Starting a small business from scratch can be too risky, which is why you should also consider buying an existing business. LaunchScore.com is here to help you when buying a small business, with this comprehensive guide and resource.
An existing business may very well a better option given that it already has a location, supply-chain, trained employees, brand, customer base, historical cash flow statements, and tax returns.
There is already a formula in place to run the business and hopefully all it needs to boom is your vision, enthusiasm, and determination to put in place incremental innovations. Lenders are also more comfortable financing a business that already has financial records they can evaluate.
However, there are also disadvantages. Existing businesses typically cost more than starting one from scratch. Current employees and suppliers may have practices not to your liking and may be resistant to change.
Also, equipment and inventory may become a substantial financial burden, particularly if outdated. The seller may omit or downplay existing business problems – and could even have “cooked” accounting records.
Though at first one may think that there must be something wrong if a business is for sale, that may not be the case. Hopefully, you will find a great business whose owner just wants to move on to another industry, life project, or retirement. Nonetheless, keep in mind that it is easier to fall into a lemon than a great business you can afford.
This guide is a comprehensive resource to help you fulfill your entrepreneur dream by buying a small business. It is separated into three sections to guide you to success:
- Do you have what it takes to run a small business?
- Doing the due diligence
- Negotiating the price when buying a small business
Do You Have What it Takes to Run a Small Business?
The first step is to select the right type of business for you. Being passionate about a business does not suffice. A successful entrepreneur must be equipped with adequate human and financial capital.
During the process of selecting the right type of business, consider making an introspective assessment about the fit of your skills, abilities, and experience to the venture of choice. Even if that requires spending some months actually working for someone else that operates a similar business – perceptions are not knowledge. You need to get familiar with the industry and understand it.
Then, ask yourself if you are willing to spend sleepless nights worrying about a supplier, employee, customer, product, service, or regulator – business ideas are cheap but execution is dear.
Being a business owner is like parenting a restless toddler – it requires a growth plan, constant attention, intervention, persistence, and you need to be sufficiently intelligent to ask for help (e.g. hiring employees, consultants, accountants, lawyers, etc.), punish (e.g. firing employees, suppliers, etc.), and reward (e.g. promotions, bonuses, etc.) in a timely fashion. Also make sure that your spouse or partner is on board because this venture will likely have an impact on the time you spend with them and on your stress levels.
Concurrently, you also need to evaluate your financial capital and your relationship with money. Compile a personal financial statement detailing your assets, liabilities, and net worth – you will be required to deliver it at some point during the acquisition process. Note that you should be prepared to pay 30 to 50 percent of the business’ sale price in cash and finance the remaining amount.
Do you have sufficient startup funds for the selected business type and a good credit score to get financing? Do you have retirement funds or home equity that you can use to buy the business? Are you able to make rational financial decisions or are you a reckless gambler?
Having a non-emotional relationship with money contributes to wiser business decisions, especially when buying a business. The poor management of personal finances will most likely follow you into a business. A solid financial record along with a good credit score will ease negotiations and enable lower interest rates from lenders.
Doing the Due Diligence
Once you determine the type of business that fits your competencies and experience, you need to determine the target geographic location. LaunchScore.com provides a free tool to assist you with this task – just enter the business type of choice and our database will rank the best U.S. locations by potential yearly earnings (PYE).
Once you have a location you can search for available businesses for sale using one of the many online sources (e.g. BizBuySell), local newspaper classifieds, industry publications, franchises (e.g. FranchiseGator), and business brokers (e.g. SunBelt). Then go do some reconnaissance on the business, and if it appeals to you, contact the owners or brokers.
Once you have a targeted business or businesses, you need to know what to ask for in order to assess its operations and viability. Start by asking these questions:
- what are the goods and services this business provides?
- when was it first established?
- why is it for sale?
- how long has the current owner has been operating it?
You should also get the specifics of the small business’s day-to-day management, such as:
- the lease costs and expiration dates.
- a list of licenses and permits.
- proof of compliance with Occupational Safety and Health Administration (OSHA) requirements.
- number of employees and suppliers.
- sales and corporate tax information.
- the business’s revenue generating model.
Then you need to request legal and financial information. Here is a suggestion for documents you should review (source: FindLaw):
Organization and Good Standing
- The Company’s Articles of Incorporation, and all amendments thereto.
