Steps in Buying a Business – Part 1

The purchase of a business is one of the most important and risky transactions a person can go through. There are many steps that a prospective buyer must go through for the transaction to be successful.  Anyone who has done this will attest to the fact that the process is long, challenging and stressful.  However, on the other side of the coin, if a person finds a business that fits their expertise, creates a passion for the effort that’s involved and provides positive post-debt service cash flow to cover their personal and business needs, then it is worth the effort.

At Sunbelt Business Advisors, we have found that being brutally honest about the journey a buyer is going to go on pays dividends.  Rather than lose heart towards the end of a deal let’s find out early if a business acquisition really makes good sense for the buyer.  To that end, here are some thoughts on what buyers should expect and the steps we recommend in purchasing a business.

Perform a Personal Audit

Many people we meet are interested in buying a business as a way to find a new job.  Others have had a dream of business ownership for many years.  Whatever the reasons, the initial questions are the same:  are you willing to risk much, if not most, of your savings to put into the deal;  will your spouse support the decision; are you willing to have the lender put a second mortgage on your home; do you have the skills necessary to manage and add value to a business?

There is a certain amount of safety in earning a paycheck from an employer, even if it’s not a great situation.  That certainty is significantly reduced when you are the boss.  Are you jumping from the frying pan and into the fire?  You need to look into the mirror and be very honest with yourself that you can handle the stress of the unknown.  If you’re married, you have to discuss the challenges honestly with your spouse and make sure they can handle the stress and uncertainty with you.

Can you defend your decision with parents, in-laws, friends and other advisors who are generally going to a provide risk averse perspective?  If you can’t then walk away.

This may sound trite and condescending, but we’ve had deals break down close to the finish line when a buyer loses heart.

Investment Parameters

Some folks who inquire about our listings believe there are deals out there that can be done without any cash investment.  Let me assure you, those don’t exist or at least we haven’t found any.  In general, here are some guidelines for what to expect when looking at a deal:

For the most part, conventional lenders need the entire deal fully collateralized.  This is important to recognize when you are looking at a business where the price has been determined by a multiple of adjusted earnings.  The price will always be significantly more than the value of the assets being purchased.  That collateral shortfall, commonly referred to as goodwill, needs to be filled in by the buyer.  This means pledging personal assets, home equity, stocks, etc. as collateral.  We see these deals get done and are the quickest, least expensive ways to get a deal financed.  Unfortunately, many buyers either don’t want to risk all their personal assets or don’t have enough to make the deal work.

As a result, SBA loans are used most often in the deals we work on.   A preferred SBA lender will loan on the goodwill if the business cash flows with sufficient debt coverage.  For businesses with under $500,000 in uncollateralized value a down payment of at least 20% of the sale price will be needed.  This can be a combination of buyer cash and seller note.  If the uncollateralized amount is over $500,000 a minimum of 25% down payment will be required.  Additionally, the bank will require some personal assets to be pledged.  In general, most deals require at least a 10-15% down payment from the buyer.

Seller notes can sometimes be negotiated with an owner.  As stated above, this can be used as part of the total down payment required for an SBA loan.  In order for a seller to agree to take back a note they must have the utmost confidence in the buyer’s ability to operate the business successfully and repay the loan.  There are also cases where there is no bank lending involved and the entire transaction is made up of buyer cash and a note from the owner.

The bottom line is a committed buyer will need to put significant personal funds at risk in order to acquire a business.  The decision to do so must be based on the strength of the business being acquired and the well-grounded confidence of the buyer in the skills they are bringing to the business.

Other funding sources can include family and friends.  When this is the case it is our policy to meet with all parties to understand the level of commitment to the deal and willingness to loan the funds.  Uncle Fred may have said he’d support you after a few glasses of wine at Thanksgiving, but that commitment needs to be tested and confirmed before moving forward.

Buy a Business You Like and Can Manage

In the initial phase of reviewing opportunities the first and most critical factor is being able to see yourself in the role of the owner and determining that you will look forward to going to work every day.  As you are introduced to a business you need to understand the role and responsibilities of the current owner and how your skills will fit.  In some cases you want to understand the limitations of the owner (adapting to technology, for example, or lacking a fondness for the business development process) and how you may be able to improve on those limitations.

While a prospective buyer needs have the broad skill sets necessary to be successful, they don’t have to know everything about the business.  A transition plan is built into every deal in order for the previous owner to transfer as much knowledge about the business as possible.  This transition process is also focused on transferring customer relationships and having the previous owner show support of the new owner to the employees.

Next month – an overview of the step-by-step process of buying a business.