How to Buy a Small Business
Feb 23, 2023
If you're thinking of starting a business, buying an existing business can be a great way to hit the ground running. However, the process of buying a small business or digital business can be challenging and complicated. In this article, we'll provide you with a step-by-step guide on how to buy a small business or digital business.
How to Buy an Existing Business
Buying an existing business is often the most feasible way to become your own boss. Small businesses are the financial engine of most developed economies. By acquiring an SMB brand, you can have immediate access to cash flow, business assets and the goodwill of the local community.
Step 1: Figure Out What Type of Business You Want to Buy
The first step is to determine the type of business you want to buy. Consider your interests, skills, and experience. You'll be happier if you buy a small business that dovetails with what you already like and have some experience in. Although you might just want to buy a business for the financials alone - by its expected return on investment - it's also important to align yourself with the business's immaterial goals. After all, the more knowledgeable and familiar you are with the business's model, products or services, customers, industry and trends, the more innovative and successful your new ideas will be.
Step 2: Search for Businesses That Are for Sale
There are plenty of ways to find the right business for sale that fits the criteria you've decided on. These include:
- Online business marketplaces such as bizbuysell.com, the largest site of its kind with more than 45,000 active listings.
- Craigslist ads.
- Classified newspaper ads under the "Businesses for Sale" category.
- Asking people in your network of small-business owners.
- Going to meetups or industry conferences to ask other business professionals.
- Working with a business broker.
Business brokers legally represent the seller, so you should be careful about conveying certain information to them (such as how far you're willing to go in negotiations). However, a broker can help you understand what kind of business you want, prescreen businesses to cut out all the failing companies, keep negotiations civil and smart and help you with all the necessary paperwork. Brokers do earn a commission when a sale goes through, but it's typically paid by the seller.
Step 3: Understand Why an Existing Business Is up for Sale
There are plenty of reasons a business owner might put their business up for sale, including something as simple as an innocuous lifestyle choice like retirement. Or, there might be a more worrisome reason, like a fundamental problem with the business. If you're about to buy a business, you'll want to know exactly why the businesses you're considering are no longer working for their current owners.
You should ask the current owners what challenges they've encountered, what they've done to try solving those problems and how those attempts fared. During every conversation with the current owner, you should ask yourself, "Do I have what it takes to meet these challenges with different or better solutions?"
Be on the lookout for:
- A poorly conceptualized business plan (there's just not a market for the product or service).
- Competitors that are far ahead.
- Existing business debts.
- Location problems.
- A brand issue.
- Inventory difficulties (the cost of production is too high, low quality is losing the business customers, storage is difficult, there's no supply and demand balance, etc.).
- Bad equipment (it's outdated and too expensive to upgrade).
Make sure you know as much as you can about the existing business's successes, failures, challenges and future opportunities. In addition to speaking with the owner about these concerns, also talk to existing customers, existing employees, locals in the area, neighboring businesses and so on. They'll give you an honest view of how the business is doing, without the bias of the seller trying to convince you to buy.
Step 4: Submit a Letter of Intent
Typically at this stage, you'll have had an opportunity to review the offer memorandum, as well as the company's P&L and balance sheet. Next, it's time to submit an LOI. Usually, you'll have an opportunity to speak to (or meet) the owner at this point - but not always.
The buyer issues a letter of intent (LOI) to the seller after both parties and the broker agrees conceptually on the price point and which assets and liabilities will be included in the transaction.
- The LOI should include the price proposal and the terms and conditions of the sale, indicating the seller's seriousness about seeing the deal through to the end.
- Reviewing and signing the LOI can give the seller and buyer the confidence to continue with due diligence.
Before submitting an LOI, decide if you want to work with a business partner and begin the early research on what type of business loan you might need.
Step 5: Do Your Due Diligence
Due diligence is a crucial step in the process of purchasing a small or digital business. It involves gathering as much information and intelligence as possible about the business you are considering, and it is essential to work with an accountant and a lawyer to ensure that you have all the necessary information before moving forward.
A good accountant can review the financials of the business you are considering, and a business attorney can represent you in negotiations and help you understand how the transaction will be structured. Before starting your due diligence, you will most likely be asked to sign a confidentiality or nondisclosure agreement. This agreement ensures that you will not disclose any confidential information about the business during the due diligence process, protecting the seller in case you decide not to proceed with the purchase.
