Knowing which questions to ask when buying a business will help you pay the right price for the business, and help you prepare to run the business after you close on the transaction. Typically, this means going through a five-step process that will help you determine which questions to ask when buying a business and when to ask them.
Financing is one of the most important parts of buying a franchise. You can finance your purchase with funds from your retirement account without paying taxes or penalties, called a Rollover for Business Startups (ROBS). Learn more through a free consultation with our recommended ROBS provider, Guidant.
5 Steps to Take When Buying a Business
Before buying a business, you should protect yourself against taking risks that can be avoided. This means understanding the finances of what you’re buying, how to run the business after you close, and knowing what your risks are. You should be able to get the knowledge you need to accomplish this before you buy the business.
Part of getting this information is knowing what to look for and what questions to ask when buying a business, for both the seller as well as yourself. There are five main steps that you should go through before buying a business, and we’ve included the right questions to ask at each step along the way. Below, we discuss each question in greater detail.
The 5 steps to take and questions to ask before buying a business are:
Step 1: Determine if You Are Interested in Buying the Business
Before you move forward with any official negotiations or data gathering, you should first determine your initial interest in the business. This is where you should discover important details like how the business was started and what expertise is needed to operate the business going forward.
Questions to Ask the Seller
No matter what type of business you’re thinking about buying, there are some general questions that you should ask right away, such as:
- What does the business do?
- What’s the history of the business?
- Why is the business for sale?
- How old is the business?
- How long has the business been operating under the current owner?
These are the most basic questions you should start your search with. If the business is for sale because it hasn’t been performing well financially, then you may want to think twice before purchasing it. Likewise, if you don’t have the expertise to operate the business and the business can’t operate without the owner currently, then you may want to find something else.
Questions on the Financial Performance of the Business
Once you’ve decided on your initial interest in the business, the next most important thing is to get some basic financial information, such as:
- What were the annual gross revenues of the business for the past two years and to date?
- What were the annual net profits of the business for the past two years and to date?
Get some preliminary numbers on how the business has been doing financially for the last few years. If you are interested in buying the business, then you will later get financial documents to verify this information.
Questions on the Price of the Business
What you end up paying for the business, and the assets you get with your purchase, could ultimately determine your success later on. You don’t want to pay more than you can afford, or more than the business can afford to make any necessary debt payments on. You also want to only pay what the business is worth. Some questions you should ask about price include:
- What is the asking price?
- What assets are included in that asking price?
- Is the asking price supported by the profits of the business?
- Is seller financing available? If so, how much?
There will be time for negotiations later, but you should get a price estimate for the business from the seller before you determine if the deal even merits negotiations. A good rule of thumb for most businesses is that the business valuation should be no higher than 3 times annual net profits. This varies by industry, but you can get a more accurate estimation by using our business valuation calculator.
Ask what assets and liabilities are included in the purchase price so that you have a handle on every little thing being included in the price you’re going to pay. Specific assets may include real estate, customer lists, contracts, equipment, etc. The sale may also pass debts and liabilities of the business on to you, which adds to the actual amount you’re paying.
Questions to Ask Yourself
The seller isn’t the only one that needs to answer some questions. This is the point in time when you should determine if the business purchase is right for you. Sometimes business owners get too excited about the purchase that they don’t go through these questions themselves. This can create a lot of headaches later if it doesn’t work out. Some questions to consider include:
- Why do you want to buy this business?
- Should you just start a similar business from scratch?
- Do you have the interest and experience necessary to make this business successful?
- Is there a positive outlook for this type of business?
- What’s the competition like?
- Do you plan to buy and run the business on your own or with a partner(s)?
- Can you afford to buy the business, given your personal and family constraints?
- What parts of the business do you want to buy? What is the owner actually selling? (e.g. contracts, customer lists, land/real estate, equipment, inventory, debts/liabilities, etc.).
These are some gut-check questions to ask yourself to make sure you are buying a business which meshes well with your interests, financial ability, and goals. If you’re planning to bring in a business partner, make sure that you and your partner are on the same page on the important decisions in the acquisition process.
Step 2. Find Out How the Business is Valued
Business valuation is often the most challenging part of the acquisition process, but also one of the most important. Asking these questions will help you calculate what the business is worth, and will help you know if the asking price is fair and reasonable.
Questions to Ask the Seller
The seller should be able to answer these questions for you, which will give you an idea of what the business is worth.
- How was the business’ purchase price determined?
- Is the valuation based on internal calculations or an independent appraisal?
- If there was an appraisal done, can the seller share it with you?
- Is there room to negotiate the asking price?
- What is the goodwill value of the business?
- How does the seller want the sale to be structured? (Asset sale, stock sale, or a sale of membership or partnership interests.)
