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Everything You Need to Know About Buying an Existing Business
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For every American who dreams of being their own boss, owning a business can be the path to professional and financial independence. Although some entrepreneurs opt to launch their own businesses and build them from the ground up, others look to acquire an existing business and enhance them via their experience, leadership and innovation. Either route takes significant investment, commitment and determination. For many aspiring business owners, however, buying an existing business enables them to take command of an operation already in progress with an established brand, customers and – ideally – a positive cash flow.
Keep reading to find out the steps to take when you’re buying an existing business and the pros and cons of acquiring an existing business. In addition, figure out how to research and conduct due diligence on an existing business, what red flags to avoid and how to ensure your purchase goes smoothly.
The 5 steps to take when buying an existing business
When you decide the time is right to buy a business, there are five elements to consider. In some instances, you might have to take additional steps. These might include buying a franchise, which can require approval from a parent organization, or buying a business that requires government approval. In most cases, you must satisfy these requirements:
1. Make sure you’re prepared to run the business successfully
Your interest level, experience and commitment to a particular business are key points to consider. Do you have a passion or a talent? Are you experienced in the industry? Owning a business is a round-the-clock relationship, and both veteran owners and advisors say buyers should make their personal qualifications a top consideration.
Prospective buyers should look at an industry or product that interests them and then look for a business to buy in that area, suggested Margo Reign, an adviser for Delaware’s Small Business Development Center and the University of Delaware, and an adjunct professor for the University’s Alfred Lerner College of Business & Economics. Your familiarity with the industry can help sustain you when things get stressful and guide your growth, she noted.
“Sometimes, a business is like an infant that doesn’t grow up for 10 years,” Reign said. “You can’t turn it off or stop checking on it, even if you’re on vacation. You better love what you’re going to do, or you’re going to be miserable.”
It’s also helpful to have some operational experience. For instance, someone who loves to cook might not be well suited to buy a café, said Will Katz, director of the University of Kansas Small Business Development Center. “The business of running a restaurant is very different than cooking meals for friends and family,” Katz said. “Having industry and product knowledge is very helpful.”
Reign takes that point a step further: “Experience is essential. There is too much to know in most industries to just walk in the door thinking you can do it successfully.”
2. Evaluate risks and rewards
To determine what type of business to buy, consider your appetite for risk and your definition of success, experts say. For instance, do you need to buy a business with a strong cash flow? Do you want to be based in a particular area, or would you like to travel for your business to meet with clients and suppliers? Do you want to manage employees and real estate, or would you prefer a smaller operation with minimal overhead?
In addition, small business advisors say aspiring owners should define what rewards and success they would like the business to produce, at least in the first year or two. For some individuals, that is a financial result, either in salary or at least in a growing cash flow. Others might find that just operating a business or getting the opportunity to work in a particular industry or deploy a skill set is rewarding. Your ability to target, acquire and operate a business successfully can depend on your ability to properly balance these considerations.
3. Make sure you have the funds to buy and invest in the business
Along with determination, it takes financial resources to acquire and successfully operate a business. Financial resources are particularly important if you’re buying an underperforming or struggling business. You should have solid personal finances, such as six months of savings to cover six months of personal expenses — rent, utilities and groceries — advises Bruce Freeman, a small business advisor and author.
If you plan to borrow money, look for a lender with experience loaning to small businesses and keep your lender updated throughout your process, Katz said. Borrowers can choose from traditional lenders or organizations that loan specifically to small businesses.
To evaluate your ability to get financing, SCORE, a nonprofit that advises business owners, suggests you draw up a budget, research the business’ financial health and plot your schedule to repay the loan. Although you might have enough saved to buy a business without borrowing money from a financial institution, self-funding an acquisition might afford you more financial independence, but it can expose you to risks as well. That’s because you miss out on a bank’s expertise and its own fact-finding process, Katz said.
“Bankers see a lot of deals. They see things that will throw up red flags,” Katz said. “It is another person on your team and they don’t want a deal to go through that is so unfavorable to you because it impacts them.”
4. Do your homework
Once you’ve identified a business opportunity, it’s time to do your due diligence. The fact-finding process is typically two-fold: Buyers should research both the industry the business operates in and explore the particulars of that business.
To accomplish these objectives, business advisors suggest prospective buyers reach out to people who work with the business, as well as competitors and related businesses. These contacts can help you evaluate a business’ reputation, its position in an industry and potential problems and opportunities. You might also glean important information about why the current owner is selling, which can impact your proposed deal — including the sale price — and offer you insight on cash flow.
