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How to Buy an Existing Business: What to Know
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Buying a business can be a good way to skip some of the startup costs and growing pains of starting a business from scratch, like launching a product or service or building a customer base.
But, buying an existing business comes with its own risks, and the process to close the deal is complicated. This guide helps you navigate how to buy a small business.
How to buy an existing business in 7 steps
- Find a business you want to buy.
- Learn why the business is for sale.
- Evaluate the business earnings.
- Issue a letter of intent.
- Do your due diligence.
- Secure financing.
- Close the deal.
Pros and cons of buying an existing business
Buying a franchise
How to buy an existing business in 7 steps
The process of buying a business involves identifying a business for sale and gathering the funds to make the purchase. The following steps will help you get started on that path.
1. Find a business you want to buy.
The first step is deciding what kind of business to buy. Start looking at an industry you’re familiar with. For example, if you have a lot of experience working in retail, then buying a retail shop or boutique might be a good fit for your skills and experience.
It can be difficult to succeed in an industry in which you have little experience or interest. But having prior knowledge of the industry can give you a leg up because you already understand the trends, challenges and opportunities.
If you don’t already have a particular business in mind, consider working with a business broker, attorney or commercial real estate agent in your area to find one.
2. Learn why the business is for sale.
Once you’ve identified a business, critically evaluate why it’s for sale. Is the owner just ready to retire or burnt out on the industry? In that case, you could bring some new energy and a fresh perspective to help the business grow.
But some reasons for selling may be red flags, and it might take a little more work to uncover them. For example, if the business is losing business to a more popular competitor, or has a bad reputation, you could be facing an uphill battle from the moment you take over.
3. Evaluate the business earnings.
Next, it’s time to see whether the business is worth the seller’s asking price.
There are several methods for valuing a business based on its earnings, projections and balance sheet. Each method has its pros and cons. Here’s a look at three common valuation methods.
- Asset-based valuation. An asset-based company valuation involves totaling up the fair market value of its business assets (real estate, furniture and equipment, and intangibles like patents or customer lists) and subtracting its liabilities (mortgages, equipment loans, lines of credit, etc.). This valuation method is best suited to companies in which the business’s assets are the main factor in income production, such as renting real estate.
- Market valuation. The market approach to valuation looks at similar companies in the industry that have recently sold and determines a price based on those “comparables” or “comps.” This approach is only possible if you (or a business valuation profession) can find similar businesses that sold recently and disclosed the terms of their transaction. It might not be possible to find comparables for small businesses.
- Income-based valuation. The income approach to valuation involves estimating the net income the business is expected to earn over some future timeline — five years, for example — then, this approach calculates the present value of that future cash flow. This approach is best suited to valuing profitable companies where you can reasonably forecast future earnings.
Some business valuation experts use a blend of two methods, such as the market approach and the income-based approach. In any case, the process of determining the value of a business is complicated, so you might want to consult a professional business broker or accountant who specializes in business valuations.
4. Issue a letter of intent.
A letter of intent is a nonbinding agreement conveying your intention to buy the business. One of the benefits of a letter of intent is that it gives you the “right of refusal,” meaning you’re first in line to buy the business, even if another potential buyer comes along.
A letter of intent also allows you to start gathering more information about the business. Most sellers won’t share detailed financial, tax and legal information unless they know a buyer is serious.
5. Do your due diligence.
As part of the buying process, you need to do as much research on the business as possible to ensure you don’t run into any costly surprises after you close the deal. This process is called due diligence, and it’s a chance to dig deeper into the company’s legal records, financials, tax records and operations before you commit to the purchase. Some of the areas you need to look at include:
- Licenses and permits. Check with government agencies to see what kinds of licenses and permits the business needs, and see whether the business is in good standing. Bank records and tax records. Get copies of recent bank statements and income, property, employment, excise and sales tax returns for the business. Check to see whether the financial statements or projections provided by the seller match banking activity and amounts reported on tax returns. Make sure there aren’t any tax liens on the business.
- Zoning and environmental regulations: If the business has a physical location, make sure it’s in compliance with any environmental requirements and zoning laws.
- Status of inventory, equipment and other physical assets. Review lease and loan agreements to ensure that the business actually owns all of the assets it claims to own, those assets are valued properly, and there aren’t any undisclosed liabilities attached to those assets.
- Contracts. Review any crucial business contracts to see how they’ll impact the business. For example, if business profits depend on a large customer or vendor contract, is that contract transferable to a new business owner? If there’s a lease for the business premises, make sure the terms of the lease will stay the same. You may also want to have the seller sign an agreement not to open up a competing business or go to work for a competitor.
- Organizational chart: A business’s organizational chart can provide a picture of the chain of command, flow of work and how information is communicated from management to team members. Do some members of management have too many direct reports to handle effectively? Are certain levels of the organization bloated while others are stretched thin? Who has accountability for sales, business development, financial reporting and other critical business functions?
- Legal issues. Look into any threatened or pending litigation involving the business or current business owner.
6. Secure financing.
Once you’ve decided you want to move forward, there are a few different ways to finance the purchase of a business.
- Small Business Administration (SBA) loan to buy a business. The SBA 7(a) loan program allows small businesses to borrow up to $5 million to start or acquire a business; provide working capital; and purchase furniture, fixtures and business supplies. SBA loans are backed by the federal government, but available from SBA-approved lenders.
