of a business. The method may vary based on the type of business involved – retail, wholesale, manufacturing, consulting or service – and also vary with these groupings.
Some methods for determining the price include:
Method 1: Cost of replacing business
The value of physical assets (building / equipment) minus depreciation plus current value of land, inventory and other assets. Drawbacks: The value of a business is determined by other things, such as profit potential and economic viability.
Method 2: Book value of assets
The value of assets after depreciation minus liabilities. Drawbacks: May over value the business since some technological equipment, such as computers, can quickly become obsolete. Land (book value) also can become overvalued suddenly if the commercial market is lagging.
Method 3: Expected business earnings
The price is equal to or less than five times the anticipated annual earnings. Example: Profit after all expenses (including your salary) will be $20,00; then, to pay the business off within the five-year formula, the business should not exceed $100,000. Drawbacks: By itself this factor means little; you must couple other factors with expected business earnings to get a complete picture.
Method 4: Combination of all methods plus intangibles such as good will
This is the best method. The expected earnings method should be adjusted to reflect any liabilities you’re assuming, as well as general market trends and other intangibles such as goodwill. Goodwill represents the value of the efforts the owner has poured into building the reputation of the business and developing a loyal customer base.
Sellers almost always want to be compensated for goodwill, but from the buyer’s prospective, the value of goodwill should be limited to the amount of profit the business earns in excess of the earnings of the average business of its type.
Goodwill built up by a former owner has a flip side that could come back to haunt you as a buyer” is the former owner’s reputation so great that customers will follow him to a new endeavor?
If so, you could be out in the cold with a once-thriving business that now goes begging for customers. Find out if the former owner is planning to open up a new enterprise nearby. If necessary, have him or her sign a non compete clause in the sales contracts.
Obviously, there is potential for much negotiation in determining a purchase price. Good negotiation and closing techniques are essential when you’re sizing up the seller and hammering out a deal.
The answers will provide valuable insight into the business and the owner, and could put you one step ahead if you decide to negotiate a deal.
It’s also a good idea to get an attorney to do paperwork and check out the business before you buy. Like everything else, there are specialists in the field.