Thinking about joining the club of 32 million small business owners by buying an established business?
Well, congratulations on taking your first step towards becoming a business owner – research!
Do you know the saying “knowledge is power”? That certainly applies to the process of buying a small business.
So then, your next step is – keep reading and learn how to buy a business!
Becoming a business owner can be both an exciting and daunting prospect. The exciting part is dreaming about printing business cards and t-shirts, redecorating, and inviting your family and friends to the “under new management” grand opening.
The thing is, in order to get to your ribbon-cutting ceremony, you first have to go through several important steps that will ensure that you purchase your new business successfully.
Don’t worry though! We’ve done the research on how to buy a business for you.
We’ve identified 5 important steps to take while trying to find a business to purchase. These 5 steps can serve as a roadmap to take you from where you are now – considering buying into a small business – to becoming a real live small business owner.
So, let’s get you started on that!
Step 1. Find a Business to Buy
We don’t recommend just Googling “businesses for sale” or “business on sale” and combing through the hundreds of websites that appear in over a billion results.
Where do you start, then? Start narrowing those 1 billion search results by answering these 5 questions:
1. What do you know how to do? – Warren Buffet, arguably the top investor of all time famously advised: “Never invest in a business you cannot understand.” Prioritize businesses that operate in a sector that you know and understand, or which require skillsets that you already have.
2. What do you like to do? – It’s easier to succeed in business if you like going to work. Do you like interacting with people all day? Or do you prefer working from home?
3. What do you want from the business? – Is your goal to earn a living for yourself? Is it to build up an existing business so that you can sell it at a really high price? Are you buying an existing business for side income?
4. What will you do in the business? – Do you plan on running the business full time? Or, are you hoping to hire a manager and be relatively hands-off? How much time are you willing and able to commit to the business?
5. What can you pay to buy a business? – We’ll discuss how to budget for buying a business later, but before you start searching for potential businesses to buy, make sure you have an idea of what you can afford or what financial risk you can bear.
In addition to these 5 key questions, in our article 41 Essential Questions to Ask When Buying a Business, questions 29-35 provide some ideas for what to think about before you start looking to buy a business.
Make sure to check them out!
What’s next? Once you have a better idea of what kind of business you want to buy and why it’s time to start searching for a business. But where, if not Google?
Here are some common ways to find small businesses for sale:
- Business brokers
- Online business marketplaces (like UpFlip’s marketplace)
- A business you are currently employed in
- A business you frequent a lot
- Newspaper and online ads
- Friends’ and associates’ word of mouth
- Commercial real estate agents
- Trade associations
Step 2. Determine Your Budget and Financing Options
Many of your answers to the questions in step 1 will help you to think about what your budget for buying a business should be and decide realistically what you can afford, taking into account that running a small business presents a set of financial risks.
So, you’ll need to take stock of your current and future financial picture. This is the first step in starting to think about how you will finance a business purchase.
Budgeting is a bit of art and science, so it’s time to get creative!
You will want to create a personal budget that takes into account how much you plan to spend on a business (a down payment plus monthly payments), what kind of salary or income you hope to gain from the business, any income you will lose after leaving your current job, upcoming big expenses (like a car purchase), business starting expenses, and so forth.
Need more guidance in figuring out your financial situation? Here’s a guide to making a personal budget.
In the budgeting process, make sure you begin preparing financial information to present to a seller or bank who will want to determine your creditworthiness. You can obtain your free credit reports here.
You’ll also want to prepare bank statements to show proof of funds, get your past tax returns together, and think about what collateral if any, you can pledge in exchange for financing.
Once you better understand your financial picture, you can turn your sights to financing options.
So, what are they?
There are generally 3 categories of financing used to buy a small business:
- Seller financing
- Business purchase loan
- Alternative financing
1. Seller financing from the business owner
Sixty to ninety percent of small business loans involve some degree of seller financing. With this type of funding, the business owner provides a loan to cover some or all of the purchase price. The buyer provides a down payment and pays the seller back with installment payments that include interest.
