Before you start wading through the buying process, it's imperative to learn about common pitfalls that often trip up unwary buyers and how to determine a fair value for a business that attracts your interest, even businesses that at first glance appear to have little or no reported earnings. Mr. Gibson, who has been helping buyers and sellers for more than thirty years, helps you do your due diligence. Make it a point to gain all the knowledge you can as you think about one of the most important financial decisions of your life. Learn what constitute the elements of value, why adjustments to financial statements are important and how to determine the accuracy of financial statements. Gibson also describes how to prepare a purchase contract that will protect your interests and ensure a smooth closing. You'll read case studies that help you discover if profits are overstated or, maybe, understated as in the case of "hidden" assets. And you'll read comments from experienced business owners who wish they had known more about how to avoid the common mistakes many buyers make. The book also contains a useful study and discussion guide.
HOW TO BUY A BUSINESS WITHOUT BEING HAD
Successfully negotiating the purchase of a small businessBy John V. M. GibsonTrafford Publishing
Copyright © 2010 John V. M. Gibson
All right reserved.ISBN: 978-1-4269-3618-0Contents
Preface.....................................................................vAcknowledgements............................................................viiIntroduction................................................................xiiiCHAPTER 1 WHY BUY A BUSINESS?...............................................1CHAPTER 2 WHAT KIND OF BUSINESS TO BUY?.....................................13CHAPTER 3 BUSINESS VALUATIONS...............................................23CHAPTER 4 ADJUSTMENTS TO FINANCIAL STATEMENTS...............................55CHAPTER 5 EARNINGS CAPACITY AND OTHER VALUATION FACTORS.....................87CHAPTER 6 HOW TO STRUCTURE A PURCHASE AGREEMENT.............................99CHAPTER 7 THE CLOSING ON THE SALE...........................................137CHAPTER 8 CONCLUSION........................................................159Glossary of Terms...........................................................171Index.......................................................................177Bibliography and Suggested Reading..........................................183APPENDIX A..................................................................A-1
Chapter One
WHY BUY A BUSINESS?
There are several familiar choices available to help you reach the goal of self-employment and business ownership: (1) find a location and start a new business yourself; (2) go into business with your spouse, children or friends; (3) buy a franchise; or (4) buy an existing business. This book is about this last choice.
Going into business for oneself is becoming an increasingly popular goal for many people from all walks of life. In fact, more new jobs are created each year by the estimated 10 million small businesses in the U.S. than by all the large corporations in the Fortune 500 or by the 10,000 publicly traded companies in the U.S. Small businesses form a dynamic and growing sector of our economy and by some recent estimates provide as many as 70% of all new jobs created each year. Current data about small business and the important and expanding role it plays in the economy, even in times of economic uncertainty, can be found by visiting many web sites, among them: U.S. Bureau of Labor Statistics (bls.gov), CNN.com/small business, Smallbusinesstrends.com or Bricklin.com/smallbusiness.htm.
Finding a location and starting a new business from scratch often takes a long time and often turns out to be considerably more expensive than originally anticipated. Of course, people start new businesses all the time, but start-up businesses do not have a great record of success. Some sources suggest that 50% of all start-ups fail within the first year and 90% do not survive beyond the fifth year. Franchised businesses have lower failure rates than "stand alone" businesses but their income potential seems to be lower as well. CNN.com is also a good source of data to find failure rates for start-ups in various industries. Buying an existing business is less risky and has proven to have other advantages as well.
1. It automatically eliminates a future competitor.
2. It usually saves both time and money.
3. An existing business normally has cash coming in from the first day you take over ownership, so it can pay you a regular salary.
4. If you stay on good terms with the former owner, you may glean valuable tips and leads from him or her that will help you guide the business to its next level.
5. An established business has a credit history.
Many people who sell their businesses do so because they are looking forward to retirement, or simply to getting some time off, rather than because the business is failing or has serious problems. In every case the Seller has extensive knowledge of the industry of which the business is a part and should be happy to pass this knowledge along to you.
Former business owners often have well-formulated ideas about how their own businesses could expand and become more profitable. They know their employees, customers and suppliers' habits, quirks and preferences, and can guide you in how to deal with them effectively. And they can advise you about handling the bumps in the road that every business owner has experienced. Their experience is one of the most valuable assets that a business has.
