Buying an Existing Business: The Step-by-Step Guide

So… You’re thinking of buying an existing business.

Not a bad idea! There are plenty of advantages to buying a business that’s already been around for a while—although there are some drawbacks, too.

But small business acquisition has been on the rise, and there’s never a time like the present to start working on your big goals. If you want to be an entrepreneur and buying an existing business is the path for you, then you’d better learn what it takes to do it well.

Here’s your step-by-step guide to buying an existing business, from understanding the pros and cons to closing the deal.

Why Are You Buying an Existing Business?

Buying a business doesn’t have to mean buying an existing business…

So why do it? What are the pros and cons to buying an existing business over starting your own?

Let’s take a quick look.

Buying an Existing Business: The Pros

What do you get out of buying an existing business that you wouldn’t from starting a brand new company?

1. Little to no upfront costs.

This one’s kind of obvious, but it’s a major draw of buying an existing business.

If the business is already up and running by the time you take the wheel, then… Well… What upfront costs are there?

Unless your acquisition is pretty atypical, you’ll already have a building, a brand, a customer base, maybe some employees, the management processes and policies, an understanding of your competition and market, and more, all already in place.

Starting a business from scratch involves a lot of expenses, but buying an existing business is a sort of shortcut—all that stuff has already been done for you!

2. Don’t sweat your cash flow.

There’ll be no need to worry about your starting cash flow, either—you’ll almost definitely have inventory and equipment, and possibly employees, right off the bat.

With those safety nets in place, buying an existing business doesn’t require that you scramble around at the beginning of your ownership: this business should already be making sales and generating revenue when you first step in the doors.

That’s something that new-business entrepreneurs can only hope for a few months out, and it certainly takes some stress out out of your job.

3. Lower risk.

Although buying an existing business isn’t always lower risk, it’s often a safer path.

Why?

Unless you’re buying a business that’s always underperformed, then you’ve already proven out that your acquisition is capable of giving you some return on investment.

And with most (if not all) of the important foundations already laid—like the brand, marketing strategies, employee policies, customer base, product offering, and so on0—then you’ve got a lot less to invent without testing… And a lot less to lose.  

4. Patents and copyrights.

If your business-to-be offers patented products or has a copyrighted slogan that wins over customers, then that intellectual property will probably transfer over to you.

This isn’t a factor with every business acquisition, naturally, but it could be critical if you’re dealing with something that you think could be expanded even more. What if you turned this small business into a national franchise? All of a sudden, that patent and copyright becomes a lot more important.

Buying an Existing Business: The Cons

Those are just a few of the advantages… But what about the drawbacks of buying an existing business?

1. High purchasing costs.

While you won’t have to deal with upfront costs to doing business when you own that business, you’ll probably be facing some pretty sizable purchasing costs.

In fact, those purchasing costs might very well be greater than what it would take you to start the business instead of buying an existing business.

That’s because, in addition to the obvious assets, you’re also buying ownership over the…

• Customer base
• Built-out brand
• Design work, from logo to store interior
• Business concept and plan
• Time, effort, and money spent testing out products
• Refined processes, procedures, and policies
• And more!

2. Unfamiliarity.

If you’re buying an existing business, you’ll necessarily be a bit less familiar with its inner workings and the details of its products, processes, employees, and financials. This could be a bit of an obstacle, especially when you’re just starting out.

Meanwhile, starting your own business requires that you eat, drink, sleep, breathe, and dream all those things every day.

3. Risk of a hidden problem.

We’ll go more into this later on, but by buying an existing business, you run the risk of taking on an issue that you’re not even aware of.

If you’re lucky, the seller will let you know upfront if there’s a serious reason why they’re looking for a buyer… But there’s always a chance you don’t catch onto their ulterior motive until it’s too late.

Buying an Existing Business: How to Pick the Right One

If you’re set on buying a business, then of course, make sure you pick the right business for you.

Here’s how.

Figure Out What You’re Interested In

First things first: narrow down your passions, interests, skills, and experience.

If you’re buying an existing business, you’ll probably be happier if you’re buying a business that dovetails with what you like.

For example, if you love cooking… Why buy a gardening supplies store?

While you might just want to buy an existing business for the financials alone—by its expected return on investment—it’s also important to align yourself with the business’s immaterial goals.

After all, the more knowledgeable, curious, and familiar you are with the business’s model, products or services, customers, industry, and trends, the more innovative and successful your new ideas will be.

