The Right Way to Buy a Business
Some new entrepreneurs seek to jump start sales by buying an already-existing business. Some established businesses attempt to streamline their expansion by doing the same.
If you’re considering buying a business, understand this is likely to be one of the largest purchases you, and your company, will ever make. Each business and industry is different. It is crucial to assure you know what you’re buying.
Here are 6 Steps to Take Before You Buy a Business
Step One: Know Your Options
People rarely go car shopping and immediately buy the first car they see. The same goes for apartment hunting, house shopping, and dating.
Buying a business is no different. Even if—due to the location of, a prior relationship with, or the unique niche of a business—you are firm in the specific business you want to buy, it pays to shop around. Shopping around gives you comparators—not only in price, but with regards to the nature of the business, how it’s run, and other aspects of operation and structure.
An easy mistake to make when purchasing a business is deciding to buy the business before confirming all the facts. In the world of business—particularly small and medium-sized businesses—a modest price move or limitation on the property or business being sold can turn a good deal to a bad one. Every dollar and asset counts.
Knowing all you can about comparable options will allow you to make informed decisions, not only initially, but throughout negotiations. It will also provide you with peace of mind that your offer is a reasonable one—and confidence to know if and when the deal is no longer favorable to you.
These comparables may come from investigating similar businesses, researching public information on other businesses (for example, franchise packages for those types of businesses), and reviewing materials available through trade- or industry-specific networking groups.
Step Two: Consult Knowledgeable Professionals
At this stage, you may well have plenty of information on the business. Facts and figures, in aggregate, can quickly become overwhelming—the nuances slipping by due to the volume.
Now is the best time to bring in professionals to assist with your considerations.
The Accountant: You need a numbers person—someone knowledgeable with how finances work in a business and how they should be done. The quality of a business’s finances speaks volumes as to how the business has been run and the care likely taken in other areas of the business based upon the care given to the records.
The Lawyer: It is always good to be aware of any legal issues that might arise during the process. However, the lawyer’s role extends far beyond that: the lawyer will normally take the lead in the due diligence process, will be central in negotiating the finer details of the purchase (most likely with a lawyer on the other side of the deal), and will draft the documents to assure the terms are clearly set forth in writing.
Perhaps the most important thing the lawyer will do is assist in determining how the purchase is structured. This will have drastic consequences on the liability you assume from the previous business as well as important tax consequences. Knowing what to look for, and how to posture the initial offer, will allow you to begin the process positioned to move effectively and efficiently.
The Mentor/Colleague: Whether you’re starting out in a new area of business or a seasoned entrepreneur, an extra set of eyes on a deal can be exceptionally helpful. A trusted advisor, mentor, or confidante can be an invaluable asset to bounce ideas and concerns.
Step Three: Offer/Letter of Intent
Once you—directly or through counsel—negotiate terms generally acceptable to the business you wish to purchase, you and that business agree to a Letter of Intent.
The Letter of Intent is a written document that sets forth the broader strokes of the negotiation. Do not underestimate the importance of the Letter of Intent. Although some view it as a “starting point,” that is deceptive. The major terms set forth in the Letter of Intent (including purchase price) are difficult—and may be impossible—to change during the remainder of the negotiation without risking losing the deal entirely.
The Letter of Intent should be viewed as an initial deal for major terms—based upon the information both parties have at that time. Again, a lawyer here can assist in structuring the language to reflect the intent of the parties. Drafted one way, a Letter of Intent may create an implied contract—a duty of good faith to negotiate toward a deal. Drafted differently, the Letter of Intent might expressly disavow any such implied contract. Whenever you have a written agreement, binding or otherwise, little nuances in language very much matter.
Although neither party can know for certain what new information will arise during the next phases (which can be grounds to suggest a change in the initial terms), the Letter of Intent should be based upon some degree of solid understanding of the key attributes of the business and the buyer.
For instance, a Letter of Intent usually contains things like:
- The purchase price
- How and when that purchase price will be paid (e.g. a lump sum on closing of the sale, a promissory note to be repaid over time, a combination of the two)
- Whether you are purchasing the whole company (including liabilities) or just its assets (e.g. you may want to buy the location and equipment, but use your own business name, products, menu, etc.)
- How the deal will be structured (e.g. what amount of money is allocated to purchasing what thing—this can have substantial effects on how the purchase is taxed for both parties).
Ultimately, the Letter of Intent should set forth all the major components of the offer to the extent possible. If it’s important to a party—particularly, anything where you won’t proceed on the deal unless X—then X should be part of the Letter of Intent. Purchasing a business is an expensive process; if there is a deal-breaker term for the parties, that should be discovered now before you spend another dime.
