Investigate these 7 Points When Buying a Business

Investigate these 7 Points When Buying a Business

Investigate these 7 Points When Buying a Business

Buying a business can be a great move but it takes a lot of due diligence investigation. Due diligence is often thought of as “finding the bad stuff” but it is also important so that you understand what it will take to operate the business after you own it. OJT (on the job training) is helpful but preparation is even better.

Buying a Business

Know what to research

Keep in mind that these magnificent 7 aren’t the only things you need to investigate but they are 7 that are often overlooked or short-changed when buying a business.

  1. Cash Cycle – understand the cash cycle from when you incur cost to when you collect cash. 10 days? 30 days? 60 days?  Think through the stages, when do you spend money? When do you collect money? Every business has a cash cycle, dissect the steps to make sure you understand when cash is expensed and when you receive cash. If you have 10% profit you have 90% you owe other people. You’ll need to fill the “cash gap” with financing or cash injections from other sources.
  2. Hidden Costs – know the “hidden” costs in the system, warranty, call backs, inventory losses, un-billable hours, and uncollected AR. Most business owners only think about these things at year end when the CPA does the business taxes but this effects your cash every day.
  3. Specialized Knowledge – know the specialized knowledge of the current owner. Technical knowledge? Craft knowledge? Relationship knowledge? Supply source knowledge? The employees will judge you beginning day 1. Make sure you know what they expect you to know.
  4. Cash Needs -know your cash per sales growth requirements; don’t grow yourself into poverty. For every dollar in sales you’ll need to have some dollars available to fund expenses and products until you collect the cash from the customer.
  5. Pricing – understand how the current owner prices products and services.  Markup? GM? Guesses? Competitive comparison?  Is there room for improvement? Does current pricing have anything to do with the market? Who has special deals?
  6. Insurance – understand the current insurance coverages and make sure your coverages reflect your risk tolerance levels. Get an insurance audit. Make sure you review every aspect of insurance you need. Often we find sellers are under insured. Getting proper insurance could effect the biz earnings and the amount you might be willing to pay to buy the business.
  7. Licenses – make sure you research the licenses, permits and compliance requirements needed to operate the business. Don’t assume the seller knows everything. Buying a business not in compliance with current requirements is risky business.

While you may be itching to simply sign on the dotted line..

Thinking about what businesses might be for sale?

STOP:  your preparation and due diligence will save you a great deal of  hassle and surprise. Buying a business takes time, thought and research. As an entrepreneur, this is just your first step in creating a successful business.

So You have a Deal to Buy a Business, now what?

So You have a Deal to Buy a Business, now what?

Congratulations but don’t pop the champagne yet. Now is when the real work begins in your quest to buy a business.

Essentially, there are 3 fundamental phases to orchestrate before your final takeover of the company. Keep in mind that each business or industry may have several variations of the progression. Here are some general guidelines but you and your advisers may have other steps or systems to add to this buying chain.

Please keep in mind your agreement to purchase likely has important dates identified. Keep track of those dates and take the action necessary to comply with those.

Phase 1 – Initial Due Diligence and Lender Commitment

This phase is mostly about the financials of the business and your personal financial situation.

Basically your lender will want to make sure that the likely cash-flow of the business fits your overall financial situation. Get with your lender immediately and begin the financial due diligence. Your lender will provide you with a list of items they need. The goal here is to do enough due diligence to get your loan commitment as quickly as possible. Get your advisors (typically at least an attorney and CPA) lined up quickly so they can help on the tricky items

Phase 2 – Full Due Diligence

This is where you and your advisers come up with a list of everything you want to know about the business. It’s important to have the loan commitment in hand when you get to this stage because sellers want to make sure they have a qualified buyer with the funding lined up before they release very highly confidential business information.

This due diligence takes a lot of time.

You need to commit to move thru it quickly, in a very organized manner. Remember, this stage is where you personally and along with your advisors, review, confirm, and challenge all aspects of the information. When conducting due diligence, forget about what the broker or seller or your buddy has said, it’s your job to review and confirm things yourself.

Remember, due diligence is about you, the buyer, managing your risk by knowing the facts.

Put in the work, it’s important.

Phase 3 – Closing Process

This begins after you have completed Phase 1 & 2. At this stage you’ll likely be asked to release or waive the contingencies in your offer and authorize the closing company to begin preparing closing documents.

