Getting Into Business:
Many of us have felt the entrepreneurial pull of running our own business at one time or another. The allure of being your own boss can be really strong, and no wonder. Small business ownership and its operation has proven to be one of the most financially rewarding and intellectually stimulating pursuits that you can follow in your working life. And, you have the opportunity to be a master of your own financial destiny.
But, it can also be very frightening for those of you just starting out! We have all heard about the high mortality rates for new business ownership; 50% do not make it through the first three years and 70% will be gone after only five years. There are many reasons for this including; insufficient operating capital, poor management, an unworkable business concept, inability to develop a strong customer base, and just plain old bad luck. It would be great if these potential problems could be eliminated or at least minimized for you as a new business operator Well, they can!
Buy an existing profitable business instead of trying to start one from scratch! There are several key advantages to this:
Existing successful businesses have a proven track record of profits that will most likely continue long after the business sale. Now you get to apply your new ideas, expertise, and renewed energy to take the business to even higher profitability.
You will have established customers for immediate cash flow. No suffering through a long start-up period where you struggle to attract customers to your business. Use these customers as a building block for future business growth.
Typically, you will be able to use a business seller's financing of a large portion of the purchase price to maximize your buying potential. You will get more bang for your investment dollar!
Although I do not know of any solid statistics that exist anywhere that I can quote, it has been my experience and that of my many business broker colleagues, that the vast majority of profitable businesses that are purchased continue to operate successfully for many years to come. There is no question in my mind that the success rate for new business owners that buy an existing business is much higher than for those who start a newly formed business. This makes good sense. An existing profitable business has already proven that it is successful. As long as you continue to follow the basic business approach, you too should be able to operate the business successfully.
However, the actual process of purchasing an operating business can be a challenging and complicated undertaking and you will want to be as fully prepared as you can. You need to gather as much information as possible which will help you to; find a suitable operating business for sale, properly value the business, arrange your purchase financing, successfully conduct negotiations, and finally, to actually close the deal, buy the business and transfer ownership. The good news is that tens of thousands of small business sales occur every year with little or no real problems and the new owners and the sellers both realize their goals. But, you must be fully prepared and knowledgeable for this success to occur! In this article, I will provide you with an overview of each aspect of successfully buying an existing profitable business.
The first step in this process is to find out if you are truly fully motivated to operate a small business (whether you start it or buy it). Ask yourself these questions:
- Do you know what kind of business you want to buy?
- Are you "technically" qualified and experienced enough to run the business?
- Do you have the temperament to deal with fickle customers, demanding creditors, and difficult employees?
- Do you have the attention-to-detail that most businesses demand?
- Can you deal with the bookkeeping requirements of the business?
- Are you prepared to devote a great deal of time to the business ?
- Can you deal with adversity without losing your cool?
- Can you deal with uncertainty without losing sleep?
- Are you a good people-person who can successfully deal with both customers and employees?
- Can you accept the potential significant financial loss that investing in a business exposes you to?
Next, you need to determine what your key reason is for buying and operating a business (in addition to the obvious reason of making money):
- Buying a job to earn a living.
- Acquiring an attractive lease or other real estate.
- Buying prestige (many business owners are respected community leaders).
- Eliminating competition if you already have a business.
- Buying a hobby or retirement occupation.
- Seeking self-fulfillment and control of your own destiny.
- Seeking an opportunity for a child or other family member.
Now ask yourself, what is it that I really like to do, and what is it that I am really good at? If you have determined that you are a truly motivated buyer and you know the reasons that you want to own and operate a business, then you should begin searching only for those businesses that match what you like to do and ones that match your skills, capabilities and knowledge.
There are many sources of businesses for sale and quite a few businesses can be relocated, but to maximize your opportunity of finding the right business for yourself, you should be prepared to relocate to the business's location if at all possible. Some good sources of information about businesses for sale include:
- Newspaper classified advertising under Business Opportunities.
- Newsletters of various kinds (in-house brokerage publications, regional and national independent publications, etc.).
- Business Brokers (most reputable ones are listed in the telephone yellow pages and can be checked out through the national professional associations).
- Word of mouth through friends, family, and colleagues from all walks of life.
- Magazines and other periodical publications.
- The Internet (but usually not under Business Opportunities, but rather, Businesses for Sale).
Now that you know what your motivations are for buying a business and where to find a good company for sale, you will need to have some idea about how to apply a realistic value to the company that you are considering buying. This is no easy task! Remember, the seller will want as much as they can get, and you will want to pay as little as possible. The key is to strike a fair deal for both of you. Remember that buying a business is fundamentally a financial investment for most of you and consequently the business is worth only as much as its ability to generate profits. If you are going to work in the business as most people do, then the business should also pay you a fair wage in addition to the profits. The best way to determine a business value is to work backwards from the available profits that a seller can prove.