Although it is possible to negotiate the positions in the Letter of Intent later, because both parties enter into the rest of the negotiations with the assumptions set forth in the Letter of Intent, attempting to depart from those will, at minimum, cause friction and jeopardize your ability to negotiate other terms, and—quite likely—will derail the negotiations entirely.
Keep in mind: for many willing to sell their businesses, the business is not just a matter of numbers, but a culmination of years or a lifetime of hard work and sacrifice. The offer price is something more than just money; it is a validation of those effects. This causes many individuals selling their businesses to lock onto the terms of the Letter of Intent (including the amount of the purchase price). Lowering the offer or otherwise attempting to renegotiate it later can trigger a reaction based as much in emotion as economics.
Step Four: Due Diligence
The due diligence step is sometimes overlooked. Parties often fail to budget sufficient time and expense to adequately conduct due diligence—very much at their own peril.
Due diligence is the opportunity for you and the potential buyer to learn more about the other side’s business and circumstances—by requesting documents and further information from the other side.
This step requires an understanding of law, finances, and the nature of the business. For this reason, the process should be a combination of your own knowledge, with that of your attorney’s and your accountant’s.
It is strongly advisable to have an experienced attorney conduct due diligence and work with you and your accountant to assure you receive the information you need to know; discover the risks you’ll be undertaking; sort out what you need to do to continue to run the business; and determine what risks and obligations must be addressed in the purchase documents.
The information you need varies drastically based upon the nature and scope of the business. To provide an idea of the numerous moving parts, here are some of the issues that might need to be explored in due diligence inquiries:
- Information on all suppliers used by the business, including contracts (and whether those contracts are transferable to you as a buyer, and the business’ obligations under those contracts)
- Information on all customers, including contracts (and, again, whether those contracts are transferrable)
- All financials for the business—including profit and loss, debt, loans, recurring bills, operating costs, etc.
- All employment contracts—including ongoing employee rights, restrictions on employees leaving the company to compete against you with the same business model, and associated matters
- Information on any lawsuits, past or ongoing, or potential lawsuits
- Any licenses held by the business (and again, whether those licenses are transferrable, and under what terms)
- Leases (again, including if the lease is transferrable and what is required)
- Specifics on the equipment to be purchased
- What intellectual property the business uses, what of that it owns, and whether others can use it
Ultimately, you want to mitigate against potential risks and avoid any unwelcome surprises upon purchasing the business. This is your chance!
For example, if the profit sheets are favorable but the business relies heavily on special relationships with the customers (e.g. patronage by family members, fellow church or group members, below-market deals with suppliers who are friends, etc.), you need to know that before you’re left with a business that doesn’t resemble the one you were trying to buy.
Additionally, due diligence provides you substantial information on the practical aspects of how the business is run. If your plan is to continue operation of that business, you’ll want to make sure, before your first day as owner, that you have everything in place—contracts, workers, suppliers, etc.—to hit the ground running.
Due diligence is there to protect you and to prepare you for the reality of successfully running the business. Take full advantage of it. Business purchasers who spend extra time and money to fully explore their pending purchase are unlikely to regret it.
Step Five: Documents
What documents you require will depend upon the nature and structure of the transaction. There are several key points you’ll want to consider in your purchase:
- The structure of the purchase (particularly with regard to tax consequences)
- The property being conveyed (real estate, equipment, IP, cash in business accounts, etc.)
- The liabilities assigned
- The timeline for when exchanges and transfers will be made
- How current employees of the selling business will be addressed
- How the purchase price will be paid
- Any additional knowledge, training, or information required from the selling business
- What contracts the selling business has, which can be and will be assigned to you, and which you will need to renegotiate or replace
Step Six: Closing
Once all the t’s are crossed and i’s are dotted, the documents are ready to be signed. It is important to assure that, at the signing, all transfers and exchanges are in place or ready to be executed upon signature. If that isn’t possible, a formal timeline is an excellent way to keep both parties on track with expectations for a smooth and timely transfer of assets and operations.
Purchasing a business can be an exceptional way to jump-start your client base, bypass the growing pains of starting from scratch, and innovate a business already in operation.
However, it takes time, money, and patience. Many first-time business buyers think: “I’m just trying to buy this simple business. We have an agreed price. We just need the paperwork.” Unfortunately, those individuals often learn, after the fact, that there is a great deal more that goes into purchasing a business than a price. They realize too late that what their purchase price bought them wasn’t what they wanted or needed to operate a successful business.
When you are considering purchasing a business, assure you are taking the best approach to maximize the likelihood of your success. Assemble your team—your accountant, your lawyer, perhaps a business confidante—and hit the ground running.
If you are considering buying a business and have questions, contact us here.