At the same time you’re working thru the closing documents, you’ll also need to be focused on what’s involved in taking over the business and all of the details.

  • Is your insurance in place?
  • Do you have required licenses and inspections?
  • Is your merchant services account ready to go?
  • How will you introduce yourself to the staff? Is your payroll service set up and ready to go?
  • Have you formed your new entity or LLC?
  • Do you have your sales tax #?
  • Do you have your Fed ID #?

Make sure you’ve created a complete inventory beginning with the above suggestions. While it seems like an endless list, knock them off 1 at a time to create an even stronger foundation for the success of your new business venture.

After Phase 1, 2 & 3 you’ll be a new business owner.

Working thru these 3 phases can be exhausting and frustrating for both the buyer and seller but we’ve had 100s of people make it thru.

Keep a good attitude, try to avoid ultimatums, stay on good terms with the seller and realize there are lots of 3rd parties (banks, landlords, inspectors, etc) who often move at their own pace.

Business Sale: Tangible vs Intangible Assets a Quick Analysis

Business Sale: Tangible vs Intangible Assets a Quick Analysis

We find a wide variety of views and preconceived notions about business value from individuals as they review a business sale. Most the time, the discussion turns quickly to the business assets. That inevitably leads to a discussion of Tangible and Intangible Assets.

Investors involved in a business sale generally have a reasonable understanding of tangible assets but usually a less than good understanding of an intangible asset. They have a tendency to use disparaging terms like “Blue Sky” or “air ball” when they don’t understand the true value of intangible assets.

First let’s try to reach common ground on some basic definitions that are commonly used but not always understood.

Tangible Assets

Tangible assets are really based on banking and lending definitions. A general definition is an asset that has a physical form. For instance a truck is a tangible asset. You can touch it, feel it and more importantly sell it. While a truck is a tangible asset that may be salable, there are other tangible assets that might have different characteristics. Suppose you own a widget shop and you have a special machine you invented that bends the widget a special way. You love the machine but it’s of no use to anyone but you. That is still a tangible asset but it has relatively low value to the outside world. The truck you can likely sell pretty easily but finding a buyer for the widget machine might be a whole different problem.

Intangible Assets

These are assets that don’t have a physical form. For instance the trademarked Nike swoosh is a very high value intangible asset. One way to think about tangible vs intangible assets is tangible assets are used to make or deliver the product or service and intangible assets are what are used to generate the demand for the product or service or create the system to produce the product or service efficiently.

A very well known intangible asset is the secret formula for Coca-Cola. That formula has no tangible form, it’s basically words written down somewhere (likely different parts of the formula in different places). But that intangible asset is worth much more than the cost of the machines (tangible assets) used to produce Coke.

Now that we have a basic idea of the assets, let’s talk about why we have assets at all and how they effect a business sale.

Assets in a business have only one purpose (or one purpose that makes sense), to generate profits.

So what kind of assets are best for generating profits?

I’ll give you 2 simple but real life situations.

1) Let’s say you can buy a machine for $100 that will generate $25 more per year in profits. You decide that’s a good investment, so you invest the $100 and you’ll get your $25 per year profits for as long as the machine works. So now you have a $100 tangible asset (the machine) and a $25 cash flow from it.

2) Now let’s say you add an email capture tool to your website, it captures visitors’ email addresses which you can use to automatically send out specials and mailers. The email tool costs $100 and generates $25 in cash flow.

In this case you created 2 intangible assets:

a) the email tool on your website and b) the list of emails of people interested in your products.

The intangible asset with the highest value is the list of emails for people interested in your products. Anybody can buy the email tool for $100 but you have the specific list of people’s email addresses that represent potential sales, this list is an intangible asset.

Think of it this way. Two businesses are exactly the same except one has the email addresses for these customers and one business doesn’t, which business is worth more?

The moral of this story is that when investigating a business sale and determining the value of the business for purchase, the assets that have real value are the assets responsible for generating the business profit, regardless of if they are tangible or intangible. A smart buyer knows how to identify those assets and isn’t blinded by the tangible asset mantra preached by the bankers.

What on earth is a coverage ratio in financing with an SBA Loan?

When dealing with financing of various sorts you will come across the term “coverage ratio”. It my be in the context of “Interest coverage ratio”  or “debt coverage ratio” or some other similar nomenclature.