Valuation may be based on revenues, profits, or goodwill value or on a combination of these things. The value of the business may be higher to an owner who has put their life’s work into it than it will be to you or a prudent buyer looking to pay a value based off of what the numbers say.
It’s important to gather enough information to back up what you believe the purchase price should be, and an independent appraisal is a good way to do that. You can also gather data around what similar businesses in the industry have sold for as proof of the true value of the business you’re buying.
While most business acquisitions are asset transfers, some are treated as stock sales or mergers. How the sale is structured has legal and tax consequences, so it’s important you discuss expectations with the seller fairly early in the process.
Step 3. Think About Financing Options
Once you and the seller decide on a fair price for the business, it’s time to think about how you will come up with the money. Some buyers are able to do all-cash deals. In most cases, however, you’ll need some type of financing.
Questions to Ask the Seller
The first thing to consider is whether the owner offers seller financing. Seller financing is an attractive aspect of any business acquisition because it shows that the owner believes in the business and the new owner-to-be. Seller financing usually covers about 10-25% of the purchase price of a business and can be used to supplement a down payment for long-term financing.
Most lenders of traditional loans, or SBA loans, will require the seller to take a standby position for two years, which means the seller won’t receive any payments during that time. Knowing whether or not the seller will take a standby position is important to know up front if the seller is willing to finance part of the purchase but not all of it. Other questions you should ask include:
- Is seller financing available? How much?
- What are the terms and conditions of seller financing? Interest rate? Length of the loan? What happens if you’re unable to pay back the loan?
- If you’re also planning to get an SBA loan or bank loan to buy the business, is the seller willing to take a standby position? For how long?
- Will the seller wait for you to find external financing if no seller financing is offered?
- How long is the seller willing to give you to perform due diligence required by your lender?
- How much access are they willing to give your lender to the company’s books?
Questions to Ask Yourself
Financing is a very personal thing for small business owners. Your credit profile, willingness to take on debt, and thoughts about the future of the company will dictate how much financing you take. You should ask yourself some important questions before you apply for a loan to buy the business.
- Do you really need financing, or can you afford an all-cash deal?
- Do you have personal assets, such as retirement funds or home equity, that I can use to finance the purchase?
- Do you have enough money for a down payment? (10-20% for most traditional loans)
- Have you written out a business plan with financial projections to provide to lenders?
- Do you have a resume to provide to lenders which highlights relevant industry experience and/or business management experience?
- Do you have a good credit score (680+) that will allow you to qualify for long-term financing? (check your credit for free)
- How much collateral do you have?
Few buyers can afford all-cash deals, and even if you can you may not want to take that much risk. Regardless, you’ll have to bring some cash, typically 10-20% minimum, to the deal at closing. Lenders want you to have some “skin in the game” when it comes to your business acquisition.
If you don’t have cash in the bank to use as a down payment, you can get funds by utilizing your retirement account. Through a ROBS, you get access to those funds without paying withdrawal penalties or taxes and don’t have to make any loan payments for the use of that money. Sign up for a free consultation with a ROBS expert through our recommended provider, Guidant.
Step 4. Gather all the Necessary Documentation
If you’re a serious buyer at this point, you should work with the seller and the seller’s broker to see important financial documents for the business. You can use these documents as a window into the business and to verify information that the seller has already given you. This due diligence before you buy the business will help you confirm whether or not the business is worth what you’ll potentially pay for it, and it will help you find any red flags that may exist.
Common Due Diligence Questions to Ask
Going through due diligence is only as valuable as you make it. The seller isn’t going to tell you what to look for, so it’s important that you know what questions to ask and what documents to ask for. You can consult with an attorney or other M&A professionals to help you with this process, but here are some questions you need to find the answers to:
- What documents should be examined before buying the business?
Some Examples Include:
- Organizational documents for the business (e.g. incorporation docs, certificates of good standing, business licenses, etc.)
- Previous 3 years of business tax returns
- Current year income statements, balance sheets, and cash flow statements
- Revenue broken out by customer for the last 3 years
- Information on existing business liabilities
- Customer lists with proprietary information blocked out as necessary
- Existing contracts – can these be assigned to the new owner?
- Commercial lease or other property documents
- Rent rolls if the property has tenants
- Uniform franchise disclosure document (if the business is a franchise)
- Employee and manager information
- Marketing and advertising materials
- Legal records for pending litigation, if any
- Do financial documents show volatility in the business’ financial condition? If so, what explanation(s) does the seller provide?
- Will the owner sign a non-compete agreement to prevent interference with the business?
- What documents are needed at closing?
Some Examples Include:
- Purchase Agreement
- Promissory notes and collateral agreements for any financing that you’ll be using.