There are many advantages to seller financing, which is why it’s such a popular funding source for the purchase of small businesses. This method of financing allows a lot more room for negotiation on financing terms such as the amount of down payment, interest rate, and monthly payments.
Tip: The willingness of a seller to finance a sale, and the degree to which they are willing to finance you, is a good indicator of how much they believe in the business and how confident they are in its ability to generate enough cash flow, if not to pay you a big salary, at least to pay them back over several years.
2. Business purchase loan from a bank
Since a seller is unlikely to finance the entire purchase price, many folks who are buying an existing small business will consider taking out a loan to fund the difference.
One of the most popular sources of loans to buy a business is the Small Business Association (SBA) loan program. The SBA provides a variety of government-backed loan programs to small businesses that are executed through approved banks and lenders. Contact your bank to find out if they are an SBA lender. If so, they can guide you through the requirements and the process.
Tip: The Small Business Association provides a wealth of information, classes, and supportive resources for free that can assist you with buying an existing business. It’s a good idea to check it out.
What about other types of bank loans?
It’s generally more difficult to get a traditional bank loan to fund the purchase of an existing small business. In some cases, however, when the price paid is very close to the value of assets and equipment of the business, a bank may be willing to lend against the value of the business assets that are pledged as loan collateral.
One other bank loan option, if you are sure about the viability of the small business you want to purchase, is a home equity loan. For these loans you borrow up to 80% of the value of your home, pledging your home as collateral. While somewhat risky, the advantage of these loans is that they typically have longer payback terms than personal loans.
Tip #1: The SBA has a loan program specifically for women-owned businesses. You can find more information on it here.
Tip #2: If the business you are buying an existing small business that has a bank credit relationship already and if your creditworthiness is good, you might want to try and obtain a loan from that business’ bank. The bank will know the business you are purchasing more intimately and so might be more receptive to lending.
3. Alternative financing methods
There are many reasons to explore alternative methods of financing including a lack of immediate funds for a down payment, poor credit, or simply because you want to diversify your financial obligations.
If you are currently working in a company that you’d like to own, an owner buyout plan may be an option. A little-known secret is that the majority of business owners (aka Baby Boomers) do not plan their business exit, yet they expect the sale of their business to fund their retirement.
What’s more, the majority of existing business owners have their personal assets locked up in the business.
A study by the Exit Planning Institute found that most soon-to-retire business owners have trouble selling their small business because they haven’t planned for it, as the following results from the study show.
What does this mean for you?
Well, particularly, if you are planning on buying a small business with no money in the bank to commit, you might consider trying to buy out your current employer or targeting a company to buy where you can work while you buy out the owner.
Technology has enabled new types of personal and business lending platforms. Popular examples are Funding Circle, Street Shares, and Smart Biz. These platforms offer an alternative to traditional banks. For a more complete list of newer lending platforms check out this article on peer to peer lending sites.
If you’ve been squirreling away money into your retirement plan, you don’t have to forego the opportunity to be a business owner. Under current rules (as of May 2020) you can borrow up to $100,000 from your retirement account or 50% of the vested value, whichever is higher.
For more information on taking money out of your 401k, read this Investopedia article.
Friends and family
Remember Apple was started in a garage?
We now live in a world of Go Fund Me and career entrepreneurship. Don’t underestimate the power of asking friends and family to help you buy into an existing business. The fact that you will be personally held responsible to pay them back is also a great way to make sure that you don’t take unnecessary risks in buying a business.
Using credit cards to fund a business venture is the definition of a “shoestring budget”. You’re more likely to use this expensive alternative to fund business expenses once you’re the owner. However, if you’re short $10,000, even $20,000, on the sale price credit cards could be your last financing resort.
Step 3. Do Your Due Diligence
OK, you’ve thought about what kind of small business you should buy and how much you can afford. Then you’ve identified an existing business that you want to own.
Now what? How on earth do you buy a business?