For example, let us say that a business has a total of $100,000 pre-tax profits (proven by IRS tax returns for the latest full year of operation), before allowing for an owner/manager 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 deduct the income taxes that you will have to pay. They 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.
There are many ways to work with this $42,000, but most lenders of money to buy a business, whether they are the sellers themselves or others, want to see a relatively short payoff term (about 5 years) and a fair interest rate on the money (say 10%). When you do the math to determine the value of $42,000 in yearly payments for 5 years at 10% interest, the amount turns out to be about $165,000. This is the approximate total value of the business and a good starting point for negotiations. I say approximate because if the business has inventory, and/or real estate, and/or accounts receivable (or other current cash assets) that are to be transferred as part of the sale, their value will be added to the overall calculated value of the business. The actual sale price will then be negotiated between the buyer and the seller.
This is of necessity a simplistic example of a fairly complicated process. There are many other issues associated with valuing a business and a prospective buyer is well advised to read as much information on this topic as possible. And of course before you actually proceed with a purchase you should seek the advice and guidance of competent legal and accounting professionals.
Next, you will need to start thinking about how you will pay for this business. This also becomes an integral part of the negotiation process to arrive at a selling price for the business. One of the most crucial steps in the purchase of a small business is to establish the financing necessary to accomplish the transaction. This issue is of equal importance to both the buyer and seller. The buyer needs to find the capital necessary to purchase the business from the seller under acceptable repayment terms. The seller needs to ensure that the buyer has established a realistic financing arrangement such that they will receive the agreed upon funds from the buyer. Since many business sales involve some form of seller financing and the seller is likely to be required to take a secondary security position to any other lender, both parties have a strong interest in the types and conditions of the financing.
There are actually many sources of financing available to the purchaser of a business and frequently the buyer will use not just one of these sources, but a combination of several. The most frequently used sources of funding are:
- Buyer's Personal Capital
- Business Seller Financing
- U.S. Small Business Administration (SBA) Guaranteed Bank Loans
- Commercial Bank Loan
By far, the most frequently used funding sources for the purchase of a small business are a combination of a buyers personal capital and the business sellers financing. However, many transactions are also financed through the SBA Loan Guarantee program. To a lesser extent, the other sources of funding are also used and they could be an important part of your business purchase financing plan and should not be overlooked for consideration. Some of the most successful approaches to finding the financing for the purchase of a small business use a combination of funding sources, both conventional and unconventional.
In most sales of small businesses, there is usually some amount of seller financing of the purchase price. This amount can range dramatically depending on circumstances, but frequently falls in the 50% to 75% range of the total purchase price. In most situations, a seller wants to receive as much money up-front as they can, while a buyer will want to pay out as little as possible. The reasons for this are varied, but basically the seller will need a significant amount of cash to pay the IRS capital gains taxes that will be due upon the sale of the business, as well as business transfer expenses, and personal funds needs. The buyer, on the other hand, will want to minimize the cash outlay to lessen the risk in the business. What if the business is not as good as represented by the seller? The buyer will also want to conserve as much ready cash as possible to operate the newly acquired business.
The Promissory Note to the seller from the buyer is a form of deferred compensation for the seller. As already mentioned, in most cases sellers will need to accept a Promissory Note from the buyer in order to complete the sale. There are several variables that need to be considered from both the buyers and the sellers perspectives:
- Amount of the Promissory Note
- Interest rate and period over which it is to be paid
- Security for the Promissory Note
The principal amount of the Promissory Note (the amount of money owed) is usually not as flexible and able to be changed as is the interest rate and period of time over which payments are to be made. If the business has been fairly valued, there should be enough cash flow from the business operations to cover the payments the buyer must make to the seller. The business must be able to pay itself off through the business's cash flow over a reasonable length of time. The seller will want to ensure that the amount of the Note does not exceed the fair market value of the assets in the business that are being used as security for the Note. Sometimes a buyer will need to provide more cash down (20% to 50% of the purchase price is customary) to lower the amount of money owed, and therefore, lower the amount of the payments.
