“How to Buy a Business”

In some situations, buying an existing business can help you grow your business faster. You can buy your way into new markets, new products and new employees. Six steps must be followed to ensure a smooth and successful takeover: finding the appropriate business, evaluating its potential, establishing a fair price, structuring the deal, financing the acquisition and closing the deal.

In this Quick-Read you will find:

• The pros and cons to buying an existing business.
• The steps needed to find a business to buy, determine its value and fund its purchase.

SOLUTION [top]

Buying an existing business has many advantages, but there are also some drawbacks. A business owner may wish to sell a profitable, well-run business for many reasons, so selling does not automatically indicate a problem. However, you should not assume an existing business is self-sufficient and profitable. Potential buyers must conduct adequate due diligence to discover the true short- and long-term financial and marketing position of the company before buying it.

The advantages to buying an existing business that offers long-term potential include:

• Easier purchase financing because of that company’s proven track record.
• Existence of an established customer base, allowing early and ongoing sales.
• Existing profitability, allowing for the generation of regular income.
• An established marketplace.
• The ability to focus on improving products and services because operating facilities and employees are in place.
• Established inventory.
• The former owner’s expertise and knowledge of the company and its markets.
• Existing business records to guide decisions.
• The initial financial outlay is known and may be less than that for starting a similar business from scratch.

Significant disadvantages may include:

• Inheriting hidden and unknown problems or financial burdens.
• Being stuck with the company’s bad reputation.
• A less-than-ideal location.
• Facilities and equipment that may be outdated or in need of repair.
• Difficulty merging two corporate cultures.

Buying a business is a complicated process involving many types of skills. You should retain professional advisers, including a qualified attorney and an accountant.

Six steps to buying a business

1. Find a business that fits your needs. You must determine what type of business you want — its function, location, size, involvement, amount of risk and so on. Be certain the industry has strong potential for long-term growth.

   Sources for finding an appropriate business include:

   • Classified sections of newspapers, magazines and trade-association journals. Look for the want-ad heading “Business Opportunities” to see offerings. You also can place ads in these publications announcing your intention to buy.
   • Business brokers and real-estate agents. (But because they earn a commission based on the sale price, they will be looking to secure the highest possible sale price.)
   • Wholesalers and vendors in the industry.
   • Local chambers of commerce.
   • Your own professional advisers who may have clients with businesses for sale.
   • A direct approach to a business that may not be for sale. Your interest may be enough to encourage the owner to consider your offer.
2. Evaluate an acquisition candidate’s profitability and potential. There are a variety of factors to investigate before deciding on a specific business’s potential. These include:
   • The owner’s reason for selling.
   • The business’ reputation among customers and competitors.
   • Profitability over the past few years (not just the current one).
   • Assets and liabilities.
   • Personnel and key employees’ future plans.
   • Customer retention possibilities (learned from calling key customers).
   • Location.
   • Hidden liabilities, such as unpaid back taxes, undisclosed lawsuits, unpaid bills, pension and vacation liabilities, and environmental liabilities.
3. Establish the price. This is one of the most subjective steps. Several factors affect the ultimate price at which both buyer and seller are satisfied, such as:
   • Recent profit history.
   • Market demand for the business’ product or service.
   • Ability to transfer goodwill and other intangible assets.
   • Future market potential.
   • Special circumstances of the buyer or seller that affect their need to buy or sell quickly.
   • Tradeoff between cash and terms, which affect a buyer with less liquid cash up front.

   A qualified business appraiser or accountant should be used to help determine the value because there are many financial considerations and tax laws constantly change. Two simple ways to determine the value of the business are by calculating its net worth and its return on profits.

   The net worth approach uses the balance sheet to establish value. Auditors verify the assets and liabilities, with the latter subtracted from the former to determine the company’s asset value. The return-on-profits method uses the company’s income statement. This method assumes there are investment choices that can produce a return on investment (ROI), and investing in the company is one of those options. Using this method requires the buyer to determine his anticipated ROI and divide that into the average annual profits of the business.

   Other more complicated methods also can be used. Some examples may be found in the Quick-Read “How to Value Your Company“. An accountant can advise you on the proper approach for your specific situation.

