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Guide to Buying a Business - Buying a Small Business

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Buying a Small Business


This guide discusses buying a business and buy business tips. Sometimes the best way to become the owner of a business is to buy a going concern. If you are considering this option, most of the factors already discussed should be considered plus these additional points.

Advantages to Buy Business

Certain advantages may be gained by buying a going business.

  • You may be able to buy business at a bargain price, if, for personal reasons, an owner is sufficiently eager to sell.

  • Buying a business as it stands will save time and effort in equipping and stocking it.

  • You gain customers accustomed to trading with the establishment.

  • Key personnel with customer following may be willing to stay.

  • The "good will' created by the previous owner may be a valuable asset.

 Disadvantages of Buying a Business

  • You may pay too much for the business because of your inaccurate appraisal or the former owner's misrepresentation.

  • If the owner had a bad reputation you would inherit prejudices of former customers and, perhaps, of merchandise and equipment suppliers.

  • The location may be going sour.

  • Fixtures and equipment may be outmoded or in bad condition. Check carefully.

  • Too much of the merchandise or materials on hand may be old or poorly selected.

In deciding how much to pay for a going small business, consider its profit potential. Tangible assets such as equipment and inventory may be important to you, but only to the extent that they contribute to future profits. If the seller is asking a large sum for the intangible asset of good will, estimate carefully how much - if anything - it will add to your future profits. Also, determine and assess precisely the cost of any liabilities you will be expected to assume. Get it in writing!

Profit Potential

While considering buying a business, you must be concerned with the future profitability of the business. Most businesses have a natural cycle. Retail stores usually have a cycle of one year. That is, each year follows the same pattern and several years indicate a trend. Certain types of heavy manufacturing companies may have up to a 7-year cycle. Try to estimate several (at least three) cycles. Thus, in some businesses you will be estimating three to five years while in another you may be estimating future sales and profits over a 25-year period. Obviously your estimate for the next two years will be more precise than your estimate for 25 years in the future. This doesn't mean you should be careless in your long range planning. It does mean your long range estimates will be more general and subject to change.

To estimate future profits, begin by analyzing the present owner's balance sheets and profit and loss statements for at least 5 years back. Going back 10 years would be even better. Many businesses have inadequate or no records, but all should have copies of their income tax returns. Sometimes even these are lacking or, more likely, very suspicious. Some businesses have been known to prepare inaccurate tax returns. Insist on seeing accurate records. If you are serious about purchasing a particular business, consider making a deposit subject to receiving accurate business records.

You want to look at many factors and ratios from this financial data. What has been the rate of return on investment? Does it compare favorably with the rate you can obtain from other investment opportunities? How does it compare with averages for other businesses of the same kind? Have sales over the years been increasing or decreasing?

What share of the market is the business obtaining within its market area? To find out requires an analysis of the local market for the particular firm in which you are interested. What is the competition in the area, the population, the purchasing power? What are the trends? What is the outlook for increasing sales?

Are the profits satisfactory? If not, what are the chances of increasing them? Have profits been consistent over a period of years? If the last year's profit was unusually high in comparison with previous years, why was it? What is the profit trend? Have profits been increasing consistently? Have they leveled off? Started to decrease? What are the reasons for the profit trend, whatever it may be? Be sure such questions are answered to your satisfaction before you buy.

Study the expense ratios. How does the percentage for each expense classification compare with the average for the trade? The availability of average operating ratios for certain trades has already been mentioned. Comparison of the figures of the business offered for sale with standard ratios will bring out any discrepancies. In discussing these discrepancies with the seller you may become aware of operating problems which will help in making up your mind how much to pay for the business, or whether to buy it at all.

You need not necessarily be discouraged from buying the business if past profit records are not favorable. Very often the reason the business is for sale is because of recent poor earnings. Examination may reveal that these have been brought about by poor management; and you may be convinced that your management will improve the situation. By the same token, an excellent past earnings' record, in itself, should not persuade you to pay a large amount for the business without further investigation.

Ask the seller to prepare a projected statement of profit and loss for the next 12 months. Such an estimate will probably be very optimistic and should be compared with your own estimate. With a detailed estimate of the next 12 months' operation, you can compute working-capital requirements for each month. Next, estimate the value of assets and liabilities as of the end of that period. Find the estimated return on investment by dividing the projected net profit by the price asked for the business. If you believe additional investment will be needed immediately to make the business run profitably, add this to the price in your computations. The highest price for the firm which brings you a return with which you are satisfied is the maximum price you should pay for the business. Thus, an estimate of future profitability will give you the basis of a logical offer for the business.

If you are not familiar with accounting and income tax records so that you may verify records of past operations and make a reasonable forecast of future operations, have an experienced accountant or management consultant work with you to help you understand the records and assist you in your evaluation.

Tangible Assets

The most commonly purchased tangible assets, in the buying business process,  are merchandise inventory, equipment and fixtures, and supplies. If the business you plan to purchase sells on credit you probably will take over accounts receivable.

What is the condition of the inventory you are purchasing? Is the stock current, clean, well-balanced, in good condition? How much of it will have to be disposed of at a loss or given away? Make a careful appraisal of the stock. Each item should be separately priced and given a reasonable value. If at all possible, the inventory should be "aged"; that is, the length of time each group of items has been in stock over 18 months old,1 year to 18 months, 6 months to 1 year, and less than 6 months should be calculated. Usually, the older the inventory, the less its value.

