Many entrepreneurs today are considering buying an existing business, rather than starting a new business. This approach offers the ability to enter self-employment with an established, on-going business, which offers an existing stream of income. Advertising and marketing for the startup phase has been achieved, and those months of establishing a reasonable cash flow have been accomplished.
The main reason to buy an existing business is the drastic reduction in start-up costs of time, money, and energy. In addition, cash flow may start immediately thanks to existing inventory and receivables. Other benefits include pre-existing customer goodwill and easier financing opportunities, if the business has a positive track record.
In many cases, this can be the most financially sound method of entering the self-employment field. However, there are some important issues you need to address if you are considering purchasing an existing business. The biggest block to buying a small business outright is the initial purchase price.
Because the business concept, customer base, brands, and other fundamental work has already been done, the financial costs of acquiring an existing business is usually greater then starting one from nothing. Other possible disadvantages include hidden problems associated with the business and receivables that are valued at the time of purchase, but later turn out to be non-collectable. Good research is the key to avoiding these problems.
You must do a thorough investigation of the business to make sure you understand ALL facets of the existing owner’s situation. This process of digging down into the operation of the business is called Due Diligence, a process that begins after you’ve done your preliminary investigation and determined that you are sincerely interested in buying the business.
When you’ve made this decision, you will submit to the owner a document called a Letter of Intent, which states that you are going to buy the business if the Due Diligence process goes smoothly, and the results of the process don’t turn up any red flags. At this point in the process the owner(s) should open up the business’s books to you, to let you investigate them thoroughly, looking for any financial problems with the business.
You would be well advised to obtain the services of a professional accountant to help you with this process. In fact, the accountant will usually work alone during this process and supply you with a written final report of the findings, and any recommendations that need to be brought to your attention.
It can be to your advantage to retain an accountant that has an established practice in the community where the business is located. It may also be to your advantage to use an accountant familiar with the industry segment the business is in. An established accountant is going to know a lot about the business community where they practice, and will be able to recognize problems with the business that may be otherwise overlooked.
You can also check online resources such as Bizcomps.com and Business Valuation Services, to get a good idea of what businesses similar to the one you’re investigating commonly sell for in your geographic area. The cost of information at this point is outweighed by future savings.
A significant portion of the asking price for a business is what is called “Blue Sky.” The Blue Sky” is merely an estimate of the income potential of the business over the next few years. This usually represents how much income the current owners might have expected to receive from the business if they had continued to own and operate it.
Blue Sky can range from a few months to a few years worth of income depending on the type business. This is also the portion of the asking price you need to fully understand, as it will also likely be the area of most negotiation. Think of it this way: If you pay three years worth of income as the Blue Sky piece of your purchase price, you will have to make that level of profit for three years to be able to start earning real income from the business.
A well-structured Due Diligence process will include a close look at the cash flow of the business under consideration, the accounts payable, the age of accounts receivable, and a detailed listing of clients and their financial status. There are some obvious factors here: noticeably high accounts payables may indicate an inability to pay the bills. Aged accounts receivable can indicate difficulty on the part of customers to pay their bills.
There has been more than one case where the accountant has been able to identify customers who are in dire financial straits, and may not continue to be customers much longer. This would be extremely valuable information when considering the purchase of a business. There are a number of resources that need to be utilized during this process, including Dun and Bradstreet reports on each of the major customers. These $125 reports will help you get a better understanding of the client or customer base for the business, and may point to the need for further investigation.
While the accountant is checking out all things financial, you should also do Due Diligence on the legal side. You need to discover any liens, judgments or other legal actions against the company. You can often discover this type of information by doing some searching of files at the Recorder’s office at the county courthouse. The Secretary of State will also be able to provide you with any information of legal activity against the company.
It is at this point a small business attorney becomes very important to this process. If the company has passed all the tests, and you are favorably impressed with the results, you need to take one more step. Have your attorney do an investigation of the business. Potential buyers are often surprised by the information an attorney can uncover for you, and it can result in saving you a great deal of money.
Attorneys have access to the workings of the legal system, and during their discovery investigation may turn up information about pending legal actions that a layman could miss. One participant on my Entrepreneurship webinars related a story about a business he had been considering, and during the Due Diligence process, the attorney uncovered a pending lien by the Environment Protection Agency.
It seems the small manufacturing business under consideration had a very well established niche in the marketplace, and would have been a good business to operate. However, the business was operating out of a former gas station, and there were still gas tanks underground. The EPA was going to require that those tanks be removed at an estimated cost of over a million dollars!
Uncovering this kind of information is what Due Diligence is all about, and the process will cost you in reports and fees for the professional support. The savings, however, if you decide to purchase the business can be dramatic. The process normally knocks the top edge off the Blue Sky price, resulting in a fair purchase price, and a much easier transition into owning your own business.