Thinking about buying a business? Here are five steps to find the right business and close a favorable deal.
1. Consider the Pros and Cons of Buying a Business
- Less risk. As opposed to starting one, buying a business gives you access to immediate cash flow and profits. You get an established reputation and brand, loyal customer base, profitable patents, and successful business formula. There’s no pressure to develop organizational procedures and policies, or hire and train new employees.
- Easier financing. This lower risk makes getting financing much easier than if you were to start a new business.
- More costly. However, buying a business usually requires a larger initial investment than starting one. All the work that’s been done to lower your risk will cost you more because it’s valuable.
- Hidden problems. If you don’t do your due diligence, you can be stuck with outdated inventory, problem employees, hidden debts and antiquated work processes.
2. Decide the business you should buy
It’s important that the business you buy is a solid fit. The US Small Business Association (SBA) recommends knowing the answers to these questions:
- What are your interests? Choose an industry that you’re passionate about. If you don’t feel strongly about one, start by excluding all those that do not interest you.
- What are your skill sets? Be ruthlessly honest about your strengths and weaknesses and match them to a business. Don’t choose a business for which you have no applicable experience or don’t understand.
- What business conditions do you need? List the business conditions necessary for you to succeed. This includes business size (number of employees, locations and sales), geographic location (labor pool, cost of living, cost of doing business, taxes), and time commitment.
- Why is this business for sale? With these criteria, start searching for specific businesses to buy. Look through newspapers and the classifieds, run your own want ad, contact a business broker or even cold call businesses that fit your requirements. Just because a business isn’t listed doesn’t mean it isn’t open to offers. But always remember to understand the reasons a business owner wants to sell. It will help you determine its true worth and negotiate a favorable price.
3. Determine the Value of the Business
The SBA recommends using these methods to fairly price a business:
- Capitalized Earning Approach. Determine the return on investment that you expect.
- Excess Earning Method. Determine the return on investment that you expect, separating return on assets from other earnings.
- Cash Flow Method. Determine how much of a loan the business’s cash flow can support. Use this adjusted cash flow to measure the firm’s ability to service debt.
- Tangible Assets (Balance Sheet) Method. Use tangible assets to value the business.
- Value of Specific Intangible Assets Method.: Compare buying a wanted intangible asset versus creating it.
Finally, analyze the company’s reputation and business relationships. Entrepreneur Magazine suggests interviewing customers, suppliers and vendors. Make sure the company has no complaints with the Better Business Bureau, industry associations, or licensing and credit-reporting agencies.
4. Finance the Purchase
Consider these three approaches to obtain financing:
- Debt financing. Borrow money from an outside source — most likely a bank but consider loans from friends and family — with an agreement to pay it back with interest. The SBA offers banks guarantees to lower the risk of long-term small business loans.
- Equity financing. Sell shares of your business to investors. You give up some ownership and control, but you won’t have to repay debt.
- Seller financing. Borrow money from the seller. This usually means higher interest rates, but it gives the seller incentive to ensure the business stays profitable. It also gives you more flexibility to negotiate loan terms.
5. Negotiate the Price
There are many reasons negotiations become stuck. These suggestions can help avoid a drawn out process:
- Consider complications. Make sure you understand the emotional connection a seller has to the business before starting negotiations. It might be too difficult to get a fair price if the attachment is too strong. Also understand if the seller is inflating the price to pay off other debts.
- Plan contingency situations. When making an offer, make it contingent on specific conditions being met. Thus, if you unearth any misrepresentations by the seller, you can get a lower price or back out of the deal. Make this offer in writing and only pay the full price once you’ve done your due diligence and you’re satisfied. Put a small percentage in an escrow account as a show of good faith.
Ready to get started on buying a business? Contact UpCounsel Commercial Attorneys to get started.