Buying a Business

Entrepreneurship is a risky business. A great way to reduce risk is to buy a business that has demonstrated the ability to succeed. For a financing perspective, you’ll have a much easier time securing capital by taking over an established business. You’ll also dramatically minimize the financial risk to yourself and your finance partners because the company will have proven revenue and a customer base. Many lenders will fund 50% to 75% of the acquisition cost for businesses depending on a number of factors such as the cash-flow numbers, assets and security available.

Buying a business will dramatically reduce the risk when compared to start-ups since statistics estimate that 60% of start-up businesses fail within the first three years. It generally takes two years on average for a start-up to become profitable, even though every entrepreneur thinks their method will be different. Even comparing start-ups with such other options as home-based businesses or MLMs, in most cases, your chances of success are still clearly best when you buy an existing business.

1. Much lower risk of failure
2. Business generates cash flow from day one
3. Proven concept and processes
4. Proven products, services, marketing and sales strategies
5. Established customer base
6. Established suppliers
7. Trained staff
8. Immediate credibility
9. Seller likely to lend support and may assist with financing
10. Easier to secure affordable financing

While a competent commercial law attorney may seemingly have an important role, problems arise when they see themselves as negotiators instead of lawyers. Attorney’s naturally want to get what’s best for their clients damn the cost. What they forget is that getting the “best deal” has to involve both parties, the buyer and the seller. Compromise is usually the best solution, and lawyers generally have a difficult time with compromise in this type of situation. Usually an attempt at a lopsided deal for either party will result in “no deal” at all.

All business brokers dealing with the public are generally bound to be honest and forthright in their conduct concerning the businesses that they represent for sale. But they also have a fiduciary or, position-of-trust to uphold between themselves and their clients. They must present the business for sale in its “best light” without misrepresentation while not pointing out all of the potential pitfalls of the business. The best course of action for a buyer is to trust only what they can verify during a rigorous due diligence process and obtain a good dedicated commercial representative.

Buyers and sellers are natural adversaries; the sellers want as much as they can get and the buyer wants to pay as little as possible. So, what process should you use to value a business? Forget about putting a value on the assets based on resale value. Forget about comparing the business to the one in the next town that sold for a particular amount. Forget about all the “rules of thumb” like X times earnings or Y times gross income or some dollar amount per account or any other shortcut formula. A business value, and therefore its selling price, only makes sense when it’s based on the capitalized earnings stream. Capitalization is simply the process used to determine today’s value of a stream of future earnings. In the case of valuing a business, “today’s value” is the value of the business, and the “stream of future earnings” is the expected future years’ profit of the business based on current earnings. Most small businesses sell for a price in the range of 2-5 times earnings before interest and tax expenses are deducted.

The assets of the business are just the tools of the trade that enable an earnings stream to be realized. Without the earnings stream, the business essentially has no value. You should note that in using this method, a business may actually be worth less than its fair market asset value or in many cases worth substantially more. A seller will be able to get the most they can for a business by showing a buyer the true investment value in the business based on provable earnings.

This is a very sensitive subject known as unreported (to the IRS) cash sales. Some business sellers may try to get you to accept their claim that they had significant amounts of cash income that did not show up on their IRS Tax Return and accordingly want you to include this phantom income in your valuation of their business. I highly recommend that you totally ignore these claims and deal only with the business’s reported income. Who is to say if the business owner’s claims are true? If the business owner will lie to Uncle Sam might they not also lie to you?

Most sellers are honest people trying to get by in life like everyone else. However, a buyer should approach all information provided in the sale with some skepticism. Buyers are making a major financial decision and should carefully consider all information presented during a detailed due diligence process. If a buyer approaches the purchase of a business with a good healthy dose of “prove it to me,” then it will be difficult for them to get burned.

Most businesses have some negative feature(s) that the seller will be reluctant to talk about. You can be sure that any problems will come out later as buyers begin analyzing the business (due diligence), and it could kill the sale if the problems are perceived as cover-ups. This is because buyers will ask themselves (logically) “if they hid this fact from me, what else are they hiding?” If the negative aspect(s) is clearly presented and discussed with the buyer, it may not be a serious problem because the buyer may feel that it can be overcome, avoided, or changed. The seller should strongly consider this and determine all of the possible negative factors that could affect the sale of the business. If the problems are very serious and non-correctable, the business may not be salable.

Once the Purchase and Sale Agreement has been signed by both the seller and buyer, there is an excellent chance that the sale will actually take place. But, there must be an end to the negotiation process or things will begin to unravel. The deal at this point is like a house of cards with many parts of the negotiated deal contingent on another part. Trying to reopen negotiations after a Purchase and Sale Agreement has been signed will most likely lead to a collapse of the entire deal.

Of course, this doesn’t hold true if you’re buying a turnaround situation; but in general, if the business you are buying is profitable, leave it alone while you learn how to manage it in accordance with the status quo. One of the experiences I have had that best illustrates this point is as follows: One buyer of a fast food chicken franchise soon after the closing changed meat suppliers because he found that he could get the chicken at 10¢ a pound cheaper. What the new owner did not realize was that these chicken pieces were 25% larger than those provided by the original supplier. The problem with this is; the franchise doesn’t sell chicken by the pound; it sells it by the piece. The new franchise owner completely wiped out his profit margin by paying a smaller price per pound but delivering to the customer 25% more chicken at the same retail price!

Agreeing to keep all information about the opportunity to purchase or invest in a business confidential is an important prerequisite to learning anything at all about the specific opportunity. This is because uninformed employees, suppliers and customers may assume that the company is in trouble or that they will be left without jobs, warranties or payment due. Their inappropriate reaction which may include key employees leaving employment and suppliers canceling payable terms may cause severe hardship on a company where confidentiality is breeched.

You typically will be asked:

1. Not to divulge any information regarding a company’s operation or financial position
2. Not to contact the owner or employees directly
3. Not to reproduce or divulge information to others
4. To use this information solely for the purpose of evaluating interest in buying the company and
5. To return all information provided upon request.

You may also be asked to sign a non-piracy agreement. In this contract you agree not to use information provided to solicit, divert or in any way interfere with employees, customers, suppliers, contractors or other relationships which are related in any manner to the business activities.

If you are already in the same industry and may have relationships or even contemplate relationships with the same suppliers or customers, you need language that will not preclude you from these relationships. In all cases it is best to have the agreement reviewed by your counsel prior to signing.