Ideally, you’d try buying an existing business that matches your interests and that will be financially rewarding!

Figure Out If It’ll Be Successful

This is where you’ll need to decide on the more hard-and-fast aspects of your new business acquisition.

For example, how much do you want to spend? What kind of time and energy commitments are you looking to make? Do you want to be the manager who’s “on” at all times, in the weeds with your employees? Or would you prefer to delegate and, one day, plan to own multiple businesses?

Calculating the ideal size, location, sales, staff, and so on of your business is an important step, since it will give you a scale to keep in mind when you’re shopping around.

And along those lines, here’s an important question to ask yourself…

Why Is This Business For Sale?

In other words… What’s wrong with the business?

There are plenty of reasons a business owner might put their business up for sale, ranging from a completely innocuous lifestyle choice to something fundamentally wrong with the business. And if you’re buying an existing business, you’ll want to know exactly why this business isn’t “doing it” anymore for its current owner.

So, what are the main challenges that the current business owner has come up against? What have they done to try solving those problems? Why did those solutions fail? And do you think you have the time, energy, money, experience, and skill to try other, more successful solutions?

It might just be that the seller wants to retire, or they’re bored of their job, or they’re moving to another country… But maybe not.

Make sure you know.

Be on the look-out for:

• Existing business debts
• Location problems (Maybe there’s not enough foot traffic to sustain sales?)
• A brand issue (A tweet went awry and now the owner is trying to jump ship!)
• Inventory difficulties (The cost of production is too high, low quality is losing the business customers, storage is difficult, there’s no supply and demand balance…)
• Bad equipment (It’s outdated and too expensive to upgrade)

And plenty more.

Talk to the owner about these possibilities—but also talk to existing customers, locals in the area, neighboring businesses, and so on.  They’ll give you the big picture view of how the business is doing, without the bias of the seller trying to convince you to buy.

Finding the Actual Business

There are plenty of ways to find the right business that fits all the criteria you’ve decided on, including…

• Classified newspaper ads under the “Businesses for Sale” category
• Ads that you’ve posted yourself
• Asking around in your network of small business owners
• Going to meetups or industry conferences to ask professionals
• Working with a business broker

Note that, with a broker, you’ll probably have to pay a 5-10% commission on the price of the business.

But what do they add?

Quite a lot, actually. A business broker can help you understand what kind of business you want, pre-screen businesses to cut out all the failing companies, keep negotiations civil and smart, and help you with all the necessary paperwork.

If you’re buying an existing business for the first time, a business broker might very well be worth the cost. But if you’re confident you can handle the process on your own, then you might want to hold off on hiring a broker until the very end—because even the savviest entrepreneurs can have trouble filing forms and following proper legal procedure.

Before Buying an Existing Business, Do Your Due Diligence

Before buying a business, it’s important to work with a banker, accountant, and lawyer to make sure you’ve got all the information you need to move forward.

The Basics

There’s plenty of documents, files, agreements, statements, and whatnot you’ll want to collect and analyze—or pay someone to analyze for you—but first, check up on these three things before wasting any time.

1. Licenses and permits.

Does the business you’re looking at have all the licenses and permits it needs? If you’re going to be taking over the business, will it be able to continue running—or will you get shut down in your first week?

2. Zoning laws.

Check with your area’s local zoning laws to make sure that the business you’re purchasing isn’t violating any restrictions.

3. Environmental regulations.

Has this business been secretly dumping chemicals into the nearby reservoir? Make sure the answer is a firm no before signing on the dotted line. Double-check that this business abides by all of the area’s environmental regulations.

Getting in Deeper

Besides the basics of “Will this business still exist in two weeks?”… What else should you look for?

Here’s some information that it might be handy to gather in order to understand the state of the business—and its financials.

1. Letter of Intent

The price proposal, along with the terms and conditions of the business sale, should all be included in the seller’s letter of intent.

2. Confidentiality Agreement

It’s possible that someone could pretend to think about buying a business and then, after peeking at its financials, give that information to the competition—right?

Maybe that sounds a bit paranoid, but it’s the situation that this confidentiality agreement is meant to prevent. By signing, you’ll agree not to use the business information you learn for anything other than deciding whether or not to make your purchase.

3. Contracts & Leases

Half the fun of buying an existing business is all the stuff it comes with. Whether that means a lease for the location, equipment, or something else, you’ll want to make sure the landlord is alright with transferring over these legal documents—or negotiate new leases.

