Buying a business

A person might want to buy an existing business, rather than taking a chance with starting up a new business from scratch. By doing so, the person can acquire an entity with an established presence in the market, which includes an existing customer base. Thus, the risk associated with starting up a business is reduced. However, to make this purchase succeed, the buyer should follow a series of steps to ensure that he has an interest in the target business, that the business is viable, and that he pays a reasonable price for it. These steps are as follows:

  1. Determine your interest level. An existing business likely operates out of a fixed location, with an existing staff, and requires a certain number of hours time commitment per day. Also, the business will require some kind of expertise. The buyer needs to consider these factors when deciding whether he is willing to commit a substantial number of years to running such an operation. For example, does a buyer want to drive thirty miles a day to work in a firm that engages in a business that is unfamiliar to him? This self-examination should reduce the number of available businesses that are viable purchase options.

  2. Conduct due diligence. Verify that a target company is as good as it initially appears to be. There are always some problems, which the current owners may not be overly forthcoming about revealing. Here are several issues to look for:

    • Examine the local market to see if there are lots of competitors; if so, the company may be under a great deal of pricing pressure.

    • See if the company has intellectual property that allows it to compete in a unique way; if not, it cannot differentiate itself from the competition.

    • Is the company in compliance with environmental regulations? If not, the buyer could be personally liable for cleaning up whatever the problem may be.

    • Are there any undocumented liabilities? This could take some digging, but there may be additional loans or other obligations that the current owners have not revealed.

    • Are there key employees who are absolutely necessary to the proper running of the business? Is there a risk that they could leave?

    • Are employees being paid a reasonable wage in relation to the local pay scale? If not, there is a higher risk that they could leave.

    • Is there an unusually high risk of employee injuries? If so, this could impact the amount of workers' compensation insurance that must be paid.

    • What are the cash flows of the business? Do the cash flows vary from the profit level appearing in the income statement? If there is a wide divergence, there is a risk that the income statement has been incorrectly presented.

    • How much of an order backlog is currently on the books? Is this a healthy amount that will keep the company operating? If not, the business could crash in short order.

    • Does the business have an unusually high proportion of old accounts receivable? This can indicate a number of problems, including weak credit practices and low-quality customers.

    • In what condition are the assets of the business? Are they run down? If so, they will need to be replaced or updated, which could be expensive.

    • Has the company paid all of its taxes? If not, the new owner will have to pay them.

    • What level of control is exercised over the company's expenses? It is possible that excessive expenses are eating into profits.

    • How obsolete is the inventory? It is not uncommon for a business to have a significant proportion of its inventory be unusable.

    • Are there currently any lawsuits pending against the business? If so, the new owner will be liable for any payouts. In addition, lawsuits are an indicator of poor business practices by the current owners.

    • Will a change in control of the business terminate any contracts with the company's customers or suppliers?

  3. Value the business. If the due diligence phase reveals no insurmountable problems, it is time to derive an offer price. There are several ways to do so, including the following:

    • A common approach is to offer a multiple of the current cash flows of the business, such as five times the current cash flows. Before making this offer, examine the reported cash flows to see if they are sustainable.

    • Set a price based on what other businesses in the same field are selling for; this information can come from a broker, who has access to a database of selling prices. The price is usually based on a multiple of sales. So, if a nearby business with sales of $1 million sold for $2 million, there is assumed to be a 2x multiple of sales that could be applied to the target business.

    • A price could be based on the value of the assets of the company. This approach is most applicable when real estate is involved, and the business could be broken up and sold off piecemeal. The resulting price tends to be lower, and so is less likely to be accepted by the seller.

At this point, the parties will likely negotiate over the terms and conditions of the deal. It is an excellent idea to retain a legal specialist to assist in this phase of the purchase, since there are many issues that could be a problem for an inexperienced buyer.

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