Buying a business can be a daunting process. Steps include determining your budget, finding the right business, negotiating the price, and obtaining financing. Along the way, you will need to know how to properly value a business, what documents you will need to exchange with the seller, and who your professional allies are.
The seven steps to buying a small business are:
1: Determine Your Budget for Buying a Small Business
Understanding your budget is an important part of buying a business. It is best to determine your assets and liabilities before searching for a business to buy. The business’s finances are another important piece of the puzzle, as the amount of revenue, liabilities, and debt owed by the business will help determine if the business can support itself.
Here are a few steps to help you figure out how to buy a business you can afford:
- Your liquid assets: Liquid assets are things like cash, checking, and savings accounts, as well as investments that can easily be converted to cash. In most cases, you will need to make at least a 20% equity injection into the business upfront.
- Your fixed assets: Consider fixed assets such as your home and any other real estate you might own, as well as certificates of deposit. This will help you determine your available collateral.
- Your debt: Factor your total debt obligations, such as a mortgage, student loans, and credit card payments. This will help you calculate your debt-to-income ratio (DTI). Most lenders consider a DTI below 40% to be a sign of healthy borrowing.
- The business’s income: Determine the business’s monthly net operating income. Divide this by the expected monthly loan payment, to find the debt service coverage ratio (DSCR). Ideally, the business should have a DSCR of 1.25 or more. Anything less indicates a business may have difficulty repaying debts.
When considering whether to buy a business, it is important to review your personal finances first, considering cash on hand as well as other liquid assets. This is a critical step as most lending options require an equity injection between 10% – 20%. Your fixed assets can help you qualify as well. Lenders may require you to put up your home to collateralize an SBA loan. Finally, your DTI will be considered when evaluating your creditworthiness.
The second piece of the puzzle is the business’s financial situation. Lenders will want to know that the business can afford to pay its existing debts and obligations as well as support any new loans. If the business’s DSCR is too high, you may look at expenses to reduce or eliminate such as lowering the salary you take in an effort to bring the DSCR within range.
2: Find the Right Business for Sale
There are a variety of different resources you can use to find businesses for sale. Resources include business-for-sale websites, classifieds, franchisors, and business brokers. It’s also important to note that sometimes the best opportunities are not advertised, so it’s important to ask around in your local business community.
Some common resources to find businesses for sale are:
- Business-for-sale websites: Websites like BizBuySell.com and FranchiseGator.com contain thousands of business listings. BizBuySell contains primarily private businesses, and also contains a franchise section, while Franchise Gator features franchises for sale.
- Newspaper classifieds and industry publications: Oftentimes, business owners will list their business for sale in the local newspaper classifieds, as well as industry-specific publications, which is great if you’re looking to buy a business in a particular industry.
- Franchisors: Franchisors often list information about buying a franchise online and will list phone numbers to call to get further information. Franchisors are sellers that represent themselves in the sales process.
- Franchise consultants: Franchise consultants can be a great resource if you’re unsure what business you would like to purchase, helping choose the right franchise through a selective method. They are typically paid by the franchisor at the close of the sale.
- Business brokers: Business brokers represent the seller and are paid by the seller. However, they can help you find businesses for sale that you might not find on your own. Many business brokers belong to a larger business broker network.
Finding the right business can be the most challenging step in the process. Using various resources will increase your overall chances of finding a business that is a fit for you both financially as well as something that you will enjoy doing. Using online databases like BizBuySell and Franchise Gator will help you get in contact with sellers and give you more resources to choose from.
A franchise consultant can help you by showing you several franchises (often from hundreds that they represent), helping you through a selection process to find the right fit. Business brokers work a bit differently and often represent a small handful of sellers, so you may work with multiple brokers while choosing the right business. “Buyer’s agents” exist, however they will charge you for their services.
Once you find a business that you are interested in buying, you should get a business valuation done so that you can make sure you’re paying the right price for it. Guidant is a reliable business valuation provider with dedicated specialists that will supply you with an in-depth analysis of the business in question for just $495. Get started today.
3: Know What Questions to Ask When Buying a Small Business
It’s important to ask a lot of questions when buying a business. You will want to understand the price of the business, how it makes money, its financial stability, and its assets and liabilities. You will also want to ask yourself questions during the process, including whether you can afford the business, and whether you have experience and interest in the industry.