The interest rate and time period of the Note are key factors in determining whether the business can afford to pay for itself. Interest rates charged by the seller are usually pegged to the prevailing best bank loan rates or even somewhat lower. The seller has to be careful about setting the interest rate too far below bank rates because the IRS has the ability to impute a fair market interest rate if they determine that the interest rate being charged is too low (impute means that they will tax a seller as if the rate was 8% rather than, say, the 4% rate actually being charged). However, there is usually a wide latitude for negotiation here as the best bank rate (prime rate) is about 7% at the time of this writing, and many commercial loans are being written at rates up to 12%. To give you an idea of the difference that the spread of interest rates can make in an amount amortized over ten years, consider the following:
- $500,000 for 10 years @ 4% is $5,062 monthly
- $500,000 for 10 years @ 7% is $5,805 monthly
- $500,000 for 10 years @ 10% is $6,608 monthly
The time period of the Note is also a key factor when considering the financing of a business sale. The seller and buyer will both usually want the note paid off as soon as possible for different reasons. The seller will want to collect the money for the business to cash-out as soon as possible to minimize the risk that the money will not be paid. The sellers biggest fear in accepting a Note for the business is that the buyer will run the business into the ground, effectively making the business assets worthless, and then won't pay the Promissory Note. The seller would then recover a business with little or no value and have received only a portion of the business's original worth. The buyer wants to pay off the Note as soon as possible within the constraints of the business's cash flow so that the maximum financial benefits can be realized. For these reasons, most business sale Promissory Notes have a time frame in the 5 to 10 year range. To see the effect that the different time frames have on payments at a particular interest rate, the following calculations are offered. I picked 10% as a representative interest rate for illustration purposes:
- $500,000 @ 10% for 10 years is $ 6,608 monthly
- $500,000 @ 10% for 8 years is $ 7,587 monthly
- $500,000 @ 10% for 6 years is $ 9,263 monthly
- $500,000 @ 10% for 4 years is $12,681 monthly
As you can see from the data presented above, the interest rate and time frame of a Promissory Note can have widely different effects on the business's ability to pay the note off. Herein lies fertile ground for negotiations between the buyer and seller and can make the difference between a successful business purchase and sale, or a potential failure.
Once you have completed negotiating the selling price for the business, the next step is to finalize the sale, take possession of the business, and begin operations yourself. Closing the deal is the hardest to accomplish, but usually the shortest part of buying or selling an operating business. After all, the valuations, due-diligence investigations, and negotiations are complete and now it is a matter of getting everything into writing in a form that satisfies everyone so that the transfer of ownership of the business can take place.
The best situation for all parties is to follow an orderly buying and selling process that will move things along in a business-like manner. The major elements of the business purchase and sale process are:
- Binder and Earnest Money Agreement
- Purchase and Sale Agreement
- Closing (at which actual title and ownership is conveyed)
At the Closing, the actual legal instruments of transfer are signed and filed, money and/or promissory notes are exchanged, and the buyer becomes the new owner of the business. The Closing date and place are set to everyone's convenience and all of the pre-closing tasks are assigned to the various parties for completion.
Once the Purchase and Sale Agreement has been signed by both the seller and buyer, there is an excellent chance that the sale will actually take place. The buyer's and/or the their attorney's responsibilities will include:
- Finalizing financial arrangements.
- Reviewing/signing any necessary leases.
- Applying for licenses and permits.
- Complying with the bulk sales law.
- Preparing any additional legal documentation required.
- Taking inventory of finished goods and work in process.
- Final inspection of the business assets.
The seller's and/or the business's attorney's responsibilities will include:
- Preparing the real estate lease.
- Preparing the promissory note.
- Complying with the bulk sales law.
- Settling all liabilities and liens.
- Providing for an inspection of the business and an inventory count by buyer.
- Preparing any additional legal documentation required.
- Complying with any other provisions in the Purchase and Sale Agreement.
The business broker's responsibilities will include:
- Ensuring buyer/seller responsibilities are carried out.
- Arranging for third-party leases.
- Acting as a go-between.
- Handling buyer/seller anxiety.
- Participating in the closing.
It may seem obvious, but I'll state it anyway because there may be more to it than you think. The first thing the buyer does after the closing is to take possession of the business! This may include the following considerations:
- Change the locks on the business property.
- Formally notify the employees.
- Notify the suppliers.
- Notify the customers (if appropriate to the type of business).
- File all new legal paperwork with the proper authorities (titles, licenses, liens, etc.).
Well, that's a snapshot of what it takes to buy an existing business. As involved as it may seem, it is far less trouble than starting a new business, and certainly less risky. If you have an entrepreneurial mind-set and would like to consider getting into business for yourself, even if it is only a home-based business to start, I strongly urge you to consider buying an existing profitable business. There are tens of thousands of them out there right now just looking for the right new owner.
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This article was written by Russell L. Brown, Business Broker, MBA, author of Strategies for Successfully Buying or Selling a Business! This book covers in detail such topics as Working With a Business Broker, Buyers Finding Sellers, Sellers Finding Buyers, Valuing a Business, Accomplishing Due Diligence, Conducting Negotiations, Closing the Deal, Working With the Deal Killers, Finding the Skeletons in the Closet, Example Purchase and Sale Documents, and much more. This book has been recommended by Kiplinger's Personal Finance Magazine, and has been selected as The Best Business Book of the Year by the North American Book Dealers Exchange (NABE).
