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The Complete Guide to Buying a Small Business.

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Author: Louis Cowell, CFA

Louis is the Head of Investor Relations at EquityNet.

The Complete Guide to Buying a Small Business

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.

Motivation

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.

Money

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).

Preliminary Due Diligence

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:

  • strong reputation,
  • minimal competition,
  • is a small part of customers’ total cost, yet is also essential, and
  • is integrated with its customers lifestyles or business operations.

‘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:

  • drop by the location for a chat with the owner (unannounced if possible),
  • talk with customers, suppliers, and competitors, and
  • speak with industry and regional experts.

Deeper Due Diligence

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:

  • Does it have high operating margins? If you’re using SDE to evaluate operating profit—look for 25%+ margins. Small businesses typically sell for 1.5x to 3.75x SDE.
  • Does it have recurring customers? Making your next sale to an existing customer almost always costs you less than having to make your next sale to an entirely new customer.
  • Are customers and suppliers fragmented, so there are no concentration concerns? Would losing a single customer or supplier devastate you?
  • Does revenue come from market growth, price increases, new products, not from poached customers? You don’t want to operate in an industry where customers are stolen easily.
  • Are sales steady, that is, non-cyclical? It’s pretty much axiomatic that a small business has less margin for error: A mistake during a cyclical downturn can wreck a small business.

Purchase price

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.

Letter of Intent

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:

  • Closely review audited financial statements and tax returns for the last three years.
  • Have recent, unaudited financials reviewed by an accountant whom you trust.
  • Ask for projections but also make your own (think hard about where and why the two sets differ),
  • Closely examine Seller’s Discretionary income: Are there unnecessary personal expenses? Are there sweetheart deals that will end when the current owner sells? For example, is the current owner’s brother-in-law a top-three customer? Are one-time gains buried in operating income?
  • Look at monthly sales for a few years: Are they cyclical? Ask for sales by customer to determine concentration (is one customer 30% of sales?).
  • Determine the aging of accounts receivable. What are days sales outstanding (DSO = A/R divided by average sales per day)? How does it compare to the payment terms the owner claims to give his customers? Are the customers financially sound?
  • Look at customer returns: Are they high? Does the seller have reasonable assumptions for how much of A/R will turn into cash?
  • What are days payable outstanding (DPO = A/P divided by average cost of sales per day)? Is the current owner making his payments in a reasonable amount of time or is he delaying for some reason?
  • Are there any liens outstanding (e.g., UCC liens, tax liens, judgement liens)? Any off-balance sheet liabilities? Any weird reserves for legal judgments, etc?
  • Be sure to have additional in-depth conversations with customers, suppliers, and employees.
  • Are there “key man” concerns?
  • Is there a vital and current characteristic of the business that you won’t be able to offer (veteran or minority status, etc)?
  • Has there been significant past employee turnover?
  • Inspect all equipment: Does it need to be replaced or does it need costly catch-up maintenance?
  • Will the seller offer to sign a non-compete agreement? Or remain with the company for a transitional period? This can often help you find more attractive financing terms.

You’ll also need to wade through some legalese:

  • With the help of a lawyer, review all legal documents (articles of incorporations, trademarks, patents, etc).
  • Ask for copies of all contracts such as insurance, lease and purchase agreements, employment contracts, sales agreements, etc. Look for change of control provisions.

Final Purchase Contract

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.