“Caveat Businessus Emptor” (Let the Business Buyer Beware)!
So you’re thinking about buying an operating business! That’s great because small business ownership can be one of the most self-satisfying and personally rewarding things you can do. But don’t do another thing before you read this article! Don’t make the same mistakes that many others have made when buying a business. Don’t take the unnecessary risk of turning your dream into a financial and emotional nightmare!!
I’ve been a business broker for many years and I’ve successfully brokered the sale of hundreds of operating businesses and franchises. I’m always amazed at how completely potential buyers trust business brokers and sellers. I’ll tell you straight out, business brokers and sellers are not on your side! Although most business brokers are ethical intermediaries, some are only interested in closing the deal, no matter what the consequences are to either the buyer or the seller. Remember, for a broker, if there’s no deal –there’s no commission! No matter how nice a business broker is or how helpful he seems to be, remember, it’s the seller who pays the broker and it’s the commission from the sale price that pays his bills. The higher the sale price, the bigger the commission. And if no sale takes place, no commission at all.
If you think the broker’s going to hold your hand through the process, you’re absolutely right. He’s going to hold your hand all the way to the bank. The more the broker can convince you to pay for a business, the happier he’ll be. Don’t forget, whether or not the broker feels that you can succeed in this business or make a profit at it doesn’t necessarily affect him. The primary motivation that affects the broker is the sale of the business and its price. There are many reputable brokers and sellers out there who will treat you in an ethical and responsible manner but you still have the problem that they represent the seller and themselves, not you. So what can you do to avoid making possibly the biggest financial mistake of your life? Get as much information as you can so that you’ll know what to watch for as you negotiate to buy a business. Don’t believe anyone without checking the facts and independently verifying them (the due diligence process). Here’s some of the key things you should know before buying an existing business.
A Business is Worth Only Whatever Someone is Willing to Pay!
Valuing the business is not as hard as you think, but you should never rely on a broker’s or seller’s estimate as to what a business is worth. Remember that buying a business is fundamentally an investment and consequently the business is worth only as much as its ability to generate a profit for you based on how much money you must put into it. If you’re going to work in the business as most people do, then the business should also pay you a fair wage in addition to the profit that it produces. The best way to determine a business’s value is to work backwards from the available profit that a seller can prove to you. This will at least get you to a point where serious negotiations can then take place.
For example, let’s say that a business has a total of $100,000 pre-tax profit (proven by IRS tax returns for at least the latest full year of operation), before allowing for an owner/manager’s 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 allow for the income taxes that you’ll have to pay on this. The taxes 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 (if you’re lucky enough to have enough cash to buy the business outright!).
There are many ways to work with this $42,000, but most people and organizations who lend money to buy a business, whether they’re the sellers themselves or others, want to see a relatively short payoff term (let’s say 5 years) and a fair interest rate on the money (let’s say 10%). When you do the math to determine the value of $42,000 worth of yearly payments for 5 years at 10% interest, the amount turns out to be about $165,000. During negotiations you can vary the value of the business up or down fairly significantly by changing the time period used and the interest rate paid. However, this is the approximate total value of the business and a good starting point for negotiations.
When I say total value of a business, I really mean total. The total value and therefore the business’s selling price must include all closing costs, assets, transfer and franchise fees, etc. Remember, a business is worth only as much as its ability to pay for itself over a reasonable period of time and then to produce a profit for you. Of course, if you change the time period for payoff of the purchase price, the interest rate, the anticipated taxes, the down payment and other factors, the price you can afford to pay for the business can go up or down substantially.
Most Sellers “Stretch the Truth” or Downright Lie About Unreported Cash Sales!
One of the biggest problems in the valuing of small businesses for sale is the frequent claim by the sellers that they are taking large sums of unreported cash out of the business and therefore, the “profits” won’t support the asking price of the business. But “trust them” they say, the cash will be there for you! My advice is to ignore all claims of unreported cash income!! How do you know the seller is telling you the truth? If the seller will cheat the IRS, why won’t he cheat you? And do you really think the seller will admit to you, a stranger, that he is committing what could be a criminal felony if he thought that it could be proven? If the business’s reported sales and profits as evidenced by the IRS income tax returns don’t support a reasonable asking price for the business, walk away. Find another business to buy that is run on the up and up. It’s your money and time you are about to risk — don’t risk it foolishly.
Always Assume There are Skeletons in the Closet!
Other things that you must watch out for are the “skeletons in the closet.” These are hidden problems that many businesses have and which may be motivating the seller to unload. You’ll have to be sort of a detective to find these, but I’ll list a few here so you get the idea of what to look for:
- credit problems with banks and/or suppliers
- personal affairs of the seller that may affect his ability to sell the business (e.g., divorce, death of a partner, argument with a partner, etc…)
- historic downward business trends in the seller’s particular industry
- downward business trends for this business in particular
- recent bad publicity, bad reports at the Better Business Bureau, etc.
- expiring patents, licenses, franchise agreements, etc…
- changing franchise terms that will increase operating expenses
- an impending or actual zoning change that will hurt business expansion
- major new competition (such as a new shopping center)
- increasing difficulty or expense in getting raw materials, products, or services
- the potential non-renewal of a major sales account
- significant increases in rent to be expected (if the business space is leased)
- unapproved existing variances in violation of zoning regulations
- leases that are non-assignable or non-renewable
- legal claims, encumbrances, and liens against the business
- pending litigation against the business
- state and/or federal law violations that will require a major expense to correct
- poor management of capital assets requiring near-term replacement
- obsolete machinery, overvalued inventory
- partner and/or shareholder who may not concur with the seller’s desire to sell
- unpaid taxes (income, sales, FICA)
- product obsolescence
- potential major increase in product liability insurance
- potential labor union or other employee related problems
- inability of a buyer to replace a “superman” employee
- non-compliance with environmental and/or safety requirements
- recent suspension of a liquor license for regulation violations
- need to hire a policeman to handle rowdy customers at certain times
- etc, etc…
So What Should You Do?
Although buying an operating business is filled with many potential pitfalls, it is still one of the best ways for a beginner to get into business. An existing operating business has a proven track record, an existing customer base, a well known name, location, marketing and sales strategy, etc. If you buy the business properly, without overpaying and not taking on any fatal skeletons in the closet, you’ll have your instant piece of the American dream to be your own boss and to control your own financial destiny. Get all of the information you can to educate yourself about what to look for and what to look out for. Study the particular business that you are interested in and don’t let anyone push you into buying. Tens of thousands of successful business sales take place every year and the key to a successful transaction is information and knowledge on the part of the buyer and the common sense to apply it. One good way to get this information is to read Strategies for Successfully Buying or Selling a Business! Written by the author of this article.
(excepted in part from the book “Strategies for Successfully Buying or Selling a Business“) – Russell L. Brown