Buying a Business? Facts, Not Fortune, Will Keep You From Behind the 8-Ball

Why do our brains work differently when we read the biz opps section of the paper? Why do we say things like: "I’m tired of selling tires, I think I’ll open a frozen custard stand?"

If you already own a fast-food franchise the idea may have merit. But if you’ve never dealt with a county health department, teenage employees, hoards of little leaguers and public loitering, this probably isn’t a good idea.

Many tire dealers have purchased non-tire businesses and have been successful. Some own franchises like Wendy’s or Pizza Hut while others are operating small profitable businesses of every stripe. Most dealers who expanded their domain by buying another business, however, stayed close to home and bought out another tire dealer or vehicle service business.

But success didn’t come to these people until they were well prepared for what they were about to encounter. It’s what due diligence is all about.

Doing your homework, preparing a prospectus and thinking about what it all means are what separates the guy in the Infiniti from the guy in the Yugo.

The winner is the one who looks at every aspect, from the fixed costs of the business he wants to buy to its sales revenue history, from car counts to zoning regs, from liens and taxes to a complete breakeven analysis ®“ and everything in between.

Some say the most painful part of buying a business takes place well before signing on the dotted line. This is crushingly tedious work that must be done properly or you could face disaster. Worse, without the front end work your banker won’t give you the time of day. Even if you’re on a first-name basis, he’ll still ask to see your homework. Simply put, he can’t do his job until you do yours.

Biz Plan: Stop or Go

Ideally the business you want to buy already is ®“ or has a solid chance of ®“ being profitable. And it will also tie into your strengths and skills.

Still, this is no time for complacency. If anyone says the business in which you have an interest is a sure thing, that’s a red flag. Here’s a rule of thumb to follow: Trust your business instincts, not those of a stranger. To buy or not to buy is your call, one you can’t make until all homework is completed.

A big part of your pre-purchase homework is creating a business plan (see Tire Review, August 2003). As you draft this plan, don’t be hesitant about asking others for help. While working through the buying process, you’re going to need the assistance of your lawyer, your banker, your insurance agent, your accountant and almost certainly a business broker. If you’re considering a buy and don’t have this "gang of five," start putting one together now.

A good business plan meets many needs, not the least of which is your personal education. It will tell you whether to move ahead or walk away. Fortunately, business plans have a built-in alarm system. If something doesn’t add up you’ll be the first to know. A good plan isn’t a headache; it’s a safeguard to your financial health.

Along the way you may discover that the banks in your part of the world aren’t interested in making loans for the purchase of a business. This is your cue to look into seller financing. Typically, down payments fall into the 30% range, but through seller financing this number can drop into the 20% range.

Broker experts say it’s a good sign when a seller is willing to finance the sale of a business with a low down payment. It tells you that the seller not only has faith in his business but in your ability as the new owner to continue operating the business at a profit.

How Much is It Worth?

The valuation of anything we buy is always a bone of contention. It’s no different when buying a business. Since brokers work for the seller it would behoove you not to lose sight of that fact. In other words, it’s okay to approach all of the information provided to you by the seller and his broker with some skepticism. Make it clear that the numbers must make sense. If they do, your chances of getting burned will decline dramatically.

Like a real estate agent selling a house, the broker will present his client (the seller) with a minimum and a maximum selling price. The broker will also provide the seller with a report that explains the forces that drive the value of the business, including what steps can be taken to enhance the value even more.

To get to these numbers, the broker will project the amount of cash the businesses will likely provide over its lifetime and look at current interest rate levels.

According to Russell Brown, a business broker, a business value only makes sense when it’s based on the capitalized earnings stream. "Capitalization is simply the process used to determine today’s value and the stream of future earnings," says Brown. "Most small businesses sell for a price in the range of two to five times earnings before interest and tax expenses are deducted."

Once a price range and its justification are established, you and the owner will still have to agree on a fair purchase price, as well as terms and conditions. If the purchase includes physical property (land, buildings, etc.), you’ll want to ask your banker to send out an appraiser to estimate its fair market value.

There must also be an agreement on which capital assets (vehicles, equipment, tools, etc.) are to be included, as well as establishing any remaining purchase or lease payments due on those assets. And you will also have to establish a value for any existing inventory, and it’s current status and condition.

Then you need to agree on the terms of payment. Often, businesses are purchased on an installment plan with a sizable down payment, either with your bank or through seller financing.

Meeting with companies that supply the business you’re interested in is always a good idea. You will probably need these suppliers in the future, and having a good rapport from the get go will help. This will also help you understand pricing and payment issues impacting that business.

Be sure to get with your accountant and study closely such things as income statements, balance sheets, ratio analysis and median financial operating ratios, among others. The health and potential of any business is behind the numbers.

You must understand the "cost of doing business" for the enterprise you want to buy. Take a close look at expenses, everything from salary, taxes, rent and utilities to advertising, travel and entertainment and bad debts. And depending on the type of business, your due diligence should include looking at market and customer make-up, car counts and street traffic (as applicable), the kind of reputation the business has, any difficulties it has had with local regulations, and any potential changes (zoning, land use, street repairs, other regulations) that may have an impact on your ability to succeed in the future.

