Evaluating and Buying a Business

An Alternative to Starting a Business is To Buy One

Buying a business is generally faster, less risky in terms of being a known entity and already has an operations system in place.  It can be particularly advantageous if you have some new ideas to add to the business.  For example, adding products, marketing, and the internet can make an existing business much more profitable.  The key initial risks are the purchase price, the reliability of the information, why they are selling, and what happens after current management leaves.

The most important aspect of buying a business is:  is it for you?  It’s important to choose a business that’s right for you, a decision you’ll make based on your skills and personality.  Anything less than a good fit will turn your dream into a nightmare quickly.  Take time to do some soul searching before you begin to prospect for a business and when you begin, if you find something, make sure it is right for you.

Critical Business Skills

It’s important to know the skills that drive a business — and whether you have them.  First, write down your business skills.  Do you have experience in areas like supervision, personnel, data processing, or collections?  What about skills in bookkeeping, forecasting, pricing, or tax law?  Marketing analysis, sales management, negotiating, advertising, or prospecting?  Write down every skill you can think of.  With these skills in mind, you’ll look at a prospective business and ask, “What does the owner need to know and do?  What must the employees do?  How does the owner keep the company profitable?”  Do you have the right stuff for that business?  If not, keep looking.

What Can You Afford?

Before you figure out how much you can invest in a business, be aware that most small businesses don’t sell for all cash.  The rule of thumb is that you’ll pay a third in cash and the rest over three to seven years to the owner.  The cash flow of the business must be able to service the debt.  If it can’t, it’s not a high-profit business.  If you still want it, you’ll have to increase the down payment or extend the number of years the note runs.  The seller will also want to see this form to know that you’re a qualified buyer.

Key Ingredients – Your Accountant and Attorney

A good accountant is essential to the health of your company.  It’s also important to have one along to help you evaluate a potential buy.  In selecting one, get references and try to find someone with experience in the business.

Despite how you feel about lawyers, you’ve got to engage one with experience in business acquisitions.  A lawyer can gather information that will help you devise a negotiating strategy, and he/she can uncover problems in the deal early.  For example, many businesses are in violation of zoning laws or the building code, and some may have hidden problems like toxic waste.  You may become liable for such things when you buy a business, so a good lawyer can save your neck by spotting them early.  A lawyer can also draft the purchase-and-sale agreement, form a new corporation, obtain permits, negotiate the deal, and more.

Research – Ignore at Your Peril

It’s up to you to ferret out the owners willing to sell.  By now, you should have an idea of the industry you want to be in, though your skills and desires may lend themselves to more than one.  Hit the library.  You’ll research two things.  First, you want names of specific companies.  Second, you want to understand industry issues and practices that affect any company you might buy.  Good research libraries will have access to documents from places like HOOVERS that can give details and financial information on private companies through D&B reports, etc.  Make sure to examine information from trade associations, trade papers, and related periodicals.

Industry Issues ripe for research:

• What are the key industry issues?
• Is the industry growing or dying?
• Who are the innovators in the industry? Why?
• How is technology affecting the business?
• What’s the potential over the next five years?
• Can small firms compete?
• How much revenue and profit can a small company generate each year?
• How much capital do you need to compete effectively?
• Am I interested in this industry?
• Do my skills fit this industry?

Get a List of Prospects

Your research will yield a ton of insight, plus a list of companies.  But, you still don’t know whether these firms are profitable or if the owner wants to sell.  But, when you call, you’ll be ready.  Owners, especially those who’ve never thought of selling, won’t sell to just anyone.  They’ll prefer someone who knows about the industry and its critical issues.  You should also consider brokers and internet ads to locate companies in your selected industry for sale.  It is frequently good to test these just to get a feel of what’s available and approximate asking prices.

Assuring Sellers of Your Bona Fides

You need to ensure sellers you are a qualified buyer in terms of capabilities and your ability to finance a transaction.  Nearly every deal I was involved in happened partially because of our ability to gain the confidence of the buyer that we could close the deal on his/her schedule.

Build a Relationship Between the Buyer & the Seller

The process of buying a business frequently takes time and requires the buyer and seller to build a relationship.  Start slow, convince them of your credibility, why you are interested, and work on building trust.  At the same time, gather the information you need from the seller.  Informal meetings like lunch and dinner can be particularly effective to build a relationship and trust.

Keep Your Eyes Open

Starting the Process

Remember the seller is trying to sell the business for the best price possible.  Get a history, kick tires, talk to employees and customers, etc.  Is the place neat and does the business appear to have proper operating procedures?  Determine the essentials in buying the business and be sure they get answered, e.g., what’s the rent?  Is the lease assignable?