Well, buying a business is a little like dating someone for a long time before putting a ring on their finger. You’ve got to take the time to get to know them and uncover and resolve any, err, issues before you put a ring on that finger.
As we said earlier, you need to do your research. Due diligence is a fancy word for research. There’s a lot of research that goes into evaluating an established business for sale. Don’t let it put you off though, it’s actually a good thing!
Due diligence also affords you the time and opportunity to get to know the ins and outs of running your potential business before you sign on the dotted line.
As they say, time is money. The time you spend researching a small business for sale that has caught your interest will either save or earn you money down the road.
Another reason to make sure you do enough due diligence? People lie (gasp!)
According to Andrew Cagnetta, President of Transworld Business Advisors:
“Approximately half of all deals fall apart during the formal due diligence stage, and one of the most common reasons this happens is due to the buyer uncovering an issue which the seller did not disclose earlier.”
What to look for when buying a business
There are several critical factors to investigate when buying an existing business. We outline the major items to check off here.
We previously mentioned that 65% of small business owners have never had their financials audited. That means they have been running the business books according to their own rules. If the business has a bookkeeper or accountant, have them take you through the financials.
To be sure that you get an honest view of the business performance, you’ll need to see several years of financial records including cash flow statements (most important), balance sheets, accounts payable and receivables, and debt.
Look for patterns in the financials such as increasing debt or increasing receivables that might signal trouble. Are sales and net income growing or declining? Likewise, look for opportunities to better manage the financials once you take over to increase the value of your investment.
Those with a stake in the business include employees, a customer base, suppliers, landlords, financiers, etc. Look at employee files including contracts, benefits, and compensation. Talk to employees to learn more about the business and identify issues. Talk to suppliers and assess if they are reliable.
Most importantly, look at the customer base of the small business. This will be your bread and butter, what pays your bills. Is the customer base growing or declining? What are customers saying on social media? What kind of reviews do they give?
Make sure to investigate if the business has had any lawsuits. In addition, for any major contracts, you might want to have a lawyer review them to make sure they are sound. For example, if the business has a lease that forbids someone else from taking it over without the landlord’s permission, you won’t want to sign a sale agreement until you have that permission in writing and with terms you can accept.
Other legal issues to watch out for include liens against property, business license requirements, regulatory and compliance requirements, and violations thereof.
Required seller disclosures
Speaking of sellers not disclosing information, there are Federal laws that mandate certain disclosures by sellers. It’s a good idea to familiarize yourself with these. This video by the Federal Trade Commission explains the requirements of the “Business Opportunity Rule” which mandates business sellers to provide a one-page disclosure document with specific information to buyers, for example, to support any earnings claims about the business.
Other important information to investigate
The more you dig, the more questions you ask, the more parts of the business you research, the more educated you’ll be about the next two steps, and about running a business in general. So here are some other factors to nail down in your due diligence:
- Buying assets vs. business entity – Are you buying just the corporation, partnership, or LLC? Which assets/equipment come with the business purchase and what are they worth?
- Owner involvement – Is the owner willing to remain for a while after the sale to teach you the business?
- Key employees – Will they stay and under what conditions? Do you want them to stay on? Can you let them go?
- Taxes – What items might the business allow you to write off? For what taxes is the business liable?
- Insurance – What kind is required and what does the business currently have? Will you be able to take over the policy?
Feeling like you might need a checklist at this point? SCORE, a national organization that provides free mentoring to small business owners, has a downloadable checklist for what to investigate when buying a business. You can download it here.
Tip: If at any point in your due diligence the seller cannot provide you with definitive information and answers or does not want to do so, that’s a good sign that you should move on in your business search. Remember there’s a 50% chance that the seller is not disclosing something you should know!
Step 4: Determine a Value for the Business
After you’ve taken sometime poking around under the hood of the business, you’ll have a much better idea of what’s there and what it might be worth. You should also have a better idea of what you’re willing to pay. You’re going to use this information to decide on your offer price.