There are several business documents, files, agreements, and statements that you should collect and analyze during your due diligence. Working with an accountant and a lawyer can help you ensure that you have access to all of the necessary information. Here are some of the essential documents that you should consider when conducting due diligence:
- Business Licenses and Permits: It is crucial to ensure that the business you are considering has all of the licenses and permits required to operate legally. Certain industries, such as food services and childcare, are highly regulated and require valid permits to stay open. Checking for proper licensure and permits can help you avoid legal complications and potential financial penalties down the line.
- Organizational Paperwork and Certificate of Good Standing: Registered business entities, such as LLCs and corporations, have organizational documents on file with the state. These documents may include articles of organization or incorporation, and they can give you valuable insight into the business's legal and financial structure. Sole proprietorships and partnerships may not have official founding paperwork, but it is still essential to verify their standing and legitimacy.
- Contracts and Leases: You should review any outstanding agreements that the owner has with vendors or customers. This can help you determine if the business has any significant financial obligations that may impact your decision to purchase. It is also crucial to review any existing leases for the business's location, equipment, or other assets, as they will affect your ongoing expenses.
- Business Financials: Before purchasing a business, you should examine its past few years of financials, including tax returns, balance sheets, and cash flow statements. It is best to have a certified public accountant audit these financials, as this ensures their accuracy and objectivity. You can use this information to analyze the business's income stream and determine whether there is a clear path to profitability.
- Organizational Chart: If the business has employees, you should request an organizational chart that shows the ranking and relationships among employees. This chart should include compensation data, management practices and processes, benefit plans, insurance, and vacation policies. This information can help you understand the business's internal structure and identify any areas that may require your attention as the new owner.
- Status of Inventory, Equipment, Furniture, and Building: It is crucial to assess the condition of any assets that you will acquire when purchasing the business. This includes analyzing inventory levels, equipment, furniture, and the physical building itself. You may need to invest in repairs or upgrades to ensure that these assets are in good working condition and meet your needs as the new owner.
Always dig into the business's assets and the existing customer base to truly understand the sales records and historical performance. A big part of this is also evaluating how much comparable businesses have sold for.
In conclusion, conducting due diligence is a critical step when purchasing a small or digital business. It involves gathering and analyzing a range of documents and information, and working with an accountant and lawyer can help ensure that you have access to all of the necessary data. By carefully reviewing these documents, you can make an informed decision about whether to proceed with the purchase and negotiate a fair price for the business.
Step 6: Negotiate and Sign Purchase Agreement Contract
When you decide to acquire a business, it’s time to sell the business at an acceptable price. It generally happens in writing, either in writing, a non-binding offer or verbatim. If your offer reflects the amount of cash offered by the seller they will begin negotiating. Most commercial transactions require going back and forth to negotiate different purchase costs or conditions before reaching an enforceable final contract. These terms are subject to change after a due diligence investigation.
Evaluate the price of the business with the earnings, assets or market approach
Many deals can fall apart because the buyer and seller place very distinct values on one or two businesses. In the past, buyers have used price models to determine a ballpark number and frame negotiations. During such an exercise it can become useful to consult with an expert business value analyst. Valuation services are available online and by mail, but they can save your money by giving you a good price.
Use income-based valuation methods
The value of businesses is determined using the expected revenue of any business using an income approach to valuing the business. You'll want to look at the sales price in relation to EBITDA and seller discretionary earnings (SDE) to determine the multiple and if it's in line with market averages.
Step 7: Secure Financing
Obtain financing through either traditional bank loans or the SBA can take several weeks. It's best to start the process early by getting your own tax returns and financials lined up.
Use Seller Financing
Sometimes, the seller is willing to hold a note or accept a fixed payment as a lender might do. They can then guarantee income for the next month and/or year according to your program. The rules for selling the product may be different unless it includes another form of financing. For example a seller must be on standby for the same loan as the SBA, ensuring the buyer is aware the money can only come in after you repay your loan. Many sellers will also offer to trade some of their own property for less than the original asking price.
Final Tips for Buying a Small Business
A business purchase is a huge decision. If you are successful at hiring employees, growing existing cash flow and improving business operations, you'll have a fantastic opportunity for building wealth.
When does buying a business make sense as a business investment?
Investing experts encourage the younger generation of business owners to invest. Anyone willing to take the plunge into a new business could also prove to be an excellent business acquisition candidate. The business buying process is not simple, but is extremely rewarding. If you can find a company with a proven track record and a strong business model, you'll have a chance to grow future cash flow and ultimately, generation wealth.
Consult with a business broker
Once you begin searching online or even calling local small businesses, the logical next step when buying an existing business is to consult with a broker (or several). Most of their services are offered for free. They can provide a CIM (confidential offer memorandum) for various listings and even help you review the financial statements.