Questions to Ask Yourself
The questions you ask yourself will help you determine what type of business you want to buy as well as your budget. Having these questions answered will help you compare businesses quickly, as well as present yourself as a serious buyer when making inquiries.
Some questions to ask yourself are:
- Why would you buy this business as opposed to starting a new business? What are the benefits, such as location, customer base, reputation, etc.?
- Do you have experience in the industry in which the business operates?
- Can you afford the business? Will you require a loan, and if so will you be able to qualify for it?
Some aspects of the business, such as whether it can afford its debt service, will need to be determined by the specific business you choose; however, you should have a basic idea of whether your credit is strong enough as well as how much you can put down as an equity injection if you intend to borrow to buy your business.
Questions to Ask the Seller
You will want to ask the current owner questions like why they’re selling the business, how old it is, and how it makes money. You should ask how they arrived at the purchase price, what is included in the sale, whether it leases space, and if any special permits or licensing are required to operate.
Some of the questions you will want to ask the seller are:
- Why is the business for sale?
- How many years has the business been operating? How long has the seller owned it?
- How does the business make money, and what are annual gross revenue and net profits for the past two fiscal years, as well as year to date?
- How was the purchase price determined, and what assets are included in the price?
- Is seller financing available, and if so, how much?
- What are the business’s liabilities? Does it lease space, and if so, when is the lease up for renegotiation?
- Does the business require any specific licenses and permits?
Many sellers will be hesitant to share the financials behind their business unless you are a serious buyer. They may ask if you have been prequalified for a loan, or ask you to prove you have the money available before allowing you to perform due diligence. At minimum, you should ask what the business’s gross revenue and net profits were for the last two years.
Try to talk to as many different people as you can such as employees and nearby business owners, about the business’s history and prospects for future success. You may also want to speak with customers. Try to determine how critical the current owner is to the business’s success, or whether they are detrimental. This will help you determine whether it will survive ownership transition.
4: Conduct a Business Valuation
When evaluating businesses to buy, determining the proper value of the business is a critical step. The seller will give you a purchase price based on the value of the business’s assets, inventory, and goodwill, which is any value of the business not based on tangible assets. The seller may also factor revenues and profits into this.
Some considerations you will want to make when valuing a business are:
- Tangible assets: This includes items with an established monetary value such as cash-on-hand, land, vehicles, and equipment. To measure tangible assets, add up the fair market value, and subtract any debts or other liabilities.
- Inventory: While inventory is often listed under tangible assets, it is still important to consider stock on hand as a separate asset that may fluctuate between the time you express interest in the business and close on the sale.
- Goodwill: Examples of goodwill include repeat customers, brand reputation, as well as positive employee relations. To measure goodwill, simply add up the fair market value of assets, less liabilities, and subtract these from the purchase price of the business.
- Revenue: Revenue is a measurement of a business’s sales. You should look at the last three years of sales to identify any decline in sales. Ideally, the business’s revenue will grow incrementally each year.
- Profit and owner’s salary: Profit is a measurement of the business’s sales, less the business’s liabilities such as rent, debt service, and salaries. Knowing the owner’s salary will help you determine whether this business will provide enough income to be viable.
Many businesses are valued using a simple business valuation calculator where the annual sales or profits are multiplied according to an average multiple for the industry. This model, while common, is not highly accurate, as it does not take into account factors such as inventory on hand, account receivables, and the debt service the business has.
5: Get Your Documents Together
Buying a business is a paperwork intensive endeavor. It is important that you exchange several critical documents with the seller in order to avoid any financial or legal issues in the future. Should you choose to utilize a business broker, you should still have all documentation reviewed by an attorney and an accountant as appropriate.
Some of the documents you will want to be aware of when buying a business are:
- Financial documents: You will want to have the last two years of the business’s tax returns, annual income statement, and balance sheet, as well as year-to-date documents for all three.
- Organizational documents: Obtain the articles of incorporation, secretary of state certificate, business license, and any other related items.
- Location paperwork: You should get copies of any existing leases for the office building or other space, and pay attention to the lease expiration date.
- Existing contracts: Make sure that all promissory notes, collateral agreements, and existing contracts with customers and vendors are accounted for.
- Sale agreements: Review the purchase agreement, bill of sale, non-compete agreement, and bulk sale documents, as well as IRS Form 8594, which details how assets are allocated during the purchase.