How to evaluate a business to buy
Determining a fair value or price at which to buy a small business is, like budgets, a bit of art and science. It’s important to understand how to value a business because chances are the owner may not have done any official valuation of the business, although they most certainly will have a sale price in mind.
For an in-depth guide to evaluating a business, we recommend you read our comprehensive guide here. In this guide, we outline the potential challenges of valuing a small business, and describe several different valuation methods, weighing the pros and cons of each. We also provide an example to use as a reference.
Don’t have time to read all that? Here’s the super summary of five approaches you can use to value the business you want to purchase.
- Asset-based method – This is what it sounds like. The value is determined by adding up the value of all company assets. Asset value minus liabilities equals company value.
- Revenue Method – This method of valuation simply relies on taking the top-line revenue or gross sales and applying a multiplier to determine the maximum value of a small business. The multiplier can be less than one, or up to 2x typically. It will depend on the industry, economic environment, and business performance.
- Discounted Cash Flow (DCF) – DCF is one of the most heavily used methods to value a business. This method takes the business’s projected future cash flow and the time value of money to determine the current value. The concept of DCG is best expressed by Aswath Damodaran, author of the book The Little Book of Valuation:
“…we observed that the value of a firm is a function of three variables—its capacity to generate cash flows, its expected growth in these cash flows, and the uncertainty associated with these cash flows.”
- Income Stream Valuation – This method of valuation differs from DCF in that it looks at cash flows over a specific period of time (rather than projecting them out into the future). Alternatively, it uses other income streams such as net profit, earnings before taxes, operating profit, or earnings from a specific period only. These are then discounted at a rate reflecting the business risk.
- Range of Values – This method combines each of the previous methodologies and tries to derive an agreed-upon valuation through triangulation. With this method, the business owner or buyer can add other factors that affect business value. For example, if an owner knows that a small business has been lacking, he/she can indicate in the final value that with better management, the company could be making more and hence increase the value.
Do numbers freak you out?
If after reading about valuation methods, you’re feeling a bit unsure about the whole process, you may want to enlist the assistance of a professional appraiser.
If you can’t afford one or want help, a great option again is SCORE. SCORE provides free business mentors that can assist you with all aspects of buying and running a business including valuation.
Step 5: Create a Business Sale Agreement
Drum roll, please.
If after all that due diligence and number crunching, you’ve agreed on a sale price with the business owner, you’re ready, to use the previous dating metaphor, to put a ring on it. You do this by executing a business sale agreement.
The sale agreement should capture every detail of the sale so that the seller can transfer ownership to you on the closing date without issue. Yes, it sounds complicated and it is. This is because you want to protect yourself and make sure to cover all the potential risks in the agreement. So, if you can afford it, it’s a good idea to have a lawyer help you draw up and review your agreement.
Don’t like paying lawyer fees?
If you have some degree of trust in the business owner and feel pretty confident about the transaction you can access templates for sale agreements from a variety of sources such as LawDepot.com, nolo.com, and LegalZoom.
Following is a high-level outline of what should be in your sales agreement.
- Who is selling the business
- Who is buying the business
- What the business is – assets or entity, and what assets are included.
- Sales price – for assets such as inventory, equipment, and receivables.
- Liabilities – who is responsible for pre-sale debts, lawsuits, liens, back taxes.
- Payment terms – deposit required, payment to be made at the closing, promissory note, other seller security.
- Liabilities – how they will be addressed and by whom
- Representations – seller and buyer
- Noncompete agreement – restrictions on the seller
- Seller agreement to stay on – doing what, when and for how long
There are other legal clauses and language that will need to be in the agreement, but the above factors are some of the most important details to outline.
In addition to the sale agreement, other legal documents will need to be drawn up including the promissory note (for seller financing), a bill of sale, a lease assignment, and others.
By the time you get through these five steps and have examined the other resources that we’ve referenced throughout this article, you’ll have learned a lot about what it takes to find, vet, value, finance and make an offer for an existing small business that could become your key to success and happiness.
So, after reading this, what’s it going to be for you: stay in your job, start your own business, or buy an existing one?