Aspiring owners can also enlist help from outside advisors, such as the local chapter of the SBDC; SCORE, a nonprofit that provides free mentoring services to prospective business owners, or the Women’s Business Development Council, which advises and mentors women on business ownership. Each of these organizations enlists veteran financial advisors and retired business owners to consult with prospective buyers and provide coaching on the acquisition process and business operations.
5. Cut the best deal
Negotiating the best deal and working toward a successful closing are the most important steps in buying a business. Securing a deal to buy a business is the culmination of your work to identify a business opportunity that could satisfy your personal and financial aspirations, as well as justify any loans or personal sacrifices you’ll need to make to buy it.
To help you cut a favorable deal, both business experts and experienced professionals advise working with outside advisors who complement your skill set. That might include business brokers, accountants, lawyers, certified valuation analysts, marketing professionals and small business advisors. These experts can help you evaluate a business’ financial health and operations and shape your business proposal.
When you set your budget, business advisors say important to be realistic about how much you’ll need to buy the company and operate it successfully. If you don’t borrow enough money or have cash on hand to cover unexpected expenses — including payroll, rent and any equipment maintenance — your business could be in jeopardy. “You don’t go out of business when you’re not profitable, you go out of business when you run of out cash,” Katz said.
Pros and cons of buying an existing business
- Head start. The biggest upside of buying an existing business is that you’re buying an entity that is already established. By acquiring an existing business, the basic infrastructure is already in place, including technology, real estate and business relationships in the supply chain. As the new owner, you can focus on growing the business, including adding products or services and adding employees.
- Existing position. Presumably, the business you’ll be buying already has clients or customers and a position in an industry. In addition, it hopefully delivers a positive cash flow. You can lean on that existing business while you improve operations and grow. “With an existing business, you’re buying visibility and an idea of what the future will look like,” Katz said. “There is historical evidence of cash flow that will hopefully become future cash flow.”
- Someone else’s vision. With an existing operation, you inherit a business that its last owner created and developed. For some entrepreneurs with strong convictions about how to run a business or deploy a product or service, it can be difficult to work within the confines of someone else’s structure. Although you can change a business over time, in the beginning, you inherit many of your predecessor’s systems and history. “You are a steward of vision someone else had and it may take some time and careful market testing to get your vision executed,” Katz cautioned.
- Buyer beware. Even the most solid businesses come with surprises that crop up after closing, business advisors said. Freeman recalls a friend who bought a deli, only to see the neighborhood’s population change. When new residents didn’t frequent his eatery, it hurt his sales. Freeman noted that the previous owner might have known the area was in transition. “No one will tell you what the problems are. You have to figure that out on your own,” he said.
Choosing what business to buy
When evaluating business opportunities, business owners and advisors say it is a wise idea to choose an area in which you have some expertise and contacts. If you have working knowledge of a product, service and its industry, you’ll have a head start on operating your new business. Being familiar with an industry is particularly important for first-time business owners because many of the other duties that come with owning a company — including employees and operations — might be new.
“We are always trying to buy businesses that offer complimentary product lines to what we already had, operations or product lines that could be integrated easily into what we’re doing,” said Todd Miller, an owner of Isaiah Industries, an Ohio-based roofing material manufacturing company. In recent years, Miller’s company has bought four existing businesses that dovetail with his existing operations, including a building-material distribution firm.
Familiarity with an industry gives a new owner a critical head start, Reign said. “If you know the key players, how it is affected by ebbs and flows of economy and the seasons, you’ll be much better at running that business, then coming in cold.”
To identify businesses for sale, business advisers say prospective buyers can work with business brokers in their area, use aggregator websites like BuyBizSell.com and also network within their communities. Katz recommends entrepreneurs engage in what he calls “prospecting,” which involves reaching out to current owners of operations you’re considering buying.
“A business may not be for sale on open market but doesn’t mean it isn’t for sale and that owner isn’t looking for some sort of transition now or in the future,” said Katz. “Think about businesses you like that you see in the community you want to be in and businesses you have something to add to.”
Potential red flags and how to avoid them
Sellers should be ready to provide detailed financials in a timely fashion, as well as other important information, such as leases or information on partnerships or ownership structures that could impact a sale, according to Katz. “Financial information is the most important. That’s the most important piece that gives them feedback on their business and gives the buyer information,” Katz said.
