Growing Your Business in Chunks
One of the 3 ways to grow your business is to acquire new customers. Most business owners do this incrementally, through their normal marketing and sales process.
But there is another way to get new customers in a large group: buy a competing or complimentary going concern business.
This option has some distinct advantages, as well as big risks if not done properly and with help.
The first advantage is something marketing doesn’t offer: a funding source. In most small business purchases, the seller finances part of the purchase. So, when a deal is structured properly, the existing business’ cash flow gives you the money to pay the seller.
Also, if the business is similar to your existing operation, you can reduce or eliminate back-office operations or overhead and increase profit.
You’ll be able to grow profit by selling more to each customer and getting them to buy more often (look at last month’s column).
As a result, you can let the business pay for itself while it pays you.
You must do your homework, though.
Buying a business is not like buying real estate. Real estate has value even if it isn’t producing income. Small businesses without cash flow are usually worth little.
To buy a business right, you need to follow certain steps, give yourself enough time to analyze the business, avoid “falling in love,” and get help from a lawyer and an accountant.
The steps to buying a business are:
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Find a suitable business.
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Conduct a preliminary investigation.
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Value/Price the business and make an offer.
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Conduct a detailed investigation
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Prepare, negotiate and sign contracts.
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Close and consolidate operations.
Finding a Suitable Business.
Finding a suitable business usually means working with an experienced business broker. A good broker can be an invaluable member of the transaction team.
When working with a broker, you should first understand the type of relationship you have with the broker. A business broker is either a single agent broker or a transaction broker.
A single agent broker is the agent and fiduciary of the seller or the buyer. A transaction broker is not the agent of either party and must keep certain information confidential.
So, if you were to tell the seller’s single agent broker you’d be willing to pay more, she’d be obligated to tell the seller. A transaction broker, on the other hand, must keep that secret. As a result, transaction brokers are better suited to facilitate buyer and seller reaching a mutually beneficial deal.
Preliminary Investigation.
Conducting a preliminary investigation of the business involves reviewing the information provided by the broker, meeting the business owner and making a physical inspection of the business. Buyers are often surprised to learn that they usually don’t get to make a greater inspection before making the offer.
Value/Price the Business.
The value of a small business is determined by the cash it produces. The listing broker will have prepared recast financial statements where the business financial statements were modified to show something called owner benefit.
Owner benefit is the theoretical cash flow produced by the business that the owner can utilize. Depending on various criteria, the purchase price is multiple of owner benefit (typically 2 to 4).
You’ll eventually investigate the financial statements, the tax returns and the amount of owner benefit. They’re not usually accurate. But, for purposes of making the offer, you assume them to be correct.
Making an Offer.
If everything seems to be in order and you like the business, you’ll move to making an offer through a signed contract or a letter of intent.
If you use a contract, you must be sure it contains all of your deal terms, such as price, amount and terms of seller financing, it holds the seller to the important statistics about the business such as gross sales and net profit, and it allows you to get out of the deal if you aren’t happy after you perform a detailed analysis. Once signed the contract is binding.
Making an offer through a letter of intent (LOI) is easiest for the buyer. It will have the same items as a contract, but less “legalese” because it isn’t binding (except, perhaps, for a confidentiality provision).
Using a LOI is not always best, though. The seller could jump to a better deal made by another prospective buyer. And the LOI is another document to prepare.
Pricing.
Of course, making an offer means you know how much to pay.
Many (if not most) small businesses are over priced. The bottom line: business value is about the numbers.
This is where the owner benefit (discussed last month) is key. After a reasonable down payment (30% to 70%), owner benefit should cover the seller financing payments; the business must pay for itself.
Depending on the amount of financing, the term is between two and seven years, and the interest rate near prime.
When the numbers work to cover seller financing and are based on a legitimate multiple of owner benefit, the business is probably priced right.
Detailed Investigation.
After your offer is accepted, you’ll conduct a detailed review, analyzing all financial records, important contracts and leases. Professional assistance is critical.
Remember small business financial records aren’t prepared with the same expertise as a larger business. Investigate behind the financial statements.
Also, you don’t want to buy the seller’s mistakes on contracts or leases. Review them with your lawyer to make sure there are no landmines waiting for you.
Prepare, Negotiate and Sign Contracts.
The contract you’ll use is one of your most important safeguards against losing your shirt. Unlike real estate there really aren’t any “standard” business purchase contracts.
Your contract must contain everything you’ve been told about the business and be specific to your deal. It must hold the seller to all of her statements about the business (e.g., income, employees, or the equipment used in the business) and her post-purchase promises (e.g., transition assistance).
A lawsuit over the purchase of a cement plant resulted when the seller told the buyer the equipment had a 250 cubic yard daily capacity. After closing, the buyer realized it was only 100 cubic yards. Of course, the equipment and business were much less valuable than the purchase price.
However, a court rejected the buyer’s claim because the contract didn’t contain any mention of the plant’s capacity. The buyer lost several hundred thousand dollars.
Your contract must also discuss other agreements the parties will sign at the closing, including non-compete agreements, lease assignments, promissory notes and security agreements.
Closing.
Once the open issues are completed, the parties meet to close the transaction. Closing should be nothing more than signing documents and delivering checks.
After the closing, you’ll have grown your business in chunks.