Essential elements to successfully buying a business
“5 Cardinal Rules”
In the past 30+ years I have assisted hundreds of folks successfully buy a small business, with over 97% of these businesses continuing to be successful 5 years after closing and zero litigation. In addition to this direct experience I’ve had the opportunity to observe countless unsuccessful and often disastrous transactions, whether through ex-partner brokers or prospective clients contacting me for assistance to try and clean up the mess.
I have learned and share with every buyer the 5 essential things to keep in mind when buying a business, which I have learned will greatly increase the likelihood of a successful profitable win-win transaction and minimize the risk and hassles associated with a deal gone bad.
Number 1 – Never buy a business from someone you do not LIKE.
This is first and foremost for a number of reasons. Step back for a minute and consider what is “the business”? What we see is a collection of stuff; desks, chairs, computers, fixtures, machines, tools, forklifts, trucks…….. just a bunch of stuff. Anywhere in the country, on any given weekend, you can find an auction or liquidation outfit and buy this stuff. Buyers perceive this used stuff is far below its actual in place value and they can buy the same used stuff for pennies on the dollar. We then have to add inventories to the mix. You could simply setup a wholesale account and acquire the same clean new inventory. You can place an ad or two online and hire all the folks they need to replicate employees. Next, we need a building. Frankly it’s just a facility; an alternative can be built, leased or purchased, relatively easily. So we have the “stuff”, order the inventory, hire staff and move in to a facility, have you duplicated the business?
NO – a business is in many ways a living creature, how customers are treated, how employees are dealt with, all of its operations, procedures and practices, in short everything that makes it a going concern, has the owners personality all over it. Human nature is that we like individuals who are similar to ourselves and dislike those who are not. If you like the seller, chances are good that the customers and employees will also be comfortable with you, and the operations will be easier for you to adjust to. There will be far less likelihood of dramatic changes, capable of upsetting the business. Keep in mind folks usually resist change and an ownership change can be a very traumatic occurrence.
On a personal note, it is far easier to work with people you like, rather than those you don’t and remember there will likely be a good amount of time you will need to spend working with the seller after closing. Life is too short to be involved with folks you do not like.
Number 2 – Never buy a business from someone you do not TRUST.
Does the reason for selling ring true? Does the story change? Do you get straight upfront answers when you ask the seller a question? Are reasonable documents provided? What does your gut tell you about this seller? Can you put yourself in the sellers’ shoes and from where they sit does what they are saying make sense? If the deal sounds too good to be true, it is likely not true.
The reason that this trust is critical, is that your primary source of data and the viability of your investment will be based on the financial information you are provided. Frankly, liars figure, figures lie. I see a surprising number of businesses with “cooked books”. The seller can make the numbers say anything they want them to say and you will not catch them. The integrity of the data is directly tied to the integrity of the individual. Be very cautious with super clean books and records, often the cleaner they are the more likely they are laundered. Kind of like a used car with brand new paint job, makes you wonder, yes? My preference is to see real world records which are rarely perfect; I generally go further asking the seller very specific questions related to the balance sheets in the historical tax returns, if the seller can answer, I see a big red flag. The real answer should be “I don’t know you will have to ask the accountant”, business owners generally have very little intimate knowledge of what the CPA does on the tax returns, as this is not relevant to operating the business, it simply determines the size or the check they need to write to pay taxes for last year’s performance. Your best bet is to use the same data the seller uses to make his business decisions.
You must be confident the seller is honest, direct, straightforward, realistic, and has no hidden agenda, if you cannot get to this point walk away.
Number 3 – Never buy a business from a seller who refuses to provide any FINANCING.
This is the check on number 2 trust, it is highly unlikely the seller would commit a fraud and then expect you to make payments to them. Universally, the sellers with cooked books and/or problems with the future of the business demand all cash. If you take a close look at the real dollars after tax, net net to a seller in an all cash transaction versus a reasonable five year payout you’ll see the seller is likely far better off carrying financing for you than receiving all cash at closing. If a seller tells you they do not believe the business is worth anything as collateral and they don’t believe you can successfully make the payments LISTEN to them.
Understand the reality is that no seller wants to be assisting in financing the acquisition for you and be careful, not to think real estate or other financing deals; this is not that type of transaction. Typically the seller financing in a successful business sale is in the range of 40-50% of the total deal, in my opinion not less than 50% real cash investment from you the buyer. Be aware price and terms are inversely related – the greater terms you offer the better price you will get, with increased risk of course, likewise an all cash deal may get you a substantial discount from market value. If you are unwilling to be as heavily invested in the business as you expect the seller to be don’t expect the seller to be thrilled with your deal, they need to believe your willing to go the extra mile to protect the business, your investment, and therefor their financial interest as well.
If you’re truly convinced you want to leverage to the hilt and get the bank to do the deal with a government guaranteed loan. Best of luck to you, this is a subject for another day.
Number 4 – You cannot pay for POTENTIAL
Be smart; you should not pay someone for what you produce in the future. Sellers who harp on all the untapped potential are simply trying to get you to pay for more than the business is worth. Yes you want to see opportunities exist to improve performance, discuss with the seller what they would do if you had the energy and desire to grow the business, but know that if it was easy they would have already done it.
Work in the reality of the here and now, what is the business doing today and where was it that month, last year, and three years ago. Deal in fact not fantasy. You can only buy what is known today historical fact. Do not get yourself into thinking “if I just increase revenue 20% it will make sense, it either makes sense today or don’t do the deal. You will do well to maintain the business year one, expectations of grandiose improvements will get you in trouble. We have no control what the future holds, we simply do not know. The economy, world events and countless factors out of our control could wreak havoc on the small business world.
Number 5 – This is NOT a “used car” purchase do not treat it as such.
Successful are transactions done “at will” by business people who want to work together in a true win-win fashion A business is not just a thing, it’s closer to a living creature, unlike anything else you’ve bought before. When buying a business you will be receiving copious input of knowledge from the seller, a great rapport and mutual respect is required.
Understand the fair market value of the business establish that the you can see a reasonable salary, reasonable return on investment (ROI), service any debt and leave a residual for growth or those just in case items. Recognize reasonable market price and terms and step up to the plate. Do not offer 20% less just to give you room to negotiate this is counterproductive. Just as in a “used car” deal in the end both sides end up with a bad taste in their mouths, that ‘I could’ve gotten more or could have paid less” sentiment. This will permeate the relationship during transition period and likely make working together much less positive.
Do not engage a seller who is not realistic in his expectations, agree to disagree and move on. There are realistic sellers out there, or this seller may likely comeback once they better understand the market, it is just a matter of time.
I have come to realize over the years the keys to a successful sale of the business are; the parities like and trust each another, both have skin in the game and a mutual objective the successful future for the business, have based their decisions on current and historical facts not theoretical expectations, and dealt in good faith avoiding nasty negotiations prior to the sale.