If a business has a good credit history, suppliers will probably ship goods without requiring payment at time of shipment or requiring your personal guarantee. If the business has been established for several years and has a history of generally paying its suppliers on time (or early, to receive purchase discounts) the business will have a favorable credit history. Do not underestimate the value of this hidden asset.
On the other hand, while starting a new business, it may take a long time to find a suitable location and to develop the facilities and contracts needed to establish a profitable business and a positive cash flow. It may be difficult to find trained and reliable employees. With a "new" business, it may take months or even years before it grows to the point that it is breaking even and maybe even longer, before it can pay you a salary that matches the salary you earned in your last position. Generally, when buying an existing business, you will not lose salary during your "startup" period and you may avoid some of the typical startup costs associated with a new business. Buying one that has been around for a while provides you with a running start.
First Generation and Second Generation Business Owners. A business is often called a "first generation" business if it was founded by its present owner. The buyers of first generation businesses become second generation owners and the businesses then become second generation businesses. The differences between the two are instructive.
The first generation owner typically starts his business with little capital and with little formal business training. It is unusual to find a first generation owner who has previously worked in "corporate America." For these reasons the typical first generation owner has limited management skills and little formal knowledge of accounting or bookkeeping. He does not delegate much authority to employees. However, he usually has solid technical skills. As the business grows, this first generation owner goes through a steep learning curve, and over the years, through trial and error, he develops the policies, procedures, business forms, job descriptions and vital contacts that enable his business to survive, operate efficiently and to become (in most cases) profitable. All of these "assets" have value because they would cost money to develop, but their value would rarely appear on the Balance Sheet of the business.
Many times, also, the first generation owner mingles business accounts with his and his family's personal funds. To these owners there is no distinction between "personal" and "business." What the business earns is what they earn. Many first generation owners did not incorporate their businesses; they operate as sole proprietors and file their business tax returns on the Schedule "C" of their individual tax return.
The second generation owner, by contrast, often has less technical knowledge but extensive business training. He tends to keep "business" and "personal" affairs quite separate and, therefore, operates his business as a corporation. The corporation pays him a salary and employee benefits (funds permitting). One consequence of these differences is that first and second generation owners speak, quite literally, different languages when it comes to discussing finance and many other business related matters. A second generation buyer tends to know precise definitions to common business terminology while a first generation/startup owner may not. This is no reflection upon intelligence; it is simply a result of different training and experience.
A second generation buyer may consider buying a particular business because he sees better or more efficient ways of making or marketing a business's products or services. This is what makes commerce work; some people can see a better way of doing things and back their ideas (or hunches) by making investments—an investment in purchasing a business or, after the purchase, an investment in new equipment, facilities, or personnel. There are weaknesses in almost every business, that is, areas that can be improved in ways that will make the business stronger and more profitable. Sometimes the "better way" is to purchase new, state-of-the art equipment; at other times it is simply to operate with fewer assets (fewer trucks or less inventory) and to convert the "excess" assets to cash.
But, it is unwise for buyers, the second generation owners, to discard too many of "the old ways" too quickly. Some were learned through painful and costly experience. Second generation owners should attempt not to repeat the learning curve of the previous owner who is usually quite proud of the business he has created. It is often wise to learn why the owner is interested in selling. There are many predictable reasons but, in my experience, they boil down to one common denominator; the business has grown beyond the skills or "game plan" of the founding owner and needs fresh ideas or energy, or both, to grow to the next level. Be careful not to discard the old game plan too quickly. The following story gives one reason why.
Case History: Mismanaging Accounts Receivable
The buyer of a company with annual sales of $4,000,000 had accounts receivable aged on average to 90 days, longer than had been acceptable in his previous place of employment. He felt he could improve cash flow by implementing some new measures. So, against the seller's advice, he began to add late fees and interest to the overdue accounts. Before long many older customers canceled their accounts. The buyer did not understand the relationship that the seller had built with them. What the buyer did not know was that years earlier, the seller, who shipped orders in his company trucks, asked customers if he could ship by the truckload even when they had only ordered a partial load. Many customers agreed provided they could pay as they used the product. The seller readily agreed because truckload shipping was more efficient. However, when product left the plant, the seller booked each truckload as a sale and left the full trailers on his customers' lots. Each truckload was also booked as an account receivable, so it appeared on paper that the accounts were older than they really were.