4. Business Financials

Before buying a business, make sure to examine its past few years of financials, from tax returns to balance sheets, cash flow statements, and more.

Also, double-check that a real CPA firm passed an audit letter along with these documents—don’t accept financials from the sellers themselves.

This includes sales records, accounts receivable, accounts payable, debt disclosures, advertising costs, and whatever else you think you’ll need to evaluate the business’s health.

5. Other Important Documents

This is sort of cheating, we admit… But there’s a lot you’ll want to examine before buying an existing business.

For example: property documents, brand assets for advertising materials, employee policies and contracts, incorporation information, customer lists, etc.

6. Organizational Chart

You won’t want to walk in blind. If you’re buying a business with employees, make sure you understand how they rank and relate to one another. This should also include compensation data, management practices and processes, benefit plans, insurance, vacation policies, and so on.

7. Status of Inventory, Equipment, Furniture, and Building

Make sure to critically analyze these aspects of the businesses, since their values will directly impact the cost of the business.

Check what’s on-hand, its quality, how sellable it is, how fast and for how much each type of inventory has sold in the past, the present condition of equipment and furniture versus its original selling price, whether it was maintained well or needs repairs, if this furniture will be useful to you or you’ll need to replace it to be operational or for aesthetic reasons, if you’ll need to make larger modifications to the building, and other similar questions.

In other words, assign the correct value to the tangible assets you can see, feel, measure—and look up the prices for.

8. Sales Agreement

When you’re buying a business, the sales agreement is what ties it all together.

It’ll enumerate everything you’re purchasing, including:

• Tangible assets (inventory, equipment, furniture, building)
• Customer lists
• Intellectual property (patents, copyrights, etc.)
• Intangible assets (goodwill, brand value, etc.)

Have a lawyer help you put this document together—or, at the very least, review it before you sign.

Evaluating the Price for Buying a Business

Before you can gather your finances together, how can you figure out the amount you need?

There are a few ways to assess the value of an existing business. Let’s run through 5 common methods.

1. Capitalized Earning

This is basically equivalent to figuring out your expected return on investment. Generally speaking, a small business will return between 15% and 30% of the money you spend purchasing it—and a good capitalization rate is between 20% and 40%.

Here’s how it works:

You take the normal earnings of the business and project them forward, predicting future earnings.

Then, you’ll divide the future earnings by the capitalization rate—or the risk comparison of buying this business versus investing in government bonds or long-term stocks.

In other words, you’re making sure that this business acquisition will return more money than a simple, stable, standard market investment. And if it doesn’t, well… You’re better off not working so hard just to lose money.

2. Excess Earning

Excess earning is the same as capitalized earning, but you’ll separate the return on assets from the return on everything else. It’s not as common.

3. Cash Flow

Looking at an existing business’s cash flow in order to evaluate its worth… Now why would you do a thing like that?

Essentially, you’d be using cash flow as a proxy for understanding the business’s ability to service debt—or, in other words, to grow in the future. With this valuation method, you’re looking at a balance of potential and risk and seeing if you can expect a gain if you sell the business 5 years down the line.

4. Tangible Assets

This one is pretty self-explanatory: you value the business according to the value of its tangible assets, as listed on the balance sheet.

Just make sure to take depreciation into account when you’re looking at the business’s inventory, equipment, and other assets. Balance sheets usually list fixed assets by their depreciated values, not the cost of replacement, so you’ll need to do some research (and some math) to make up the difference.

Of course, this also means that you’ve already examined those assets and determined their wear, as well as whether you plan to keep them.

5. Intangible Assets

On the other end of the spectrum, this method compares the value of a wanted intangible asset—like a business’s brand—with the assumed cost of creating that asset.

For example, it might have taken years of hard work, marketing dollars, and inspiration to come up with a brand that kept customers coming back for more. A seller might request that intangible assets like these be considered in the price when you’re buying a business, since they’re definitely contributing to your bottom line.

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The point of all these methods is to assess the current financial health of the business, as well as the growth potential that you’re also paying for.

To fully understand these, you’ll want to see…

• Balance sheet
• Cash flow projection
• 3+ years of tax returns
• Income statements

And, likely, much more. Consult your lawyer, banker, and accountant for help!

Also, beyond these valuation methods, there are a few things you’ll want to keep in mind that might influence your price negotiations:

• How badly does the owner want to sell this business?
• How’s the economy doing? (Businesses sell for cheaper when it’s not so good)
• What does the industry look like?
• How prepared was the seller in figuring out their price? Did they figure it all out, or just arbitrarily pick a number? (As always, the more prepared you are, the better!)
• Does the seller have any personal financial problems that they’re trying to solve with this business sale? (If so, time is on your side.)