Frankly, you need to consider everything. And the list can get long. This is why you should never attempt to buy another business on your own. You are going to need experienced help to get through all the tangibles and intangibles.

Watch Unreported Income

In trying to justify their asking price against the business’ reported profits, sellers may claim they’re taking large sums of unreported cash out of the business. They may tell you these "profits" more than support the asking price of the business. In fact, they are asking you to trust them ®“ the cash will be there for you, the business will deliver more than you might expect. Be wary.

It is always safest to ignore all claims of unreported cash income. The premise here is that a seller who cheats the IRS will be just as willing to cheat you. Find another business to buy is what most experts say.

The truth is every business has something to hide. As part of your "due diligence" assignment, it’s up to you and your experts to find the so-called "skeletons in the closet."

Some red flag issues include credit problems with banks or suppliers, recent bad publicity, bad reports from the Better Business Bureau and major new competition being planned two blocks away. You must also conduct some deep research into such matters as legal claims, encumbrances and liens against the business.

Looking at the Flip Side

It’s impossible to look at the buying side of acquiring a new business without looking at the seller’s side of the equation. Someone owns the business you want to buy. Their business may have been for sale for months or just a few days. Either way you need to know.

You may have seen their "Business For Sale" ad on the Internet. A business being sold online is often a sign that the seller has never sold a business before and doesn’t know where to begin. Or the seller may have been trying to sell for a long time with no luck and is looking for a wider audience. Perhaps the business is highly specialized with few qualified buyers who might be interested.

Included in most seller ads are such basic things as asking price, annual gross sales, net income before taxes, adjusted net income, required down payment, and terms (interest rate and note length).

You will also see a dollar figure provided by the seller for the value of the real estate, fixtures and equipment and inventory. If you don’t see find this information in the sale information don’t let it slide. These are critical numbers that can become deal breakers.

Again, go back to your experts and ask for their advice. Expect to hear some warnings. You may be advised to require a statement from the seller stating that all taxes have been paid and the buyer (you) assumes no liability for any unpaid taxes.

As the buyer of even a portion of a business, you may be held responsible for the previous owner’s liabilities ®“ regardless of any contractual language to the contrary. Make sure that the seller provides proof that there are no hidden liabilities.

In the state of Michigan, for example, the Department of Treasury will provide a tax clearance letter to the existing business owner which you may not request until the time of closing or the signing of any purchase agreements. If you are in a hurry to buy a business in Michigan ®“ or any state with similar rules ®“ ask the seller to escrow sufficient monies to cover any potential tax liability until you have the tax clearance letter in your hands.

There is also the matter of successorship. When you buy a business, you become the successor employer. Does the business you want to buy have employees?

Why all the questions? Because a successor employer (you) inherits the unemployment account of the predecessor. If their unemployment account has a negative balance the successor (you) will pay a higher than normal unemployment rate, possibly as much as 10%. Since the annual rate is based on the benefits charged over the last five years and the balance in the account, it is possible that you could pay the higher rate for five years out.

How do you avoid this pitfall? According to the Michigan Economic Development Corporation, you should request a disclosure letter from the seller. Next step: Contact the unemployment bureau and ask for the amount of the benefits charged over the past five years and the reserve balance (positive or negative).

Your request should be in writing and should be accompanied by some form of commitment to purchase the business. When you receive the information, what do you do? If the report is bad should you look for another business to buy? Not necessarily. Include the higher cost into cash flow and profit projections. If the business still looks like a winner, buy it. But you may want to offer less for the business since you’ll be assuming a long-term liability.

While it’s impossible to cover every "red flag" issue you might encounter in a single article, looking at a few problems and solutions is helpful. Again, your "gang of five" is important to the process. Before you decide to buy or walk, be sure to have them in place and ready to look over your shoulder at a moment’s notice.

You can’t, and shouldn’t, try to buy a business on your own or only on the word of a broker. That is not to demean brokers, they do their best. Rather, it just makes good business sense not to go it alone.

Should the Seller Stick Around?

You should consider the possibility. Many buyers ask the previous owner to stay on during a transition period. If the business you’re buying is a wholesale distributorship with lots of customers you will want to meet all of them. Ideally, the prior owner will make the necessary introductions and provide consultation, as well. This may go on for a period of weeks or months, the terms of which should be built into the purchase agreement.

Finally, if the purchase looks solid and your team of experts concur, move forward quickly. Dragging your feet can only make the experience bad. If things bog down, do your best to be patient ®“ and offer that same advice to the seller. Be willing to stay involved in the process even if you’re tired or discouraged.

Buyers and sellers often get to an arm’s length point in the negotiations when it seems as if nothing is happening or things are turning south. This is where you let your team of experts take over the negotiations while you recharge.

Above all, remember you’re the one holding the cards. If the deal is going to go through it will be your name on the check that makes it happen.