4. Structure the deal. Once a fair price is established, the deal must be structured. Tax and other consequences for both buyer and seller play a critical role in how this money should change hands. Purchases can be structured several ways:
   • Asset Transaction: The buyer buys all assets except cash and accounts receivable, and the seller uses this money to pay off all liabilities. This protects the buyer from any outstanding liabilities that weren’t disclosed. This is the simplest format.
   • Stock Transaction: This method calls for all assets, liabilities and stock to be transferred to the buyer. This is the most desirable method because it limits the number of changes required in existing contracts.
   • Installment Sales: A business seldom is purchased strictly for cash. Usually, a down payment is supplied with the rest financed by the buyer through a promissory note secured by the company’s assets.
   • Leveraged Buy-out: The assets are used as collateral for the purchase, but the buyer puts in a minimal amount of money. Instead, a loan is secured with the assets serving as collateral. This option is used when the business has a large asset base. But it burdens the company with debt that makes it difficult to expand or change in the early years of new ownership.
   • Stock Exchange: The seller may accept stock as payment, usually with a waiting period before it can be cashed in. That leaves more cash for doing business and enables the seller to postpone and spread the capital gains tax liability.
5. Finance the purchase. With the deal arranged, several other financing options are available:
   • Equity financing: You pay through cash or assets for the company, either solely or with the help of partners, who may be silent (i.e., staying in the background and allowing you to make all business decisions).
   • Debt financing: Banks, suppliers, friends or family members invest in the business and are repaid from profits. This option may prove difficult if the business has financial hardships for an extended period during the transition of ownership.
     • Short-term lending or a line of credit: These loans typically are for one year or less and use business assets as collateral.
     • Long-term lending: These loans are for longer periods and are used for the purchase of major assets. Collateral almost always requires a first lien on the most liquid tangible assets, such as accounts receivable, inventory, equipment and real estate, as well as a personal guarantee.
     • Other loans: Small Business Administration guarantees or underwriting from a state or municipal economic development agency may be available.
6. Close the deal. To finalize the terms of sales, your attorney will prepare a bulk transfer notice, which is a notice to creditors that the title of the business is being transferred. This notice prevents the seller’s unsecured creditors from attaching liens to the property, which would interfere with your free and clear purchase.

   The Secretary of State’s office also should be checked to ensure there are no liens recorded against the property. A title search performed on the property will eliminate any unknown claims against the property not previously disclosed by the seller. Other items of importance are:

   • Certify that all state employment taxes are paid to date.
   • Obtain from the seller a sales and use tax certification confirming that all outstanding sales and use tax payments have been paid.

   To obtain the information needed to make a legitimate offer, you will be asked to sign a confidentiality agreement to protect the seller from disclosure of proprietary information. Upon signing this agreement, you should expect the owner to supply you with any and all information needed to make an offer. If you do not get full disclosure, you may decide to discontinue the proceedings at this point or make an offer contingent upon receiving this information. In turn, the seller may request a personal financial statement to determine your qualifications as a suitable owner.

   Your purchase offer can take the form of an agreement of sale or letter of intent. The former is usually binding, the latter nonbinding. The agreement of sale is the primary document for closing the purchase, but there usually are supporting documents. The common ones are:

   • Settlement sheet, which shows costs/adjustments to be made at the time of settlement.
   • Escrow agreement, which identifies the conditions and amount of escrow.
   • Bill of sale, which identifies the assets purchased and their price.
   • Promissory note, which is used if the owner finances any of the purchase price.
   • Non-compete agreement, which protects the buyer from immediate competition from the seller.
   • Employment agreement, which is used if the seller will remain involved in the business.
   • Misrepresentation note, which protects you from any misrepresentation by the seller by allowing you to reduce the principal amount of the note if certain contingencies occur with the sale. This may require establishing an escrow account.

REAL-LIFE EXAMPLE [top]

A Florida building-products distributor was ready to sell his business, and another distributor made an offer. Rather than sell to outsiders, the owner made a proposal to three of his top executives: If they could match the price, they could buy the business. The three did not have enough equity to purchase the business outright, so they worked with the company’s comptroller and an outside legal adviser to create a business plan and cash-flow projection for the coming years to convince a bank to fund them.

The process had three elements: establish a value for the business (which, to be workable, had to be established only as higher than the purchase price); convince the company’s main supplier that the new owners would have both the financing to maintain the business and a sufficient line of credit to continue to buy products and supplies; and create a cash-flow projection that showed where income would be made and how a loan could be paid off to satisfy investors.

The supplier approved the plan, and with that approval added to the valuation and financial statement, the employees were able to secure both a financing loan and a line of credit to purchase products from the supplier. They bought the company, and it continues in business today.

DO IT [top]

1. Consider what type of business you want to buy — Are you buying the business to expand your current product lines? Are you buying your way into a new region?
2. Read trade magazines and contact associations in the specific field to learn more about industry trends and potential for growth.
3. Alert your advisers, professional peers and friends of your interest in buying a business.
4. Talk with your financial adviser about how you could leverage your own assets to create enough liquid capital to finance the purchase.

RESOURCES [top]

Books

Basic Guide for Buying and Selling a Company by Wilbur M. Yegge (Wiley, 1996).

The Small Business Valuation Book by Lawrence W. Tuller (B. Adams, 1998).

Upstart Guide to Buying, Valuing, and Selling Your Business by Scott Gabehart (Upstart, 1997).

Valuing Small Businesses and Professional Practices, 3rd edition, by Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs (McGraw Hill, 1997).

Internet Sites

“Due Diligence Before an Acquisition” by Andrew J. Sherman (Kauffman Center Resources).

International Business Brokers Association. Click on “Find a Business” to see listings of businesses for sale.

Writer: Craig A. Shutt