- Term loan. Some banks offer small business loans to help would-be entrepreneurs acquire a business. However, traditional bank loans can be tough to qualify for. They’re usually only available to buyers with excellent credit scores and a successful track record in business who are buying a company with substantial assets. Still, it’s worth checking with your local bank or credit union to see whether this is an option.
- Seller financing. The person selling you the business may be willing to loan you the money to buy the business.
- Partnership. Do you have a lot of business knowledge but not a lot of funds? You may be able to find a business partner who can provide the funding. Business partnerships come in many forms. You might find a silent partner who provides funding in exchange for partial ownership of the business but stays out of the decision making process, or a venture capitalist who provides guidance, support and business connections.
- Personal funds. If you have plenty of money saved up, you can tap into your own savings to cover the purchase of a business. You may also use your own funds in conjunction with outside financing, such as an SBA or bank loan.
7. Close the deal.
Once you’ve done your due diligence, agreed to a sales price and secured financing, it’s time to finalize the sales agreement.
There are generally two options for structuring the sale: an asset purchase or a stock purchase.
- Asset purchase. In an asset purchase, the seller remains the legal owner of the business entity, while you purchase all of the business’s assets, such as inventory, equipment, real estate, patents, customer lists, etc. Any preexisting business contracts generally aren’t included in the sale.
- Stock purchase. In a stock purchase, you acquire the stock of the business, as well as all of its assets, liabilities, contracts, etc.
There are pros and cons to each method, so you should discuss the type of transaction and its financial, legal and tax consequences with your attorney and accountant before signing.
Your attorney can also help you update any necessary leases, agreements, contracts and other paperwork after the deal is done.
Pros and cons of buying an existing business
While there are many benefits to buying an existing business, there are also risks involved. Here’s a look at some of the pros and cons of buying a business.
Existing customers. An existing business comes with an existing customer base, so you don’t have to spend as much time testing your product or service, and generating leads. Instead, you can focus on growing the existing customer base or market share.
Easier to get financing. It’s often easier to secure financing to buy an existing business than it is to get startup financing. This is because an established business already has a proven track record.
Better survival rate: Many new businesses fail in their first few years in business. According to a study published in Industrial and Corporate Change, business takeovers have a higher survival rate than new venture startups.
Reduce startup time. While buying a business involves significant upfront costs, you can start turning a profit much faster because you don’t need to spend time purchasing inventory, finding suppliers, hiring employees, etc.
Established, trained employees. Similar to acquiring existing inventory or equipment, having already trained employees can also be an asset because they know how the company operates, which saves valuable time spent on hiring and training. This can be especially helpful if you’re not familiar with the industry.
Existing cash flow: Because an existing business has all its operational processes and staffing already going, as well as an existing customer base, you can start generating cash flow on day one. In contrast, when you start a new business, it can take months or even years to turn a profit.
Established brand: Another pro to buying an existing business is that it has an established brand and market presence. This can save you significant time, money and energy that you would otherwise spend trying to grow your brand and draw customers’ attention to your products or services.
High upfront costs. Buying a successful business can be expensive. You may be able to buy a struggling business for less, but then you run the risk of acquiring a tainted brand, unhappy customer base or a dying product or service. Simply put, you get what you pay for.
Unknown or hidden problems. No matter how thorough your due diligence, there’s always a risk that the seller misrepresented financial data, glossed over problems or didn’t provide a complete picture of overall business operations.
Outdated technology or processes. Business owners that know they’ll be retiring or selling the business in the near future may not be motivated to invest in new technology, equipment and process. You may have to invest significant time and money into upgrading these elements after closing the deal.
Existing company reputation. A company’s established brand reputation can be a double-edged sword. From bad customer service to legal troubles, customers, employees and the public at large may have negative associations with the business. As the new business owner, you’ll have to overcome those perceptions.
Challenging to make it your business. When you buy an existing business, you also buy an existing company culture, mission, vision and values. It can take a lot of work to make changes that reflect your goals and turn a struggling company culture around.
Buying a franchise
If you’re on the fence about buying an existing business, buying a franchise could be the best of both options: you’ll be buying a business with an established, recognizable brand and built-in customer base, but you’ll have more freedom to hire the people you want and make the business your own.
Franchise purchase costs
But, buying a franchise business can be expensive. You typically need to pay an upfront franchising fee, in addition to the normal business startup costs, such as buying or leasing a location, purchasing inventory and equipment and hiring employees.
For example, according to LendingTree research, it can cost anywhere from $1.24 million to $3.53 million (not including land) to open a Sonic Drive-In, and $1.3 million to $2.3 million to open a McDonalds. And while you may be able to get financing to cover some of those costs, many companies require franchisees to have significant personal net worth and invest a large amount of their own money into the business.
Franchise financing options
If you believe buying a franchise is the way to go, you have a few financing options.
- Bank loans. Banks may be more willing to loan money to someone buying a franchise than starting up a new business, because the franchise is associated with a profitable and established business.
- SBA loans. The SBA offers franchise loans that can be used to finance opening a franchise. To apply, confirm that your franchise is eligible by consulting the SBA Franchise Directory.
- Loans from the franchiser. Some companies offer financing to new franchisees, and they may be willing to lend more money or offer lower rates than traditional bank or SBA loans.