- Consultation agreement: If the owner will be staying on to aid in the transition, you will want to make sure you have this documented, along with any related employment agreement, spelling out the length of time and capacity they will operate in.
While it may seem like an overwhelming amount of paperwork, each of these documents plays a critical role in the success of your business. A business broker can help navigate this step in the process, but you may also wish to work with an attorney familiar with business acquisitions, and an accountant with experience working with financial documents pertaining to a business purchase.
Step 6: Know Your Financing Options
Many first-time business buyers find a business they’re interested in buying first, and then look into financing the business. This can delay or even kill a deal. Just like you wouldn’t go to look at homes without first qualifying for a mortgage, you should consider what sort of financing you can qualify for before looking for businesses.
Some financing options to consider when buying a small business are:
- Seller financing: Seller financing is common, and usually is offered for between 15% – 50% of the purchase price of the business. Seller financing can be used to satisfy the equity injection for an SBA loan if the seller is willing to defer at least 10% of the amount financed until the end of the term, called a seller standby note.
- Commercial loan: A commercial term loan is a common method of buying a business, and funds more quickly than an SBA loan.
- SBA loan: An SBA loan is a popular way to fund a business acquisition, and tends to have competitive rates as well as the longest terms available.
- Rollover for business startups (ROBS): A ROBS is a method of buying a business by investing your existing retirement account in the purchase of business shares. A ROBS can also help satisfy an equity injection requirement for SBA backed loans.
- Friends and family: Friends and family lending is a very common method of obtaining funds to purchase a business. These loans are typically made at lower than bank rates with flexible terms.
- Other: Many buyers use cash, or some combination of cash and personal debt such as a home equity line of credit (HELOC) or personal credit cards.
Getting a loan, either a commercial term loan or an SBA loan, is one of the most common ways to finance a business acquisition. In either case, you will need strong credit (above 680) as well as some experience in the industry, or running a business. The business will likewise need a history of strong revenues as well as profitability, and show it can cover its debts and pay an owner salary.
Step 7: Build the Right Team
There are many experts available that know how to buy a business, and in many cases it may be difficult to proceed without using some combination of these professionals. Professionals you are likely to interact with include accountants, attorneys, and business brokers.
Some of the allies you will encounter when buying a business are:
- Financial professionals: An accountant, or CPA, can help you evaluate financial paperwork and interpret things like tax returns, income statements, and balance sheets. Without an experienced accountant, it may be difficult to spot red flags.
- Business attorneys: Having a lawyer with experience in business acquisitions can be very helpful, and assist you in uncovering any legal pitfalls, as well as assemble the legal pieces of the deal such as a purchase agreement, and review of any contracts.
- Business brokers: If you are buying a business, chances are that the seller is using a business broker. You may want to consider a buyer’s broker, as the seller’s broker has a fiduciary duty to the seller, and may not act in your best interests.
Having the right professionals on your side can make the difference between finalizing a good deal that is fair to both parties and closing on a bad deal that leaves you exposed to unexpected costs or legal liabilities. An accountant can help you spot potential financial snags while an attorney can help you with contracts, drafting new documents, and avoiding future liabilities.
Finding a buyer’s business broker is not required, and in fact many new business owners acquire their business solely with the help of the seller’s business broker. It is important to note that this broker is required to operate in the seller’s best interests, not yours, and so you may want to consider hiring a buyer’s broker to give yourself peace of mind.
How Buying a Business Works
When considering buying a business, it is important to understand the different steps that go into the process. For most buyers, it will follow similar steps of identifying the business, determining the asking price, evaluating the business’s value, negotiating the price, and closing on the business.
Here’s a quick overview of the business buying process:
- Identify the business: There are many resources to use when identifying a business, however among them are business brokers, franchise consultants, and online business-for-sale postings.
- Determine the asking price: Some businesses will not have an asking price listed, and others will not include add-on items like inventory, so it is important to get a firm understanding of the seller’s asking price.
- Evaluate the business’s value: You will want to evaluate the value of the business, based on its revenue, liabilities, net profit, as well as tangible and intangible assets. You should also ensure the owner’s salary is up to your expectations.
- Negotiate the price: Once you’ve evaluated the value of the business, and determined a fair asking price, it’s time to negotiate with the seller. If their price is too high, don’t be afraid to come in lower, and be ready to explain your reasoning.
- Secure funding: Now that you have come to an agreed-upon price for the business, it is time to secure funding, including applying for any necessary loans.
