This article is one of a series that offers insight and guidance into the process of buying selling or valuing a business. Whether you want to buy, sell, or appraise the valuation of a going-concern business, these articles provide specific guidance and references to help you accomplish your goal.
So You Think You Want to Buy a Business!
(excepted in part from the book "Strategies for Successfully Buying or Selling a Business")
by Russell L. Brown
Businessus Emptor" (Let the Business Buyer Beware)!
So you're thinking about buying an operating business!
That's great because small business ownership can be one of the
most self-satisfying and personally rewarding things you can do.
But don't do another thing before you read this article! Don't make
the same mistakes that many others have made when buying a business.
Don't take the unnecessary risk of turning your dream into a financial
and emotional nightmare!!
I've been a business broker for many years and
I've successfully brokered the sale of hundreds of operating businesses
and franchises. I'm always amazed at how completely potential buyers
trust business brokers and sellers. I'll tell you straight out,
business brokers and sellers are not on your side! Although most
business brokers are ethical intermediaries, some are only interested
in closing the deal, no matter what the consequences are to either
the buyer or the seller. Remember, for a broker, if there's no deal
--there's no commission! No matter how nice a business broker is
or how helpful he seems to be, remember, it's the seller who pays
the broker and it's the commission from the sale price that pays
his bills. The higher the sale price, the bigger the commission.
And if no sale takes place, no commission at all.
If you think the broker's going to hold your hand
through the process, you're absolutely right. He's going to hold
your hand all the way to the bank. The more the broker can convince
you to pay for a business, the happier he'll be. Don't forget, whether
or not the broker feels that you can succeed in this business or
make a profit at it doesn't necessarily affect him. The primary
motivation that affects the broker is the sale of the business and
its price. There are many reputable brokers and sellers out there
who will treat you in an ethical and responsible manner but you
still have the problem that they represent the seller and themselves,
not you. So what can you do to avoid making possibly the biggest
financial mistake of your life? Get as much information as you can
so that you'll know what to watch for as you negotiate to buy a
business. Don't believe anyone without checking the facts and independently
verifying them (the due diligence process). Here's some of the key
things you should know before buying an existing business.
A Business is Worth Only Whatever Someone is
Willing to Pay!
Valuing the business is not as hard as you think,
but you should never rely on a broker's or seller's estimate as
to what a business is worth. Remember that buying a business is
fundamentally an investment and consequently the business is worth
only as much as its ability to generate a profit for you based on
how much money you must put into it. If you're going to work in
the business as most people do, then the business should also pay
you a fair wage in addition to the profit that it produces. The
best way to determine a business's value is to work backwards from
the available profit that a seller can prove to you. This will at
least get you to a point where serious negotiations can then take
For example, let's say that a business has a total
of $100,000 pre-tax profit (proven by IRS tax returns for at least
the latest full year of operation), before allowing for an owner/manager's
wage. You plan to work full time in the business (and believe me,
you probably will!), and a fair wage for the work if you were to
hire someone to do it is $40,000. That leaves $60,000 of available
profit to work with. But don't forget to allow for the income taxes
that you'll have to pay on this. The taxes will probably be about
$18,000 depending on the state and city the business is in, plus
other personal factors (figure at least 30%). That gets you down
to about $42,000 of profits left to be able to either pay off the
debt you incur to buy the business or to provide you with a reasonable
return on your cash investment (if you're lucky enough to have enough
cash to buy the business outright!).
There are many ways to work with this $42,000,
but most people and organizations who lend money to buy a business,
whether they're the sellers themselves or others, want to see a
relatively short payoff term (let's say 5 years) and a fair interest
rate on the money (let's say 10%). When you do the math to determine
the value of $42,000 worth of yearly payments for 5 years at 10%
interest, the amount turns out to be about $165,000. During negotiations
you can vary the value of the business up or down fairly significantly
by changing the time period used and the interest rate paid. However,
this is the approximate total value of the business and a good starting
point for negotiations.
When I say total value of a business, I really
mean total. The total value and therefore the business's selling
price must include all closing costs, assets, transfer and franchise
fees, etc. Remember, a business is worth only as much as its ability
to pay for itself over a reasonable period of time and then to produce
a profit for you. Of course, if you change the time period for payoff
of the purchase price, the interest rate, the anticipated taxes,
the down payment and other factors, the price you can afford to
pay for the business can go up or down substantially.
Most Sellers "Stretch the Truth"
or Downright Lie About Unreported Cash Sales!
