Maybe you’ve already owned or operated a small business. Perhaps this is your first. Sure, you have to review the numbers. But what else is important when buying an existing business? What are the best practices that a prospective business purchaser should consider before buying an operational firm? What kind of legal, financial and tax issues are important before signing on the dotted line?
No Guarantees: Do Due Diligence
Jeff Veigel, co-owner of Isles Buns & Coffee in Minneapolis, Minn., has been down that road before. Veigel said there are no guarantees when purchasing an existing business. “You have to perform due diligence, explore the financials and believe you can do as well or better than the previous owner,” Veigel said.
For people owning their first business, buying an existing entity can save a tremendous amount of money. “It is already established and has a stream of revenue you can use to pay down the cost of purchasing the business. There is some security that, after looking at the books and its history, inspecting the physical plant and customer lists, you can determine that you can make a living from that,” he said.
He advised prospective owners to conduct information searches or hire an attorney to insure there are no unknown debts they would inherit, no pending lawsuits, and that all liability and assets are disclosed. “Check with the city and state to make sure there are no unpaid sewer access fees and that the county isn’t planning to close your street for construction for the next six months,” he said. “And make sure there are no lingering workmen’s compensation issues, that the previous owners have paid overtime and employee taxes. Most of this you can find in public records.”
What is Important?
Daniel Pierce, a transactional attorney with the Boston office of the law firm, Duane Morris, said owners should think about the parts of the business most important to them. “Intangibles can be difficult to get a fix on,” Pierce said. “But they can be very valuable and sometimes the entire reason for the purchase. So if this is a service or a business with a strong service component, be sure that is addressed.”
For example, he said, customer lists might be the crown jewel among the assets that the buyer is seeking. They must make sure assets like that are included in the purchase.” Pierce also said it’s worth exploring the kinds of protections offered.
“How easy is it for the buyer to terminate those contracts after the sale if things aren’t as promised on day one in the financial reports? Are the numbers the buyer is looking at dependent upon favorable terms, such as a lease rate that may not be available to you?” He also advised consulting a tax specialist in the early stages of negotiations.
“Typically buyers want to buy the assets of the business and limit their exposure to pre-existing conditions, to pick and choose the liabilities they want to accept, while sellers want to sell the stock of their companies so they can get the benefit of capital gains treatment. There may be unpaid taxes or unfunded pensions. Taxes are often big drivers of these deals, and how they are structured matters.” He said buyers should also explore potential environmental liability, particularly manufacturers or companies dealing with hazardous waste products, petroleum or chemicals.
“As a buyer you may be picking up that liability,” he cautioned.
Ed Culhane, a partner and managing director for the Boston office of the accounting firm, Andersen Tax, advised prospective buyers to examine the company books and records. “Anyone who wants to buy a company wants to see a dashboard and solid financials. They should ask questions and request revenue projections and solid business plans without having to wait three months,”
From the legal side make sure the “know how”—intellectual property, proprietary technology or secret recipe– is contractually protected. “Get a good attorney to make sure your corporation documents and stock agreements are covered.” And be sure that the valuation is performed by an experienced professional, not on the word of the seller’s Uncle Joe.
No False Confidence
David Coffman, president and CEO of Business Valuations & Strategies based in Harrisburg, Pa., cautioned prospective buyers to do some serious soul-searching first. “Often it’s someone coming off a successful corporate career that did well there and has a false sense that they know what they’re doing. But most have never run a small business, even if they operated in the same industry where they worked during their corporate careers. Because of this false confidence they often end up spending way too much money.”
Coffman said before buying into an existing business, study that industry or market, contact trade association and peruse industry publications. “Talk with people in that business. And give yourself time. Don’t rush into it. Define what you’re looking for.”
While intangibles like longstanding geographic location, good will and lists of longtime loyal customers may add value, he said finding the true worth of a business is basic. “Show me the money,” he said. “If it’s not generating profits, it’s not worth it. If you can’t convert these intangibles into cash flow, how will I do it? Never ever pay for potential. Buy the business as it is now.”
David Velasco, president of Denver, Colo.-based Strategic Valuation Associates, said obtaining an accurate financial history of a company is vital to any prospective buyer. “It should
raise red flags if owners don’t provide tax returns. Lacking that information is like making a projection off of a single data point: you need the context of history.”
Velasco said the most common mistake new business buyers make is overestimating revenues and underestimating expenses. “Most businesses fail because they didn’t deliver financially on the original estimates of the company’s value,” he said.
Early in the process the prospective owner must decide how to operate the company. Will the owner manage the business, or hire a professional manager and act as a financial
investor. “That helps determine the cost structure. Most people who buy in are looking to get a paycheck plus build value for their long term retirement. So if they’re going to work in their own company, it must return a fair share.”
He recommended contacting a transactions attorney to put together the deal, submit the terms sheet, create a definitive purchasing agreement and, if there are multiple investors, create a shareholders’ agreement.
Velasco said understanding the motivation of the seller is vital to establishing the negotiating range. “If you don’t understand that motivation and you want to play Donald Trump hardball, the sellers may tell you to take a hike,” he said. “For many owners, that small business is their baby, their bread and butter, and they want to make sure it’s well cared for. If you understand motivation, whether it’s impending retirement, financial distress, or something else, that could help close the deal.”
Lori Mize, director of the Tampa, Fla.-based online small and mid-size business valuation firm, Peer Comps, said there are many risk factors prospective owners need to consider. “Has the company’s performance been consistent? If not, why not? What about intangibles like customer loyalty? You might be buying a dentist’s practice, but his patients are loyal and may not stay with you. And consider customer concentration. If you’re a distribution company and one customer comprises 90% of the business, if that person goes, so does the business. So you want to have those commitments confirmed.”
Mize said there are diversification risks with customers, suppliers, parts and services, all of which could impact the value of the business. “Are you buying into an obsolete or soon to be obsolete industry? “Remember video stores?” she reminded.