Financial Statement Examination

Examining Financial Statements is critical to the process.  Certified statements or tax returns for 3 to 5 years are the most reliable.  Your accountant will spot things you might miss.  For example, say you get excited about a high profit business.  The accountant looks at the financials and discovers that the owner hasn’t replaced inventory for ten months.  And that he/she owns the building and rent expenses for you would triple.  Don’t ever take the financials at face value.  Financial statements in most small businesses are prepared to minimize tax liability.

The value of a business lies in its ability to generate profit for an owner.  But because many owners try to minimize taxes, they may inflate certain expenses, gain a tangible benefit and narrow the bottom line.  If you add the non-recurring/owner benefit items to the stated net profit, and subtract things you’ll have to pay more for, you’ve got a picture of the firm’s real profitability — and a figure you can use to value the business.

Make a Strong Offer Based On the Facts

Buying a business is like getting married; you have to satisfy each other’s needs.  It’s not a contest to be won, so aim for a win-win deal.

Letter of Intent

Begin with a letter of intent.  Draft it yourself, but have your lawyer look it over.  The letter isn’t a formal offer; it’s a proposal that covers your view of the key issues in the purchase.  In it, you’ll propose a price and the financial structure of the deal, and you’ll discuss contingencies.  Contingencies are issues such as the assignment of the lease, agreements to keep key employees on the payroll, what’s included in the sale, and much more.  Don’t try to specify every contingency, and don’t spell out the details of those you mention.  This gives you room to negotiate.

Thoughts on Negotiations

Decide exactly how much you’re willing to spend to buy the business.  Be prepared to walk away from the deal if it goes over that amount.  When negotiating, listen closely for the real issue behind a stated position.  If the seller says, “I want all cash,” the issue may be that he/she thinks you’ll ruin the business and the seller will have to take it back.  Once you define the root concern, you can find a win-win solution.  Some of the issues that need to be negotiated include:

• Detailed terms
• Form of transaction
• Purchase price and any adjustments
• Excluded assets and excluded liabilities
• Obligations to be assumed
• Payment terms – amount down, pay out over time, pledged assets
• Representations and warranties – how long
• Indemnification – how much and form (deductible or basket)

Attack Problems Together – Work Towards a Win-Win Deal

Expect to meet with the seller a number of times to discuss the issues.  When faced with tough problems, ask:

“How can we come to a solution that benefits us both?”

Again, think win-win.  Maybe the owner wants $750,000 for the business.  You want to pay $650,000.  The real issue may not be the price — it’s that the seller wants to clear $500,000 after taxes for a comfortable retirement.  Maybe you can offer a long-term consulting contract.  Maybe you can agree to his price, if he’ll extend payments.  If you’re truly open to a win-win deal, you can negotiate all the difficult points and arrive at a deal that satisfies you both.

In short, a good deal is built on trust, fairness, and mutual benefit.

Some useful tools and considerations to aid the process include:

Business Plan – The Why?

1. Educational process – as you prepare the plan you will learn many things you have not considered.
2. To prove that the business is financially viable.
3. To assure family, friends and associates the business is financially viable.
4. To persuade a bank or investor(s) to fund the business or to get a loan.  If you finance the business, you will be lending the business money which would call for a business plan.
5. The business plan should serve as your roadmap to organize and run the business.  The plan can serve as a guide between what you anticipate what the actual reality is.  As the plan is updated, you can rely on it as a way to better understand and manage change.  Analyzing the deviations from your plan and reality is a useful way to tune the business to the market.

Considerations to Help Determine Purchase Price

1. Ultimately the business is worth whatever someone is willing to pay for the business in an arm’s length negotiated transaction.
2. Many technology, internet, and service companies become complex because the value is frequently a multiple of some potential projections.  In addition, they frequently have very few hard assets.  As a result they become very high risk but provide very high reward if they are successful.
3. Many businesses are customarily valued by multiples of book value, net book value, sales, or earnings.  These multiples are usually calculated based on historical trends and actual transactions in each industry.
4. Some businesses are valued using discounted cash flow analysis, which requires subjective projections of future earnings and cash flow.
5. Adjusted book value – book value of assets adjusted to fair values.
6. The value is greatly affected by the value to you and the seller.  This is especially true if you have major plans to increase profits.  On one hand you should not pay him for your gains.  On the other hand, it may be cheaper to pay them a little more than start from scratch.
7. Debt-paying ability method.
8. Certain valuable intangible items may or may not be assumed in the valuation calculations discussed above.  These include a list of loyal customers, relationships with responsive suppliers, operational and technical expertise, and knowledge specific to the business.