Here’s the basic concept of a coverage ratio. The coverage ratio is designed to determine what margin for error there is in a borrower’s ability to pay back the debt.

Let’s use an example assuming you are buying a business, here are some basics:

  • Business Purchase Price $500,000
  • Seller’s Discretionary Earnings (SDE) $175,000 (Seller’s discretionary earnings is the business earnings before Interest, Depreciation, Taxes, Amortization and Owner’s Compensation).
  • Down payment Buyer has available $100,000
  • SBA Loan $400,000  financed for 10 years @ 7% =  $4,644 per month payment which = $55,750 per year.
  • Salary the Buyer needs from business to pay living expenses  $100,000.
Coverage Ration Calculation  
SDE                                       $175,000
Salary needed                         $100,000
Available for Debt Service      $75,000
Amount of Debt service          $55,750
Coverage ratio is                     1.35   Amount available for debt service divided by actual debt service.
Generally speaking when seeking an SBA Loan the coverage ratio required will be between 1.25 and 1.4.

What Price is the Right Price to buy a Small Business

If you decide you want to buy a business you need to prepare yourself for the rather inconsistent pricing methodologies used for setting the asking prices for small businesses.

You shouldn’t confuse the asking price for a business with the value of the business or what finance professionals call a Business Valuation or Business Appraisal. There are many ways to compute the value of a small business. The results can be wildly different and all correct. The issue isn’t “what is a business worth?” as much as “what is the business value to you?”. We’ll breakdown the elements and suggest ways for you to go about the process of determining a fair value for a business.

For background it also might be helpful to read  “What do you Buy when you Buy a Business?” . Also, you might want to review this Case Study How to Buy a Business –  Case Study.

In this post we will discuss the elements that create small business value. As Business Brokers we have these discussions with buyers but more importantly we have the same discussions with business sellers.

Here are the key elements that drive the value of a business up or down. Investigating these elements will help you create your own business valuation to determine what price is reasonable:

  • Stability of Earnings.  A business with consistent earnings is worth more than a business that has wild swings in it’s profits year to year. The small business profits are what allows a business buyer to pay down the loan (debt) used to buy the business. The reason small business profits are so instrumental in buying a business is simple…….. a business can never pay the current year’s expenses with next year’s profits. If you buy a business with consistent profits you will be able to borrow more to finance the purchase and therefore you can pay more with lower risks due to the consistent cash flow.
  • Customer Concentration – A company with 100 customers all doing 1% of the revenue is worth more than a business with one customer doing 70% and 3 others doing 10% each. If the customer that represents 70% of the business revenues leaves the business is in the tank. This can be a very important issue for the SBA loan if needed to buy a company. If you plan to use an SBA Loan for acquisition financing this will be closely scrutinized.
  • Business has a high barrier to entry – Not many businesses have this but, if it does, it’s worth a lot. The barrier to entry could be patents, highly recognized brands, special equipment not easily duplicated, exceptional location, etc. But beware, if the business has one of these it should be reflected in the business by delivering higher profit margins than average for the industry.
  • Management/Employee responsibilities – The less the owner of the business is involved the more the business is worth. In his book Built to Sell author John Warrilow describes how this characteristic creates value. Also, Michael Gerber has written a great book E-Myth that talks about applying these principals to small business. If you are serious about buying a business I would highly encourage you to get both of these books and read them before you begin your business search.
Now here’s a simple pricing model you might use. When looking at a business take each of the 4 elements above and score them on a scale of 0 –  4, with 4 being the best. 
Let’s say you’re looking at a widget shop. The Widget Shop has seller’s profits of $100,000 per year. You score the business this way on the above 4 categories 3,2,2,3. The average of those is 2.5.
Then simply multiply the business profits of $100,000 times 2.5 and you get $250,000. Using the above assumptions $250,000 is a reasonable value of the Widget Shop.
As you might imagine there are many resources to help you value a business. The book Small Business Valuation is especially good. Also, there is a great software package that includes Valuation and Business plan all in one called Business Plan Pro (we highly recommend this terrific business success tool.)
If you decide to buy a business you need to have some information and knowledge so that the asking price isn’t the only reference point.
Remember, it’s not what you pay relative to the asking price that’s important, it’s what you pay relative to the value to you that’s important.

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