When acquiring an existing business, owners say buyers should be on the lookout for signs that the operation — or its owner — might be struggling and looking to make a quick exit. For Miller, the surest sign of trouble is muddy financials, including when the owner or company advisers don’t have a strong understanding of their own finances, he said.
Although it might be common practice for a company to pay for some of its owners’ expenses, for things such as a car or cell phones, some business owners might have their operations pay for more personal expenses. Miller cautioned to be wary of operations that fund an owners’ lifestyle. “If it is apparent this organization has operated more of an extension of owner rather than business of itself, it can be hard to sort through and surprises can come up along the way,” said Miller.
Another warning sign could be eager sellers who might be looking to exit a business that is changing or leave an area in flux, Reign said. That could cut into future cash flow and stress a business’ — and new owner’s — finances. “People can buy a business where they don’t realize there is technology coming out that will render biz or industry obsolete or markedly change it, and then they have to make changes they didn’t plan on,” Reign said.
The relationship between buyer and seller can also be instructive. Lisa Strong, owner of the branding firm Strong Marketing in Parkville, Mo., had her office neighbors approach her and ask her to purchase their shipping business, Bellair Expediting, that they’d owned for 46 years. The couple said they wanted to retire and move to Florida. Strong said her existing relationship with the couple helped facilitate a smooth sale and that she placed a high value on discretion during the transaction, as well as her other business dealings.
“You want to maintain a certain level of privacy and confidentiality between the two parties,” Strong said. “If someone is too pushy, that’s a red flag.”
The most important step: due diligence
As part of the buying process, dig into as much information about an operation as you can get your hands on. When a prospective buyer expresses interest in a property, they may be asked to sign an agreement that gives them access to a business’ finances in exchange for their confidentiality. In other instances, after two parties enter into a sales agreement — also known as a term sheet — the buyer will receive detailed financial information from the seller. The parties sign a letter of intent with the agreed-upon price and a proposed closing date.
From there, business veterans say buyers need to pore over several years of recent financial records, including financial statements, banking records and tax returns. When Strong acquired Bellair Expediting, she called in a veteran accountant — the review included three years of tax returns and the business’ financial statements.
To properly review a business, both operators and advisers said buyers should bring in outside experts, particularly an experienced bookkeeper, certified public account or certified valuation analyst — and a lawyer with a solid track record in business acquisitions. “They know the right questions to ask,” Katz said. Retaining third-party experts is particularly important for buyers that do not have strong financial or legal experience, Reign said.
Working with banks and investors can also help buyers make educated purchases, because they’ll often conduct their own investigations to make sure a business is on solid financial footing. This also helps reduce risk for the lender — if a business is on solid footing, the borrower won’t likely default on the loan.
Getting an independent, third-party analysis can provide additional backup for buyers and instill confidence in them regarding their purchases. When buyers opt to pay cash or use a seller to finance their purchase, they can miss out on this independent verification, Reign said.
Spending time learning the surrounding environment to avoid major mistakes is also important, Reign added. For instance, if you’re buying a small hardware store and Home Depot is coming to town, that could harm your future business — or, if a new highway is going in front of your store, it could be difficult for customers to get to you. “You really need to do a lot of research and make sure you understand what is happening in the area and in the industry,” Reign said.
Negotiate the deal and craft a sales agreement
When buying a business, price is the biggest consideration, but there are other important details, including real estate, equipment and staffing. Make sure you secure all of the valuable assets necessary to run the business, including equipment, customer or client lists and any intellectual property.
To arrive at your proposed offer price, you can rely on due diligence and market research, which will help you determine a proposed value. Buyers can also work with certified valuation analysts, small business advisers and bankers to develop an offer price.
Depending on the relationship between the buyer and seller, the two parties might discuss price directly or use attorneys as intermediaries. Miller, for instance, said he prefers to speak directly to his counterparts at the business rather than negotiating through lawyers. You must use attorneys to draw up contracts and related paperwork, so keep your lawyers involved and apprised of all negotiations, as Miller does.
There are several valuation methods you can use to determine purchase price:
- Asset valuation: Value is based on tangible assets.
- Market valuation: Value is based on earnings, sales or proceeds from similar business sales.
- Income-based valuation: Price is determined by capitalization or discount rate, or a combination of both.
Steps involved in a business acquisition
Letter of intent
When you’ve decided to proceed with a business acquisition, the first formal document between buyer and seller is typically a letter of intent. This outlines the terms of the sale and proposed closing date. If you haven’t already signed a confidentiality agreement, you’ll likely need to in order to gain access to the business’ documents, including financial statements and tax returns. These agreements can be either binding or nonbinding.