- The Company’s Bylaws, and all amendments thereto.
- The Company’s minute book, including all minutes and resolutions of shareholders and directors, executive committees, and other governing groups.
- The Company’s organizational chart.
- The Company’s list of shareholders and number of shares held by each.
- Copies of agreements relating to options, voting trusts, warrants, puts, calls, subscriptions, and convertible securities.
- A Certificate of Good Standing from the Secretary of State of the state where the Company is incorporated.
- Copies of active status reports in the state of incorporation for the last three years.
- A list of all states where the Company is authorized to do business and annual reports for the last three years.
- A list of all states or countries where the Company owns or leases property, maintains employees, or conducts business.
- A list of all of the Company’s assumed names and copies of registrations thereof.
- Audited financial statements for three years, together with Auditor’s Reports.
- The most recent unaudited statements, with comparable statements to the prior year.
- Auditor’s letters and replies for the past five years.
- The Company’s credit report, if available.
- Any projections, capital budgets and strategic plans.
- Analyst reports, if available.
- A schedule of all indebtedness and contingent liabilities.
- A schedule of inventory.
- A schedule of accounts receivable.
- A schedule of accounts payable.
- A description of depreciation and amortization methods and changes in accounting methods over the past five years.
- Any analysis of fixed and variable expenses.
- Any analysis of gross margins.
- The Company’s general ledger.
- A description of the Company’s internal control procedures.
- A schedule of fixed assets and the locations thereof.
- All Uniform Commercial Code (UCC) filings.
- All leases of equipment.
- A schedule of sales and purchases of major capital equipment during last three years.
- A schedule of the Company’s business locations.
- Copies of all real estate leases, deeds, mortgages, title policies, surveys, zoning approvals, variances or use permits.
- A schedule of domestic and foreign patents and patent applications.
- A schedule of trademark and trade names.
- A schedule of copyrights.
- A description of important technical know-how.
- A description of methods used to protect trade secrets and know-how.
- Any “work for hire” agreements.
- A schedule and copies of all consulting agreements, agreements regarding inventions, and licenses or assignments of intellectual property to or from the Company.
- Any patent clearance documents.
- A schedule and summary of any claims or threatened claims by or against the Company regarding intellectual property.
Employees and Employee Benefits
- A list of employees including positions, current salaries, salaries and bonuses paid during last three years, and years of service.
- All employment, consulting, nondisclosure, nonsolicitation or noncompetition agreements between the Company and any of its employees.
- Resumés of key employees.
- The Company’s personnel handbook and a schedule of all employee benefits and holiday, vacation, and sick leave policies.
- Summary plan descriptions of qualified and non-qualified retirement plans.
- Copies of collective bargaining agreements, if any.
- A description of all employee problems within the last three years, including alleged wrongful termination, harassment, and discrimination.
- A description of any labor disputes, requests for arbitration, or grievance procedures currently pending or settled within the last three years.
- A list and description of benefits of all employee health and welfare insurance policies or self-funded arrangements.
- A description of worker’s compensation claim history.
- A description of unemployment insurance claims history.
- Copies of all stock option and stock purchase plans and a schedule of grants thereunder.
Licenses and Permits
- Copies of any governmental licenses, permits or consents.
- Any correspondence or documents relating to any proceedings of any regulatory agency.
- Environmental audits, if any, for each property leased by the Company.
- A listing of hazardous substances used in the Company’s operations.
- A description of the Company’s disposal methods.
- A list of environmental permits and licenses.
- Copies of all correspondence, notices and files related to U.S. Environmental Protection Agency (EPA), state, or local regulatory agencies.
- A list identifying and describing any environmental litigation or investigations.
- A list identifying and describing any known superfund exposure.
- A list identifying and describing any contingent environmental liabilities or continuing indemnification obligations.
- Federal, state, local, and foreign income tax returns for the last three years.
- States sales tax returns for the last three years.
- Any audit and revenue agency reports.
- Any tax settlement documents for the last three years.
- Employment tax filings for three years.
- Excise tax filings for three years.
- Any tax liens.
- A schedule of all subsidiary, partnership, or joint venture relationships and obligations, with copies of all related agreements.