One of the biggest problems in the valuing of
small businesses for sale is the frequent claim by the sellers that
they are taking large sums of unreported cash out of the business
and therefore, the "profits" won't support the asking
price of the business. But "trust them" they say, the
cash will be there for you! My advice is to ignore all claims of
unreported cash income!! How do you know the seller is telling you
the truth? If the seller will cheat the IRS, why won't he cheat
you? And do you really think the seller will admit to you, a stranger,
that he is committing what could be a criminal felony if he thought
that it could be proven? If the business's reported sales and profits
as evidenced by the IRS income tax returns don't support a reasonable
asking price for the business, walk away. Find another business
to buy that is run on the up and up. It's your money and time you
are about to risk -- don't risk it foolishly.
Always Assume There are Skeletons in the Closet!
Other things that you must watch out for are the
"skeletons in the closet." These are hidden problems that
many businesses have and which may be motivating the seller to unload.
You'll have to be sort of a detective to
find these, but I'll list a few here so you get the idea of what
to look for:
- credit problems with banks and/or suppliers
- personal affairs of the seller that may affect
his ability to sell the business (e.g., divorce, death of a partner,
argument with a partner, etc...)
- historic downward business trends in the seller's
- downward business trends for this business
- recent bad publicity, bad reports at the Better
Business Bureau, etc.
- expiring patents, licenses, franchise agreements,
- changing franchise terms that will increase
- an impending or actual zoning change that will
hurt business expansion
- major new competition (such as a new shopping
- increasing difficulty or expense in getting
raw materials, products, or services
- the potential non-renewal of a major sales
- significant increases in rent to be expected
(if the business space is leased)
- unapproved existing variances in violation
of zoning regulations
- leases that are non-assignable or non-renewable
- legal claims, encumbrances, and liens against
- pending litigation against the business
- state and/or federal law violations that will
require a major expense to correct
- poor management of capital assets requiring
- obsolete machinery, overvalued inventory
- partner and/or shareholder who may not concur
with the seller's desire to sell
- unpaid taxes (income, sales, FICA)
- product obsolescence
- potential major increase in product liability
- potential labor union or other employee related
- inability of a buyer to replace a "superman"
- non-compliance with environmental and/or safety
- recent suspension of a liquor license for regulation
- need to hire a policeman to handle rowdy customers
at certain times
- etc, etc...
So What Should You Do?
Although buying an operating business is filled with many potential pitfalls, it is still one of the best ways for a beginner to get into business. An existing operating business has a proven track record, an existing customer base, a well known name, location, marketing and sales strategy, etc. If you buy the business properly, without overpaying and not taking on any fatal skeletons in the closet, you'll have your instant piece of the American dream to be your own boss and to control your own financial destiny. Get all of the information you can to educate yourself about what to look for and what to look out for. Study the particular business that you are interested in and don't let anyone push you into buying. Tens of thousands of successful business sales take place every year and the key to a successful transaction is information and knowledge on the part of the buyer and the common sense to apply it. One good way to get this information is to read Strategies for Successfully Buying or Selling a Business! written by the author of this article.
If you're considering buying, selling, or determining the value of a business, please take a look at some of the excellent books, reports, and software we have at Business Book Press to help you achieve success. For example:
The Business Reference and Pricing Guide is the bible of the business brokerage world. If you're a shrewd business buyer or seller, you will want this book to learn what just what the business broker knows. It will pay you big dividends throughout every aspect of the purchase and sale process. Learn more about it...
BizPricer Business Valuation Software is an accurate and inexpensive resource for prospective business buyers and sellers (and business brokers) who want to know the fair market value of a business. No financial expertise or specialized knowledge is needed. Save hundreds to thousands of dollars over hiring an appraiser to provide you with a similar result. Learn more about it...
Preparing A Business for Sale provides business owners with an understanding of the process they need to know to sell their business for the most money. Contains hundreds of little known tips, ideas and strategies to maximize the selling price of a business. Learn more about it...
Strategies for Successfully Buying or Selling a Business is our bestselling book. It has been recommended by Kiplingers Personal Finance Magazine, the BottomLine Personal Newsletter, and has been awarded the Best Business Book of the Year Award from the North American Bookdealers Exchange (NABE). Learn more about it...
Anatomy of a Business Purchase Offer provides you with all of the practical hands-on knowledge you need to make a successful purchase offer to buy a business. The author uses an actual Purchase Offer form to show you exactly what needs to be written and why! He details all of his recommendations in a line-by-line format for each and every aspect of the purchase offer. Learn more about it...
The Business Buyer's How-to Kit: We've assembled a specially-priced Kit with all of the key information you'll need to know to successfully buy a business.
The Business Seller's How-to Kit: We've assembled a specially-priced Kit with all of the key information you'll need to know to successfully sell a business.