So you’re thinking about buying or selling an operating business. Well, 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 and turn your dream into a financial and emotional nightmare!
I’ve been a business broker for many years and I’ve brokered the sale of hundreds of operating businesses and franchises. I’m always amazed at how much faith potential buyers put in the business broker and the seller. I’ll tell you straight out, the business broker and sellers are not on the buyer’s side! Remember, for a broker, no deal — no commission! 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 out for as you negotiate to buy a business. Here’s some of the key things you should know about before buying an operating business.
Valuing the business is not as hard as you think, but you should never completely 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 profits for you based on how much money you must put into it. 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’s value is to work backwards from the available profits that a seller can prove.
For example, let’s 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’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 deduct the income taxes that you’ll have to pay on this, probably 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 this much cash).
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 (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 values of $42,000 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.
When I say total, I 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 produce profits for you. Of course, if you change the time period for payoff of the purchase price, the interest rate, the anticipated taxes, and other factors, the price you can afford to pay for the business can go up or down.
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 a felony if he thought that it could be proven? If the business’s unreported sales and profits 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 be foolish.
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 the ability to sell the business (e.g., divorce)
- 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 or licenses
- changing franchise terms that will increase operating expenses for the business
- an impending or actual zoning change that will make business expansion difficult or impossible
- major new competition (such as a new shopping center or a new mega store in the area) being planned
- 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
- 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” seller who has a unique capability for running the business
- 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
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. There is a proven track record, an existing customer base, a well known name, location, marketing and sales strategy, etc., etc. If you buy the business properly, without overpaying and not taking on any fatal skeletons in the closet, you will 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.
Russell L. Brown