Author: Louis Cowell, CFA
Louis is the Head of Investor Relations at EquityNet.
Perhaps you’re tired of working for someone else and would like to be your own boss. Or maybe you’ve owned a small business for a while and are looking to grow through acquisition. Regardless of why you’re in the market, there is a laundry list of things to consider before you put your signature on that final purchase contract. This article will guide you through the process.
It’s important for you to understand both your motivation for buying as well as the seller’s motivation for selling. If you’re new to the whole idea of being a small business owner and think that you’ll tell a few business brokers what you’re after and start mulling over bids a few weeks later, think again: With that mindset, you’re better off putting your money in an index fund. If you’re going to do this the right way, you’ll probably review at least a couple of hundred businesses before you plunk your money down.
As far as the seller’s catalyst, at the risk of sounding a bit morbid, there’s nothing better than a forced sale, for example, death or failing health of owner, divorce, irreconcilable/fistfight-inducing differences between co-owners, etc. What you don’t want is a business that has simply plateaued without a promising plan to improve.
You’ll want your personal finances to be in good shape pro forma for the purchase of a small business. (Note: Those in the financial field love the phrase ‘pro forma,’ which describes assumed or forecasted information.) The reason is pretty simple: If you are going to finance any part of your purchase, you’ll probably need to provide a personal guarantee, which only helps your loan application if, for example, you have good pro forma ‘liquidity’ (that is, cash in the bank), significant equity in your home, or other readily-salable assets.
Ideally some of your purchase price will be financed by seller debt, which effectively lets you defer part of the purchase price until the debt’s maturity in exchange for interest payments. It’s usually subordinated to bank financing with a slightly higher interest rate. Terms are highly negotiable, and seller debt does provide some reassurance that the seller thinks the business can succeed without him.
It’s important to have a clear sense of how you’ll finance your purchase. A typical pro forma capital structure might be 30% cash equity, 20% seller note, and 50% bank financing. As an example, if you pay 2 times Seller’s Discretionary Earnings of $200k (more on ‘SDE’ here), then your capital structure might be $200k bank debt, $80k seller note, and $120k equity. If interest rates were, say, 7% for the bank debt and 9% for the seller note, then interest expense would be about $21k, easily covered by SDE (you might be able to do more debt here if capex isn’t too big a percentage of SDE).
Unless you’re a ‘strategic buyer’ (that is, you already operate a company in the same industry and are buying for cost/sales synergies), you want to find a business with stable profits, and specifically has the following attributes:
‘Potemkin Village’ is a great expression, defined as an impressive facade or show designed to hide an undesirable fact or condition (some believe that an 18th century Russian prince put up fake settlements to fool the Russian Empress, his erstwhile lover, during her journey to his region; according to legend, the settlements were disassembled after she passed and re-assembled farther along her route to be viewed again as if new).
When looking for a business to buy, don’t be fooled by Potemkin Villages: If you tell the owner of a struggling car wash that you’ll pay him a visit on Tuesday at 3 PM, he’ll make sure it’s busy, even if he has to have his near-blind, 96-year old auntie behind the wheel of one of the idling cars. When you do find a company worth giving a closer inspection, you’ll need to do some serious detective work:
If you find a prospect worth more work, you’ll need to dissect the business in quantitative and qualitative fashion in order to answer the following questions:
Putting your money in the stock market is not as risky as, say, buying a mini-storage facility, so if you do the latter, you should price it accordingly because you need to be compensated for the additional risk, smaller size, and illiquidity. When you make your projections (and be careful about assuming hockey-stick growth or multiple expansion on exit), you should probably require a return on your equity investment of at least 25%. Putting a multiple on SDE yields a ballpark enterprise value (and potential purchase price), but you’ll need to project after-tax cash flows and make an assumption about your exit to see whether projected return is high enough. In some cases, the best assumption might be no exit, which isn’t necessarily a non-starter: For example, if you buy an asset for $100, it pays you $40 annually for five straight years, and then you simply shut it down (at no cost), you’ve earned a 29% return. If you can find a mini-storage operation like that, buy it.
If you find a business you’d like to purchase, you’ll probably sign a Letter of Intent (‘LOI’), which outlines the terms of the deal—including purchase price and assumptions, length of exclusivity period, etc—between you and the seller, and probably a Confidentiality Agreement, known to lovers of jargon as a ‘confi.’ Having signed these docs, you’ll conduct your final (and exhaustive) due diligence, which should include at least the following inspections and questions:
You’ll also need to wade through some legalese:
You’ll want to have a lawyer review the purchase contract. If you’ve been thorough in your due diligence and as thoughtful as possible in your projections, you can sign those final documents knowing that you’ve done what you can to mitigate the risks involved in being your own boss. Good luck.
Lou previously worked at Lehman Brothers as an investment banker and equity analyst. He also worked as a credit analyst at Moody's and as a debt salesman at Merrill Lynch.
EquityNet is not a registered broker-dealer and does not offer investment advice or advise on the raising of capital through securities offerings. EquityNet does not recommend or otherwise suggest that any investor make an investment in a particular company, or that any company offer securities to a particular investor. EquityNet takes no part in the negotiation or execution of transactions for the purchase or sale of securities, and at no time has possession of funds or securities. EquityNet receives no compensation in connection with the purchase or sale of securities.