- Copies of all contracts between the Company and any officers, directors, 5-percent shareholders or affiliates.
- All loan agreements, bank financing arrangements, line of credit, or promissory notes to which the Company is a party.
- All security agreements, mortgages, indentures, collateral pledges, and similar agreements.
- All guaranties to which the Company is a party.
- Any installment sale agreements.
- Any distribution agreements, sales representative agreements, marketing agreements, and supply agreements.
- Any letters of intent, contracts, and closing transcripts from any mergers, acquisitions, or divestitures within last five years.
- Any options and stock purchase agreements involving interests in other companies.
- The Company’s standard quote, purchase order, invoice and warranty forms.
- All non-disclosure or non-competition agreements to which the Company is a party.
- All other material contracts.
Product or Service Lines
- A list of all existing products or services and products or services under development.
- Copies of all correspondence and reports related to any regulatory approvals or rejections of any Company’s products or services.
- A summary of all complaints or warranty claims.
- A summary of results of all tests, evaluations, studies, surveys, and other data regarding existing products or services and products or services under development.
- A schedule of the Company’s twelve largest customers in terms of sales thereto and a description of sales thereto over a period of two years.
- Any supply or service agreements.
- A description or copy of the Company’s purchasing policies.
- A description or copy of the Company’s credit policy.
- A schedule of unfilled orders.
- A list and explanation for any major customers lost over the last two years.
- All surveys and market research reports relevant to the Company or its products or services.
- The Company’s current advertising programs, marketing plans and budgets, and printed marketing materials.
- A description of the Company’s major competitors.
- A schedule of all pending litigation.
- A description of any threatened litigation.
- Copies of insurance policies possibly providing coverage as to pending or threatened litigation.
- Documents relating to any injunctions, consent decrees, or settlements to which the Company is a party.
- A list of unsatisfied judgments.
- A schedule and copies of the Company’s general liability, personal and real property, product liability, errors and omissions, key-man, directors and officers, worker’s compensation, and other insurance.
- A schedule of the Company’s insurance claims history for past three years.
- A schedule of all law firms, accounting firms, consulting firms, and similar professionals engaged by the Company during past five years.
Articles and Publicity
- Copies of all articles and press releases relating to the Company within the past three years.
This process should be complemented by your own business plan for the targeted establishment, taking into account local competition, the current state of the industry nationwide and locally, a SWOT analysis – assessment of strengths, weaknesses, opportunities, and threats – and financial projections based on your input and historical performance of said business. You will need this document anyway when reaching out to lenders and/or venture capital investors.
Most people find the process of due diligence quite daunting given the time and skills it requires. If that is your case, you will be better off enlisting the help of professionals such as business consultants, accountants, or lawyers.
For example, a qualified attorney can help you review the legal and organizational documents as well as assist you in evaluating the business’ financial condition – concurrently, the attorney can also facilitate determining which form of business entity is best for you (e.g. C-corp, S-corp, LLC, etc.).
Negotiating the Price When Buying a Small Business
Upon review of all financial documents for the targeted business, you will be able to compare the seller’s asking price to your own valuation and that of similar businesses for sale in the surrounding area (which you may also be considering to buy as well).
Recall that extensive due diligence minimizes the problem of asymmetric information but does not eliminate it completely – the current owner has insider knowledge thus you have to thoroughly do your homework to have the best leverage possible during negotiations.
Be aware that the national, state, and local economic contexts also play a role – businesses tend to be cheaper during recessions and more expensive during expansions. In this realm, you should check the historical patterns of GDP per capita and consumer spending in the metropolitan area of interest as well, which is published by the Bureau of Labor Statistics (BLS).
There are several methods of business valuation, such as the Net Present Value (NPV), Return on Investment (ROI), multiplier, and book value (BV). During this process some sellers will also try to get paid for intangible assets (e.g. brand/store recognition, etc.) and that is when things get tricky.
It is up to you to determine the true value of such non-physical assets. Ultimately, the fair business price should be calculated strictly upon financial accounts, and then separately add whatever dollar amount you are willing to pay for such intangible assets.
The Net Present Value (NPV) method is the most scientific approach to determine the fair price of a business in today’s dollars. It consists in determining the present value of all future net cash flows (inflows minus outflows) given a desired rate of return, thus it takes into account that a dollar received today is worth more than a dollar collected on a future date – the concept of Time Value of Money (TVM).