Examine equipment and fixtures carefully. Remember you are buying second-hand furnishings with only a percentage of their original value. Be sure equipment is in working order. Find out its age. Obtain evaluations of similar equipment, new or second hand, from dealers. Not only should you know how much equipment and fixtures have depreciated, but how obsolete they may be. Office equipment may be in working order, but so obsolete that to use it would be inefficient and costly. Also, it may be difficult to obtain repair parts for old equipment in case of a breakdown. Store fixtures quickly become out of date. New, modern fixtures attract customers. Machines used in factories may have been superseded by far more efficient equipment. To pay an exorbitant price for old machinery, no matter how good its condition, is most unwise.

Make certain how much of the asking price is for furniture, fixtures and equipment. The business may not warrant the investment which the owner made. And, finally, find out if there is a mortgage on any of the fixtures or equipment, or if they even have been completely paid for.

If you are taking over the assets such as accounts receivable, credit records, sales records, mailing lists, or leases, investigate them closely. Accounts receivable should be aged to determine how many of them may be so old collection will be difficult or impossible. On the other hand, records and contracts involving favorable leases have real value. Make certain these are included in the sale.

Goodwill in Buying a Business

Over and above the total appraisal of inventories, fixtures, equipment, and other assets, there will usually be an amount asked for goodwill. Do not confuse it with "net worth", which is the difference between the dollar values of the assets and liabilities of the business. Rather it is the ability of the business to realize a higher rate of return on the investment than ordinarily in the particular type of business because of the favorable public attitude created by the owner. When goodwill exists, it is a valuable asset. Be realistic in determining how much you should pay for goodwill.

No fixed formula can substitute for good judgment. Since you are paying for favorable public attitude, make an effort to check it. Question customers, bankers and others whom you feel have unbiased opinions. Who will have the goodwill after the business changes hands? Does it go with the business, or is it personally attached to and will it remain with the seller?

Consider also that there may be "ill will" attached to a business. customers may be unhappy with the business. You will have to overcome these ill feelings to become successful.

The term "goodwill" is in some ways an accountant's fiction designed to explain the difference between the real price and the net worth. Accountants usually favor writing off this "goodwill" in a short period of time. A test of the amount asked is to compare it with past profits of the business. How many months or years will it take before the "goodwill" can be paid for out of profits? During that period you will, in effect, be working for the seller rather than for yourself. Another way to judge the value of this intangible asset is to estimate how much more income you will receive by buying the going business than by starting a new one.

Or compare the price asked for goodwill with that asked for goodwill in similar businesses. In other words, if you are shopping around for a business, compare not only the total prices asked, but the amounts asked over and above the reasonable value of the net tangible assets.

Liabilities

Be sure the seller pays off accumulated debts before you pay the money agreed upon in the terms of the sale, so the business is 'clear'. Find out if there are mortgages, back taxes, liens upon the assets, or other creditors' claims. Obtain full information about any undelivered purchases for which you will be liable. Although it is generally not desirable to assume any liabilities, it may be necessary in some instances. If liabilities are assumed, be sure their value is subtracted from the agreed-upon value of the assets.

The Price of Buying Business

After you have determined what you believe to be net value you will still not have reached the final price to be paid for the business. Value relates to what the business is worth. Other factors which affect the final price must be considered. Only then can you begin to determine the final price through negotiation and bargaining.

What has the seller's reputation been among employees and suppliers? Poor relationships may require extra effort on your part to establish a smoothly running organization. Make sure suppliers will deal with you. If a franchise is involved, obtain satisfactory insurance from the supplier that it will not be withdrawn.

Why does the owner wish to sell? This should be one of your first questions. Is the reason given -a death in the family, poor health, or a needed change in climate - the really decisive factor? Or does the seller know the neighborhood is changing so his specific type of business will no longer be needed; or that a new civic development, or zoning law, will affect the business unfavorably? Search for his true reasons for selling by questioning not only him but others whom you know to be reliable.

While buying business, take in consideration that some business owners have sold out only to start a new business in competition with the buyer. Careful consideration should be given to placing limitations upon the seller's right to compete with you for a specific period of time and within a specified area.

As a safeguard against costly errors, obtain legal advice before any agreement is made. The agreement should be drawn up by a lawyer to ensure that it covers all essential points and is clearly understood by both parties. Among the items covered in a typical contract for the sale of a small business are:

  • A description of what is being sold.

  • The purchase price.

  • The method of payment.

  • A statement of how adjustments are to be handled at the time of closing (for example, adjustments for inventory sold, rent, payroll and insurance premiums).

  • Buyer's assumption of contracts and liabilities.

  • Seller's warranties (for example, warranty protection for the buyer against false statements of the seller, inaccurate financial data, undisclosed liabilities).

  • Seller's obligation and assumption of risk pending closing.

  • Covenant of seller not to compete.

  • Time, place and procedures of closing.

As soon as possible after signing the contract, take possession. Otherwise, the seller may deplete the inventory and, in some cases, create ill will for you.


Other Topics in the 'Staring a Business' Section


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