Now, once you’ve figured out a fair price…

Buying an Existing Business: Getting the Cash

There are a few different ways you can gather up the capital you’ll need to purchase a business—some specific to buying an existing business, others pretty standard.

1. Use Your Own Money

If you’ve got it—and can stand to upfront the cost of the business—then why not?

Of course, you’ll want to consult your accountant before ponying up a large lump sum of cash. Also, make sure that you’re not using all your money… Because running a business takes capital, too.

2. Negotiate with the Sellers

Even after you’ve agreed on a price, there’s still some negotiating to be done regarding how you pay.

For example, some sellers are perfectly content with “holding a not,” or accepting staggered payments—sort of like a lender. This way, they get guaranteed income for the coming months (or years, depending on your plan).  

Other sellers might be willing to trade in some assets, like some furniture they really loved or the company car, for a lower price.

3. Partner Up

By turning to a partnership instead of buying a business solo, you can halve the payments you’ll be making while still owning that company.

Taking on a partner isn’t only useful to cut costs, though: you can also bring someone on board with more specific experience or a different skill set.

Just don’t forget to draw up a partnership agreement so co-ownership doesn’t cause any problems down the line.

4. Sell Stock to Employees

By selling company stock to its employees, you can get a big discount—making up for 50% or even 90% of the business price, by some measures. You’ll probably want to sell non-voting stock, if possible, to retain ownership over the business.

5. Lease (for Now!)

It might be possible for you to lease the business instead of buying it outright—with the option, of course, to make the big purchase down the road if everything seems A-OK with you.

Understandably, not all sellers would be open to this option, since they more likely than not want to wash their hands and walk away from the sale. However, if leasing is something you’d be more comfortable with—even though it may cost more money overall—you might as well ask.

6. Debt Financing

Buying an existing business will give you tons of documents to approach a bank or alternative lender with: financial histories, tax returns, employee records, cash flow analyses, inventory and equipment valuations, and much more.    

So if you’re looking for a small business loan, here are a few potential financing options that might help in buying a business:

Term Loan

With a traditional term loan (or a short-term loan if the business is small enough!), you’ll borrow a set amount upfront, then pay it back—plus interest—over a predetermined amount of time.

This is a pretty ideal format for buying an existing business: you’ll get the cash you need to make your purchase, then pay the lender back over time as the business generates revenue.

Although rates and terms vary depending on your financials—like your personal credit score—as well as on the lender, you can usually expect a term of 1 to 5 years and interest rates between 7 – 30%, for amounts ranging from $25,000 to $500,000.

SBA Loan

An SBA loan—one of the largest, lowest-cost, most affordable financing products out there—isn’t actually funded directly by the Small Business Administration. Instead, the SBA guarantees a big portion of the loans you can take out from a bank or alternative lender.

With up to $5 million in financing, terms of a decade or more, and interest rates in the single digits, SBA loans are the dream for most entrepreneurs. Specifically for buying an existing business, the 7(a) loan program is the way to go. It works pretty similarly to the above term loans, with a set repayment schedule and a lump sum of cash upfront.

Asset-Based Financing

When it comes to asset-based loans, you’ll borrow capital against a certain asset, using it as collateral in case you default on your payments.

When buying an existing business, you’re taking on all of its assets—which means you have a lot of potential collateral to help finance your purchase with. These loans will be much smaller than the cost of a business purchase, of course, since you’re only financing a part of the buyout, but they can still be very helpful.

(Plus, they’re way easier to qualify for!)

You can use three different kinds of assets as collateral for financing:

• Equipment
• Inventory
• Unpaid invoices

Choose the one—or all three!—that will help you finance the right amount for your business acquisition.

How Debt Financing Is Different When Buying an Existing Business

That said, finding small business financing when you’re buying a business can be a bit of a challenge.

In general, lenders tend to have higher standards for loans used to buy a business, since you don’t have any experience running this actual business. They’re betting on, not only the future success of the business, but also the future success of you.

So just like with any business loan, lenders will scrutinize your personal credit score, as well as the business’s…

• Credit score
• Annual revenue
• Time in operation
• Tax returns
• Balance sheet
• Cash flow
• Outstanding debts

However, when getting a loan for buying an existing business, you’ll also have to provide a formal business valuation (like we discussed before), explain your relevant experience, offer an updated business plan, and show your financials projections for the business under your command.