The difficulty in employing this method lies on estimating those future cash flows. However, there are several acceptable techniques. For example, one can use historical data gathered from the business’ financial statements, determine a trend for each rubric, and them assume that it will grow at a constant rate over the next years. Alternatively, those future net cash flows can be estimated based on the expected growth rate for the local industry, or some other metric of choice. The typical discount rate adopted for small businesses ranges from 15 to 30 percent – this is also often called the real rate of return or internal rate of return.
Note that LaunchScore.com provides Net Present Value estimates in its market research reports. If you’re thinking of buying a business in a specific city, check LaunchScore as another way to determine if the sellers asking price is fair.
The Return on Investment (ROI) method is a simplified version of the real rate of return given that it ignores the Time Value of Money concept, that is, it does not take into account how long the investment will take. Therefore, it is a very popular metric because of its simplicity.
The typical technique to compute ROI consists on dividing the amount of profits after interest and taxes by the investment cost (and then multiply by 100 to get a percentage). In this setup, the investment cost is the business’ sale price or this value adjusted for additional expenses that have to be made upfront.
The ROI for small businesses also typically ranges from 15 to 30 percent, depending on the industry. However, you should inquire the seller about the exact methodology employed to determine the sale price as people tend to use variations of it. For example, sometimes taxes and/or interest are omitted from the profit calculations, thus inflating ROI.
The multiplier method is another popular metric because of its simplicity. It determines the value of a business based on a multiple of sales, sales plus inventory, or after-tax profits. The factor by which one of these variables is multiplied by is not determined by rigorous science but rather based on the seller’s perceptions or historical data for similar businesses in the area – something typically difficult to verify. Hence, you must always ask about the detailed rationale adopted by the seller to arrive at the asking price.
The standard book value (BV) method basically equates the selling price to a multiple of the business’ net worth – the difference between the value of all assets and liabilities. Assuming that you asked for all financial statements, then the employed multiplier (typically ranging from 1 to 2) can be easily inferred by collecting data for the value of assets and liabilities from the business’ balance sheet.
However, there are several nuances that can occur when computing this metric, such as: a) the so-called modified book value technique, which adjusts the worth of assets to the current market value (not the same as the value they have in the accounting records); b) replacement value technique, where net worth is calculate based on the total cost of replacing those assets nowadays; c) liquidation value technique, which uses as a proxy for the value of the assets the amount of money that could be attained if the business was liquidated now.
These alternative techniques within the BV method emanate from the fact that the standard methodology evaluates the value of assets based on the acquisition cost minus accumulated depreciation – if the asset surpassed its expected accounting life then its book value would be zero. Thus it is important to ask the seller about which BV technique is being adopted to determine the business’ net worth given that such value will vary significantly depending on said choice.
Once you fully understand the methodology employed to determine the asking price for the targeted business then the next step is to negotiate the final sale price. This endeavor will also take into account how do you plan to finance the acquisition.
As typically one is expected to pay 30 to 50 percent in cash, you will need to get a deal with the seller, lenders, or venture capitalists for the remaining amount. This implies engaging in another parallel process that will have an impact on how much are you willing to pay for the business so that you feel comfortable about the expected return relatively to the amount of risk.
If you need financing, one option is to negotiate with the seller a “hold a not”, which basically means that a portion of the sale price would be paid by regular payments over a predetermined time period to the seller, just as you would do to a traditional lender.
This is a game of patience, so do not rush. If you show the seller that you are too enthusiastic about buying the business you may be charged a hefty premium. At the same time, try to find out through legal means if the seller has financial problems beyond those that you potentially identified during the review of business-related financial statements because in that case you will likely be able to buy the business at a discount.
Finally, keep in mind that everything stated here has merely the purpose of serving as a guideline. In reality, the process of negotiating a business has many unforeseeable nuances specific to each case.
Therefore, we strongly encourage you to get all the help you can enlist, and consider hiring professionals, such as consultants, accountants, and/or lawyers to assist you throughout this journey. You may want to start by searching the valuable resources provided by the U.S. Small Business Association (SBA), and benefit from the free business consulting services provided by your local Small Business Development Center (SBDC).