The advantage of buying a successful business in comparison to starting a new one can be overwhelming. Perhaps the biggest plus is that a huge amount of risk and uncertainty is eliminated. There are not only existing customers, but a track record of what is selling and what isn’t. And, since the basic business infrastructure is already in place, you can focus on improving the existing business, rather than on reinventing the wheel.
The most important asset you may acquire in buying a business are the customers. Even with a great product or service, building clientele can take time. Be sure the customers are satisfied and that they will remain loyal to the business after the current owners have sold out.
Identify and assess the value of all key employees. Arrange to meet with them. Ask yourself: How critical are the current employees to the business? Do the salespeople have strong relationships with key customers? Would a particular engineer’s or designer’s talents be difficult to replace? How important is the role of the current owner? You might even consider offering incentives to certain employees to assure that they will remain with the business at least through the transition period.
Leases are not an integral part of the balance sheet yet they can be a tremendous hidden liability. Find out if the current owner personally guaranteed the lease(s) and ascertain whether or not the landlords will insist you personally guarantee them as well.
There are important regulations to consider as well. Environmental legislation, in particular, places the burden of polluted property cleanup on current property owners and in some cases leaseholders. Find out if the property was ever owned or leased by a manufacturer involved in activities that created hazardous wastes that could have contaminated the soil. Find out whether or not any clean-up action has already been taken.
Don’t take historical financial statements at face value, especially if they are not accompanied by a satisfactory audit letter from a CPA firm. Don’t confuse a compilation (basically adding up the numbers provided by the client) or a review (a compilation with a few ratios figured out) with an audit. Only an audit requires that a CPA test financial information. If the seller offers you projections, don’t even look at them!
Chances are, if the business has receivables, their value is overstated. Carefully examine an aging of the receivables and determine what amount is outstanding past normal industry practices (nominal stated terms are often ignored). Then assume that an appropriate amount of receivables that are still current will also become bad debts.
The market value of the inventory is almost certainly going to be a lot less than what was paid for it. While even larger businesses tend to have a fair amount of slower- moving items in inventory, many small businesses are even more hesitant to write down or sell off obsolete items.
Be sure that you are not walking into a competitive mine-field! Is a price war beginning? Are your competitors slashing their margins to the bone? Did the current seller hear advance reports of a powerful international corporation entering their market niche?
Much more so than in buying a house, you need to consult with an attorney familiar with small businesses before signing an offer to buy. This is particularly important because of the many hidden liabilities you may be taking on, such as contracts, employment obligations, pending litigation, bills to vendors, leases, and more.
You need to have a firm agreement with the current owner as to with whom, at what stage of the negotiations, and under what conditions you can discuss your interest in buying the business. Telling key customers that you are considering buying a business that is not yet publicly for sale can pose a risk to the business and expose you to potential litigation from the current owner.
Start by carefully estimating the net positive cash flow for the next five years, after subtracting a good salary for your talents—one in line with your market value if you were employed in a similar management capacity elsewhere. Then determine the appropriate multiple of earnings to use to arrive at a fair valuation. The appropriate valuation should reflect the amount of risk inherent in the business and the importance of your efforts towards making the business succeed.