As the baby boomers reach retirement, many are looking at selling their businesses. This has created a great buying opportunity for many Gen Xers who are now reaching their maximum productivity to become business owners.
Buying an existing business is one of the least risky ways to become a business owner. It provides many advantages, including existing operations and customers, immediate cash flow, existing brand and goodwill, and many more. But if you are considering buying an existing small business, you should take into account several important business, legal, and financial factors. Here are nine key factors you should consider when buying a small business.
Decide on the Type of Business to Buy
Determine what type of business is ideal for your situation. What work-life balance are you looking for? What is your time commitment? Is it full-time or part-time? What industry are you most passionate about? Do you want a brick-and-mortar business, which comes with higher overhead costs, or an online business, which has fewer overhead costs? Who do you want your customers to be: other businesses (B2B), consumers (B2C), or the government (B2G)? What is your risk tolerance? What are your financial goals in owning a business? Do you have an exit strategy after you buy the business?
Review Multiple Business Opportunities
It’s helpful to review multiple opportunities of businesses for sale so that you can compare and contrast each opportunity. Just like dating, it is unwise to fall in love with the first person you date. To find a business for sale, you can visit websites such as BizBuySell and BizQuest. I often advise my clients to also consider using a business broker to bring you opportunities. Business brokers are like real estate agents in that the seller is the one who pays the commission to the business broker, so why not use one? They can also act as a third party and educate you in the process of buying a business.
Another way that most buyers never think about is to simply approach a business you would consider owning and ask the owner if they have ever considered selling. Even if they are not willing to sell, they may be able to refer you to someone else in their industry who is.
When evaluating any business to acquire, a simple rule of thumb is to base half of the decision on what the seller did and the other half on what you would do differently.
Assemble Your Deal Team
Legal: Acquisitions are heavily legal-intensive transactions, and you need a good business attorney with experience handling small business acquisitions. Just like doctors have a specialty, so do lawyers. You will want to find a business lawyer specializing in Mergers and Acquisitions.
Accounting: There are many complex tax consequences for both seller and buyer, generally related to how the purchase price is allocated. And just as business lawyers are specialized, so are accountants. So be sure that your accountant specializes in Mergers and Acquisitions.
Decide on the Type of Acquisition
In most cases, when buying a small business, you will want to purchase the company’s assets and its contracts to avoid taking on unknown liabilities in what is known as an Asset Purchase. However, some sellers may insist on the deal being structured as a Stock Purchase for tax reasons.
When you find a prospective business you are considering buying, you should prepare a non-binding document expressing your serious interest in acquiring the business, known as a Letter of Intent. A letter of intent outlines the key terms of your offer. The letter of intent serves as a starting point for negotiations and requests access to the seller’s books and records so you can perform your due diligence. A letter of intent sets the framework for more detailed negotiations leading to a formal purchase agreement. Lawyers and accountants are often involved in the drafting and review of the letter of intent to protect both parties’ interests.
Here are some key terms to include in your letter of intent:
Purchase price: Will it be all cash? Part cash and the rest payable in installments or as an earnout?
Structure of deal: asset or stock purchase?
Exclusive no-shop period for buyers to finish due diligence.
Key conditions to closing.
Timing of deal.
Any continued involvement or employment of the selling owner to ensure a smooth transition.
Non-compete by selling owner so they don’t set up a new competing business.
Confidentiality obligations of the seller.
Access to employees, books, and records during the exclusivity period.
Indemnification obligations of the seller.
Key representations and warranties of the seller.
How disputes will be handled, and in what jurisdiction?
Most of the terms of the letter of intent or term sheet will be non-binding, but the buyer will want the exclusivity due diligence/no shop provision to be binding.
Confidentiality Agreement: Most sellers will expect you to sign a Confidentiality Agreement, also sometimes called a Non-Disclosure Agreement (NDA), before they provide you with sensitive or confidential information about their business. Most confidentiality agreements are standard, but unreasonable terms are occasionally thrown in. Unless you understand all the provisions of the confidentiality agreement, have your attorney bless it before you sign it.
Due Diligence
The most important thing you must do is carry out thorough due diligence on the business you are interested in acquiring. You can download our comprehensive free Due Diligence Checklist, but here are some of the key areas:
Review financial statements and tax returns for the past three years. Have sales been going up or down recently? Is there a seasonality to the business? How profitable is the business?
Review the list of assets that come with the business and those that do not.
Review any debt or other liabilities of the business.
Review contracts and other liabilities you want or need to assume.
Do a lien search on the business.
Review important intellectual property such as patents, copyrights, and trademarks.
Do a Google or Yelp search for any reviews of the business.
Review the lease – is it assumable, and will it continue under the current terms? Are there overly burdensome terms? Do you need to amend the terms of the lease or other provisions?
Review the status and condition of any inventory, equipment, and physical assets.
Do a legal review of organizational corporate or LLC documents.
Remember that the financial reports alone may not accurately represent the owner’s true compensation. This is especially true for lifestyle or micro businesses with revenues under one million dollars. In all likelihood, the business was run in a taxed-advantaged way for the owner’s benefit. Small business owners often use business assets for personal use. For example, a home-based business may pay for high-speed Internet the owner may use to stream videos at night. Or a fleet vehicle owned by the business may be used to benefit the owner and not be accounted for on the books. If this is the case, put more stock on revenues rather than reported taxable income initially.
Assess the Risks: Discover if the business depends heavily on the owner or key employees. Are there significant potential liabilities? Is the business overly dependent on certain customers or suppliers? Are key contracts transferable or at risk of cancellation?
Verify Permits and Licenses: Find out if the company has all the proper licenses and permits, especially for regulated businesses like healthcare, childcare, and restaurants. Will you need to amend or get new permits or licenses after you buy the business? Also, verify the business complies with applicable zoning and environmental laws.
Prepare a Business Plan
Whenever you consider buying another person’s business, you should always develop your own preliminary business plan to see what you might do differently.
Some minor improvements that can pay large dividends to the buyer are as simple as staying open longer, changing prices, motivating employees, marketing more, adding a drive-through, building a better marketing process or website, and adding pickup and delivery services. Using the Business Model Canvas at this point can be an eye-opening experience.
Cash Flow Projections: Be sure to prepare monthly cash flow projections of the business for the next year or two to determine what working capital may be needed and to develop a proper budget.
The key point is that you pay the seller based on their past performance but value the business on potential future earnings. When it comes to trying to determine the income potential, you will have to account for any debt service you will incur related to the purchase. Additionally, the seller generally takes the cash in the business and is paid the accounts receivable balance as of the date of sale at the closing. As the new owner, you must inject sufficient cash into the business to cover the operating expenses until your own receivables kick in.
Set up an LLC or Corporation
Most small businesses are structured as asset purchases, not stock purchases. You will likely need to create an LLC or a corporation as the company’s buyer if your acquisition is an asset purchase. If the seller insists on a stock purchase, this step is unnecessary, as you will simply acquire all the outstanding stock of the seller’s business.
Prepare a Purchase Agreement
It’s essential that your business lawyer prepares a good pro-buyer Purchase Agreement. This is a complicated agreement to protect the buyer, especially dealing with representations, warranties, and indemnification. You can download a Sample Purchase Agreement Outline from the Free Downloads sections of SteveBizBlog.
Conclusion
Many baby boomers are selling their businesses, creating a great buying opportunity for individuals who want to become business owners in the least risky way possible. Buying an existing business provides many advantages, such as existing operations and customers, immediate cash flow, existing brand and goodwill, and many more. Systematically and carefully taking the steps outlined in this post will significantly increase your chances of having a successful small business acquisition.