Due Diligence – Do Your Homework and Make Sure to Know

1. What is the potential of the company in terms of sales and profits.
2. What are their proprietary products, technology, research investment, and brand value.
3. Make sure to review latest 3 years tax returns.
4. Quality of reported sales base – is it real?
5. Customer relationships – are customers happy, make sure to talk with them.
6. Return history and credit adjustments.
7. Supplier relationships and dependency – are they good and are materials of the quality you would expect.
8. Payment terms – can you live with them?
9. Quality of inventories- are they good and merchantable and does the 80/20 rule apply?
10. Inventory turnover and months’ supply on hand.
11. Seasonality of business and related working capital requirements.
12. Receivables – collectability.
13. Liabilities – are they all disclosed and are there any contingent liabilities.
14. Obligations – what are they and will you assume them such as lease and other contracts?
15. Taxes – have all prior taxes been paid such as payroll, property, sales, unemployment, workman’s compensation, and, of course, income.  Have all employees withholdings’ been made and remitted to taxing authorities?
16. Any current or potential legal proceedings?

Financing the Transaction

1. What % does the buyer need to put up?
2. Bank loan requirements:
   • Credit score of 700 or above.
   • Cash flow sufficient to make loan payments from day 1.
   • Collateral sufficient to cover entire loan.
3. Alternative sources to obtain financing if bank requirements are not met:
   • Community Based Lenders.
   • Gift or loan from family, relatives, friends, business associates.
   • If you must use credit cards, they should be paid back on time.
   • A partner with money, it is better to own 50% of a growing business than no business at all.  Consider a supplier, customer, venture capitalist, Angel, etc.
   • Guarantor or co-borrower.  Works well when a family member or close friend is reluctant to advance money up front but thinks the company you want to buy will succeed.  They may be willing to either guaranty a bank loan or co-sign a bank loan application.

Tips for Dealing with a Banker

1. Establish a personal relationship with the banker.  Loans are about trust, and trust starts with familiarity.  Invite the lender to visit with you at the Business.  Take advantage of his experience and contacts.
2. Know your numbers.  Learn about the balance sheet, income statement, cash flow projections.
3. Sweeten the deal. Lenders want new customers.  Ask him about his other services and products.  If satisfied, refer family and friends to the lender.
4. Do not fool yourself. Know your weaknesses.  Know the break-even point.  Use an accountant or bookkeeper to put the numbers together.
5. What to say when you meet the banker:
   • Describe your background, experience, and education
   • Stick to the facts.  Tell the lender only the truth.  He must have confidence in your ability and integrity.
   • Tell the banker how much money you require.  Never ask “how much can I get.”
   • Outline how and when the money will be used to pay the purchase price.
   • Tell the lender how the business will generate the cash flow required to service and pay off the bank loan.
   • Tell the lender how much of the purchase price you are personally funding.

Insurance – Have A Good Insurance Agent

1. Liability
2. Property
3. Fire and theft
4. Errors and Omission
5. Workman’s compensation

DEAL PROCESS REMINDERS

Buyer due diligence is critical to obtaining a fair sales price.  Do not rush into anything until you have performed extensive due diligence.  Seller must have a ready answer for every possible Buyer question.  Remember your concerns are critical and other issues besides price may be essential for you to understand and negotiate.  VERY IMPORTANT!

REMEMBER, the seller generally wants to sell stock and the buyer wants to buy assets.  The problem (other than tax considerations) is how you handle undisclosed and unrecorded liabilities and obligations.  Representations and warranties and negotiated indemnifications are usual remedies.

REMEMBER, the business is sold on a going concern basis.  The buyer gets the unrecorded assets and assumes the warts (undisclosed and unrecorded liabilities and obligations) all subject to negotiation.

Make certain customers, suppliers, and employees understand the sale event and process.

Agreements are negotiated on a page by page basis.  The principals should try not to directly negotiate.  They are behind the scene making final decisions, outside the authority of each negotiator.

REMEMBER, required closing statements are to be prepared by the Seller’s accountants and representatives.  The Buyer will most likely insist on some form of post-closing adjustment based on an audit.  Post-closing adjustments are difficult for the Seller.  He/she only has the audit opinion of his/her accountants, while the Buyer has the books, records, employees, subsequent events, etc.

In Conclusion

Negotiating and buying a business is a difficult, exciting, stressful, risky, and sometimes confrontation ridden process.  Don’t let those processes interfere with your goals and parameters.  Be prepared to give on some things that you may not want but stand your ground on critical issues and don’t pay too much just to do a deal.  Let the attorneys do much of the negotiation and keep a positive relationship with the seller.  Remember you have to run the business the next day and want to ensure the best relationships as possible with the seller, employees, suppliers, financing organizations, and customers.  That is generally accomplished with preparation, honesty, and concern about their issues.

Good luck.