In short, you’ll want to tell a story of how you will improve the business.

Buying An Existing Business: Closing the Deal

When you’ve finally found the right business, done your due diligence, agreed on a fair price, and gathered the capital you need…

Make sure you (or a broker) have all 10 of these documents, notes, and agreements in place:

1. Bill of Sale

This document will prove the actual sale of the business, officially transferring ownership of the business’s assets from the seller to you.

2. Adjusted Purchase Price

This is the final count of the cost of your purchase, including all prorated expenses—like rent, utilities, and inventory.

3. Lease

If you’re taking over the business’s lease, make sure your future landlord is in the know. On the other hand, if you’re negotiating a new lease, double-check that everyone understands the its terms.

4. Vehicles

Does the business come with any vehicles?

If so, you might have to transfer ownership with the local DMV—make sure to get the right forms complete by the time of sale.

5. Patents, Trademarks & Copyrights

Similarly, all patents, trademarks, and copyrights might require certain forms to get transferred to you, the new owner.

6. Franchise

Check the SBA’s Consumer Guide to Buying a Franchise to see if you’ll need to file any franchise documents.

7. Non-Compete Agreement

It’s standard practice—and generally a good idea—to ask for a non-compete. This way, the previous owner won’t set up shop right across the street!

8. Consultation/Employment Agreement

This document is in case the seller is staying on as an employee. Make sure to file this agreement if so.

9. Asset Acquisition Statement

IRS Form 8594 will list the assets you’ve acquired, and for how much. This document is pretty important for your tax returns, so don’t forget it.

10. Bulk Sale Laws

Bulk sale laws have to do, naturally, with the sale of business inventory. Make sure you’re in compliance!

A Few Things To Remember When Buying an Existing Business

You’ve made it—you’re just one signature away from buying a business! We’ve got a couple of last minute tips to help you finish the deal with confidence and start working on that new business venture.

These are 6 common mistakes that entrepreneurs make when buying an existing business:

1. Don’t buy “on the price”

In other words, don’t make the mistake of paying for the value of the business’s assets and financial status.

Why not?

Simple—buying an existing business should be an investment for the future, not just a purchase for the present. You’ll want to figure out the return on investment you expect from the existing business, because if it’s too low, you’re just better off investing in stocks or bonds.

In other words, spend your money wisely by planning for the days ahead, not just today.

2. Don’t spend all your money buying a business

Buying an existing business you’ve always had your eye on might be tempting—but don’t clean out your coffers for that purchase.

There’s a simple reason why not: running a business takes money, too! You’ll be stuck in a tough bind if, just a month in, you can’t afford to buy enough inventory or update your equipment. You’ll always want a cash cushion to lean on if you’re short some working capital or a disaster fund.

3. Don’t purchase all of the receivables

Just because you’re buying a business, that doesn’t mean you need to buy every part of that business.

If some of the outstanding receivables the ex-owner was dealing with are too old—90 days or more, for example—then they’ll be pretty tough for you to collect on. You might be better off asking the seller to insure them or contact the customers themselves.

Otherwise, you risk just wasting your money buying receivables that will never come to fruition.

4. Trust—but verify

The more you want the business, the easier it would be for your seller to take those high-value assets and leave behind old invoices and rickety equipment.

In other words, don’t look at the business with rose-tinted glasses: verify all the financial statements and equipment quotes you’re given. This isn’t being pessimistic or paranoid—it’s being practical. Check the books yourself, or give them to your banker or accountant, to make sure everything is as you were told.

5. Don’t overestimate your repayment abilities  

Plan for mistakes, mishaps, and unexpected disasters. If you’re going to be on a payment plan, then you should negotiate so that the beginning payments are fairly light—giving you the space to mess up when you’re new at running the business.

6. Don’t be a jerk!

Some buyers feel like they have all the negotiating power when buying an existing business—but the truth of the matter is, they don’t. Don’t risk paying a higher price or even losing the deal, to say nothing of acquiring a bad reputation, for no reason.

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That’s all there is to it!

By following our step-by-step guide, you have all the information you need for buying an existing business safely, smartly, and successfully. Good luck!

The post Buying an Existing Business: The Step-by-Step Guide appeared first on Fundera Ledger.

from Fundera Ledger https://www.fundera.com/blog/2016/08/09/buying-an-existing-business/