- Due diligence: At some point in the process you will need to perform due diligence. You should try to perform this step as early in the process as possible, which includes reviewing all financial and legal documentation.
- Closing: Finalizing a business purchase may seem simple, but be ready for a lot of documentation, including loan signing legal agreements, and loan documents.
The steps to acquiring a business do not always occur in this order, as each business purchase is unique. For example, you may be able to perform due diligence earlier in the process after showing proof you can obtain funding and signing a nondisclosure agreement (NDA). The earlier in the process you are able to perform this step, the better for you as the buyer. Be wary of unscrupulous sellers who may attempt to delay or avoid this step altogether.
Buying a Business vs Starting a Business
There are many reasons why you may want to buy a business versus starting a business from scratch. Among them is the rationalization that buying a business has fewer risks. There’s certainly some logic to this. Buying a business with an established customer base, strong brand reputation, and existing marketing efforts among other factors can eliminate the uncertainty of creating a market for your product from scratch.
With that in mind, you will also want to evaluate the intrinsic value of all of these factors, as well as consider whether the business you are looking to buy has a negative brand reputation, or has borrowed irresponsibly, or tarnished employee goodwill. If the business you evaluate is not worth its asking price on paper and you cannot make up the difference in goodwill, you may want to consider starting your own business as well.
A further consideration is whether the business you wish to buy exists in the first place. Many startups come into existence because they are providing a new solution to an existing problem. If the business you wish to start doesn’t exist, you will want to perform a market analysis to determine the value of the solution you are providing, and whether a market exists or can be created for your solution.
Mistakes to Avoid When Buying a Business
Some tips on common business buying mistakes to avoid are:
Don’t Settle for the First Business You Find
“If you compare buying a business to real estate investing, you would never walk into one open house and say you’ll take it. This is a mistake because you don’t have any comparison to determine if you’re making a good investment. How do you know if they are a quality business if you don’t look at the other options and make a comparison? To avoid this, research at least three different businesses in multiple industries.”
—Kenny Rose, Founder & CEO at Semfia
Don’t Underestimate the Value of Current Employees
“The most common mistake I have seen is new operators underestimating the challenges of building and maintaining a team. Requiring the prior owner to stay on for a while as part of finalizing the sale can help the transition and maintain relationships with staff.”
—Bethany Babcock, MBA, Founder, Foresite Commercial Real Estate
Don’t Value a Business Solely on Multiples of Earnings
“Multiples are just one way to value a business and buyers should really consider an asset and income approach as well. An appraisal by someone who transacts in small business sales is good due diligence but if you’re not ready to go to that expense, conduct a basic sanity check.”
—Charlie Cole, CEO, Cole & Company Inc.
Don’t Sell Yourself Short Trying to Save Money
“The most common mistake that I see is one side not hiring an attorney. One side, in trying to save money, will either rely upon the business broker, or an accountant, or sometimes, no one but themselves. Business purchase contracts are not simple documents and they can involve a lot of complex issues, including litigation, intellectual property, and employees. Not having an attorney makes the deal a lot more difficult and I have seen deals collapse because the side without an attorney did not know how to move forward.”
—Justin A. Meyer, Esq. of Rosenthal Meyer
Don’t Overlook the Tax Consequences of Buying a Business
“One of the biggest mistakes I see is not taking into account the tax consequences of the sale/purchase on both sides of the deal. The buyer will want to purchase the assets, both for depreciation reasons and for liability reasons. The seller is assumed to want to sell the stock to get capital gains. This gain, however, is not always important to the seller. So consider that the seller may be no better off by selling the stock than selling the assets.”
—Tom Wheelwright, CPA & CEO of WealthAbility
Don’t Gloss Over Financial Planning
“Becoming a small business owner can be an exciting and overwhelming time. In the excitement … buyers skip over much of the necessary research and planning, especially when it comes to finances. We recommend clients talk with other business owners about their experience and put together a budget with financial projections that includes a buffer (10% is a great place to start).”
—Amy Holland, Sales Operations Analyst, Guidant Financial
Bottom Line: How to Buy a Business
Buying a business is a very complex transaction with many potential pitfalls along the way. Knowing where to find the business, what questions you should be asking, and how to determine the business’s valuation will help you pick the right business. From there, understanding the financing options available and who your potential allies are in the process will help you through the transaction without a hitch.