- Commercial lease (if applicable)
- Transfer documents for any vehicles that may be part of the purchase
- Bill of sale – transfers ownership of tangible business assets
- Non-compete agreement from the seller (if applicable)
- Bulk sale documents – these govern the sale of inventory
- IRS Form 8594 – shows how assets are allocated during the purchase
- Consultation/employment agreement – this is necessary if the owner will be staying on for some time to aid in the transition of the business
- What assets and liabilities are included in the sale?
We recommend hiring a qualified attorney to review the legal and organizational documents of the business you’re planning to purchase. All agreements about the acquisition should be put down in writing. In a business acquisition, if something isn’t in writing then it’s not something you can rely on to either be a fact or to be part of the transaction.
It’s important to get a list of all assets and liabilities included in the sale in writing. This takes away any guessing, and you know there won’t be any surprises. Larry Donahue, Esq, Attorney at Law 4 Small Business, says:
“You must make sure the documents enumerate the assets being acquired. Listing every pencil is too detailed, but you should definitely include “major assets” (i.e. vehicles, expensive computers, etc), summarize significant asset categories (i.e. “$10,000 worth of stock and inventory”), and identify specific domain names, websites, phone numbers, fax numbers, social media accounts and vendors.
All liabilities better be disclosed prior to closing, and if they don’t come with the business, arrangements should be made to have them paid off at closing. Don’t allow the Seller to say he/she will pay for liabilities later on their own time, because the legal doctrine of “Successor Liability” could still have your business on the hook.”
Step 5. Learn About the Day-to-Day Business Management
Before signing the purchase agreement, you should find out as much as you can about how the business makes money and how it is run on a daily basis. This is especially important in a business where the current owner has a significant role in the day-to-day operations.
When you close, that important piece of the business operations will be gone but you’ll need to keep the business moving forward. The more you understand it, the better off you’ll be after closing. Typically the seller should be open to answering most questions about operations once you’ve signed a letter of intent or purchase agreement, including:
Questions to Ask the Seller
- Does the business currently lease space? If so, will the lease end soon? Does it need to be renegotiated before you close?
- What licenses or permits will be needed to operate the business?
- What revenue models does the business use? (One time payments, subscriptions, contracts, etc.)
- How does the business generate new revenue? (business development operations)
- How quickly does the business get paid for goods and services?
- Will the seller stay for some period of time after the sale to ensure a smooth transition?
- Who are the employees of the business, what are their roles, and what do they do every day?
- Who are your biggest competitors and how do each of them directly impact your revenue?
Businesses with a steady stream of revenue or contracts in place are generally a safer bet than businesses that make one-time revenues per transaction. However, you should find out if any contracts that are currently in place can be assigned to you as the new owner. According to Mike Powell, Attorney at Powell IP Law:
”In my experience, what most buyers fail to discover is a clear view of the marketplace and how the business is going to compete successfully in that marketplace over time. Reasonable due diligence will certainly reveal all the basic information such as how the business has performed and is expected to perform on paper, how day-to-day operations function and could possibly be improved, and what people (i.e., employees and managers) are needed for transitioning to new ownership. However, understanding the marketplace clearly and what’s truly needed for the business to succeed in that marketplace is often overlooked.”
You should also find out if other things, such as licenses and ratings, will transfer over to you as the new owner or will need to be obtained anew. It can be a nightmare for your business if the licenses don’t transfer, and you’re not prepared to apply for new ones on the day you close. Typically most states give a small window for new owners to get licensed after a business purchase.
Questions to Ask Yourself
- How will you handle payroll, including paying yourself, after closing?
- Will you take a salary from the business right away?
- Is the business highly dependent on the personality of the owner, or is it fairly independent from the owner?
- Is there a good management team in place?
- Which employees do you need to make sure is staying with the business post-closing?
- Have I talked to employees, suppliers, and other third parties to get their perspective on the business and verify information that I’ve learned from the seller?
Buying a business is not as easy as making any other large purchase in your life. You shouldn’t expect that you’ll be able to easily transition operations from a hands-on owner to you with the flip of a switch. You can solve this problem by insisting the seller agree to participate in any training or operational help that is needed over the first 6-12 months.
As you experiment and try new things in the first few months of running the business, there may be some ups and downs in revenue, particularly if the business is highly dependent on the personality of the current owner. You should factor that into your cash flow projections prior to closing.
Knowing the right questions to ask when buying a business is the key to a successful purchase, and it will help you uncover the right information about the business. By asking the right questions you’ll be well on your way to a rewarding and lucrative business acquisition. Your seller won’t tell you where to look to find any potential red flags, so it’s important that you understand what to ask and what information to collect yourself.
When starting your business, we recommend looking into a Rollover for Business Startups (ROBS). With a ROBS, you can get access to your 401k or IRA funds without having to pay any early withdrawal penalties or taxes. Get a free consultation from our recommended ROBS provider, Guidant.