A letter of intent might include the following:
- Purchase price and breakdown of price per assets
- Seller agrees to cooperate and facilitate due diligence
- Outline of contingencies to meet sale, which could include appraisals of business, real estate and inventory; any necessary franchise review; transfer of vendor and client lists; review of facilities, equipment and machinery.
- Proposed closing date
At this point, many buyers have already secured a lender, but, if you haven’t, you’ll want to arrange financing and work out the terms of your loan. Miller said he likes to involve bankers as soon as possible and keep them updated regularly. “I tell them what we’re looking at and how it is coming together. That way, if something happened and it wouldn’t be financeable, we would know it before we get to the final terms,” Miller said.
The sales agreement, sometimes called a purchase agreement, formally outlines the purchase and the details of the acquisition, including any assets and liabilities. This document moves the process from the letter of intent and toward an eventual sale. It will cover all the tangible and intangible assets you intend to buy, including property or real estate, technology, customer lists, intellectual property, equipment, vehicles and even furniture.
The two sides might trade versions of the proposed purchase agreement. Before Lisa Strong acquired Bellair Expediting, she rejected two proposals from the seller’s attorney before her team negotiated terms that satisfied both sides.
Asset sale vs. stock sale
When structuring your deal, one of the most important considerations is how to structure your purchase. The two most common ways to do that for small businesses are via asset sales or stock sales. In an asset sale, the buyer acquires the physical characteristics of a business but forms a new legal entity. This is sometimes called a debt-free sale, because the seller retains any outstanding financial obligations. The new owner is not responsible from any obligations the former company had in effect, including liability, debt and any future claims against the business, such as employee issues, warranty claims or OSHA violations.
In a stock sale, a buyer purchases the ownership of a company and everything that stock controls. You are transaction ownership of the corporation, which can make it easier to transfer intellectual property or contracts. This model can be helpful for retaining and transitioning contracts with vendors, suppliers and customers.
Closing the deal
Depending on the complexity of a sale, the closing process typically takes between 30 and 60 days. During that time, you should have conducted your due diligence and ironed out any financing snags.
Once those requirements are satisfied, business advisers say buyers should give the entire deal one last checkup. Several organizations that provide advice, including the U.S. Small Business Administration, have checklists to help owners track the closing process. Their tips include talking to your banker, attorney and accountant to make sure any outstanding issues are resolved. Before closing, buyers should also review and verify all the related documents and any existing agreements that the business has, including franchise documents, employment agreements and leases.
Before closing, the SBA advises buyers to validate ownership, including checking titles and ownership documents for all property, equipment and assets that are transferring. At this point, you can adjust the purchase price if necessary.
The bottom line
If you’re looking to buy a business, experienced buyers and advisers say prospective owners could benefit from a few additional tidbits of advice:
Keep the previous owner involved. If appropriate — and possible – new owners could benefit from the sellers’ institutional knowledge and experience with a product, vendors and customers. Lisa Strong negotiated for her seller to remain with the business for six months. In other cases, sellers might stay on as contractors or informal advisers.
Set a budget and then bump it up. Along with your purchase price and any fees you’ve paid to outside advisers, veteran business owners say unexpected expenses are bound to pop up. You might need to buy new equipment, upgrade technology or shell out for more advertising.
“Anytime I do a budget for a business, I add 15%,” Freeman said. In addition, business advisers say you should make sure they have enough money in the bank to cover six months of personal expenses, in case you defer a salary from your new business or the cash flow doesn’t support your financial needs.
Be persistent. If you’ve set your mind on buying a particular business and the deal isn’t working out, don’t give up. Stay in contact with the owner and keep up on the industry, Miller said. Several years ago, he attempted to buy a business from a divorced couple, but the owners couldn’t agree to terms. Five years later, the couple settled their differences and Isaiah Industries successfully acquired the company. “If it still seems like the right move, there could be opportunities down the road. Don’t give up,” Miller said.
Timing is everything. Baby boomers are moving toward retirement, so there might be more opportunities than ever to buy an existing business, Reign said. “They were among the most entrepreneurial generation and many of them own businesses and are looking to sell. That means there are a lot of opportunities out there for buyers,” she said.
Trust your instincts. After you’ve closed and taken over your new business, brace yourself for a transition period. If you have employees, take the time to get to know them, value their experience and lean on them for assistance. “Trust your homework, your team and your ability to hit the ground running,” Katz said.