Moral: Understanding what has been responsible for success in the past is as important as a buyer's new ideas.
HOW TO GET STARTED: The majority of small business owners will probably agree with the sentiment that "there's nothing like being your own boss." So, the first step is to be sure that you have a strong desire to be your own boss. Buyers whom I have worked with over many years tell me that another strong motivation in wanting to buy a business is to be free of the restrictions, frustrations, the sometimes endless meetings, and other seemingly unfulfilling activities that were part of their present or previous employment. For millions of people business ownership has been the best investment of their lives and a major step toward achieving their goal of financial independence. If any of these reasons fit you, you are in the company of thousands of Americans who buy or start new businesses each year because of their desire to have more control over their lives and their economic future.
Some small business owners tell me that they never doubted that one day they would be in business for themselves. When the opportunity arose, they jumped in with little hesitation. Others tell me that they agonized for months or even years while wondering if they were cut out for self-employment, or to be entrepreneurs, before deciding to buy a business. To help you make this decision, review some of the good sources of information on the web such as the web site of the Small Business Administration of the U.S. Department of Commerce: www.sba.gov/ smallbusinessplanner/ index.html. Other helpful web sites are Bizbuysell.com, bizquest.com, and diomo.com.
Let's say that you're convinced that it is more prudent to buy an existing business than to start one from scratch. Now you want to know how to get started. Buyers normally have two big questions. First: Where do I find an attractive business for sale? Second: What is it worth? Regarding the first question, if you haven't found one, there are two main resources:
1. Conversations with people experienced in the field: lawyers, accountants, bankers, business owners and, of course, business brokers and leasing agents, specialists who earn their living representing or assisting business owners 2. Reviewing the "Business for Sale" column in local and national newspapers and trade magazines and, in more recent years, looking through various internet sources. In the papers, some "businesses for sale" are offered through brokers and some are "for sale by owner."
This book assumes that you, the prospective buyer, have already found a business that looks attractive. You have finished the search process and now want to learn "how to buy the business without being had."
First, arrange to meet with the owner, or his agent, probably away from the place of business to avoid alarming employees or revealing to others that the business may be for sale. During this initial meeting, try not to sound critical or skeptical. You want the owner to like you and, over time, to take you into his or her confidence. Then, take a tour of the plant or place of business. This will probably occur outside of business hours. And jot down all questions that pop into your mind, however inconsequential they may seem.
A Word About Small Business. Businesses with fewer than 50 employees are considered small. Some economists define "small" as a business with fewer than 100 employees. A small retail establishment might have annual sales (revenue) of $100,000 per employee. A distributorship might have revenue of $1,000,000 per employee. So a business with ten employees might have revenue of $1 million to $10 million. With fifty employees, revenue could range from $5 to $50 million. The majority of small businesses, however, have fewer than ten employees and revenue of less than $1 million.
Small businesses are different from their larger corporate counterparts. The financial press and even some university curricula now recognize them as different. They have less administrative staff. Their owners have little time to study problems; decisions often must be made quickly. This includes being able to spot a good business when it comes on the market and move decisively, if the business seems right for you.
And small businesses are usually thinly capitalized. They have few lines of credit or capital reserves. And, because of these factors, they require a different style of management, a very "hands on" style of management. Owners may have to participate in every facet from handling sales, to greeting customers, meeting their bankers, loading trucks and even sweeping the floors.
A Word About Business Brokers. Brokers generally represent business owners, not the buyers. While learning about a business you found through a broker, most of your contact will be with the broker or agent (or perhaps the seller's lawyer or accountant) who will get answers to your questions. Contact with the owner is usually limited because he is busy running the business and, at first at least, does not know if your interest is serious enough for him to justify taking time away from the business. He is also inclined to protect his business secrets and any information that might assist a potential competitor.
The broker or agent's job is to save clients time and money by presenting their businesses to interested parties and, by screening, to determine if buyers are financially qualified. Business owners do not want to spend much time with buyers who are not financially qualified- they are easy to find. And if word does get out that a business might be for sale, a seemingly endless stream of buyers often appears at every seller's door, interrupting the business and alarming employees.
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Excerpted from HOW TO BUY A BUSINESS WITHOUT BEING HADby John V. M. Gibson Copyright © 2010 by John V. M. Gibson. Excerpted by permission of Trafford Publishing. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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