What are the fundaments of buying existing businesses?
Be careful, buying existing businesses, they might look good on the outside, but…
Buying an existing business can be a great thing. But the process can be daunting, especially if you’ve never been in business before. Or you are buying a distressed company in a drought, or a poor location. Buying an existing business can be easier than setting up a new business from scratch.
As more and more large companies downsize, robotics and other new technologies replace employees with computers and outsourcing critical jobs, literally millions of people, many in their 40s and 50s, are looking for a new career opportunity. Many of them are thinking seriously about buying an existing business.
There are no guarantees of success in any form of small business, and even though an existing business might seem to offer more security, it is still a business venture with many of the same risks inherent to any other business venture. Risks must be fully understood and appreciated.
The main reason most people buy a small business rather than starting one is for the established infrastructure and ongoing cash flow. People also buy existing franchises for similar reasons, they usually come with seller agreements and a proven system of what works and what doesn’t.
The information disclosed here should only be used as a guide. Consult your business and legal advisors for appropriate information for your community, or country.
Why do you want to buy an established business?
If you have decided to buy an existing business, you will want to be sure you are making the right choice in your new venture. Only you can determine if an existing business is right for you.
Here are a few of the reasons people buying existing businesses:
- Because it offers an increased degree of security, particularly if it is well-established.
- To eliminate existing competition.
- The business will have an existing customer base.
- You can have a positive cash flow immediately because of existing inventory.
- It can be cheaper than starting from scratch.
- Can’t find a job, or a suitable job.
- To secure a specific location.
Determining the value of a business
There are several different methods to determine a fair and equitable price for the sale of the business. Here are a few, but it is best to consult your advisors:
- Capitalised earning approach – This method refers to the return on the investment that is expected by you.
- Excess earning method – Like the capitalised earning method, except that it separates return on assets from other earnings.
- Cash flow method – This method is typically used when attempting to determine how much of a loan the cash flow of the business will support. The adjusted cash flow is used as a benchmark to measure the business’s ability to service debt.
- Tangible assets (balance sheet) method – This method values the business by the tangible assets.
- The value of specific assets method – This method compares buying a wanted asset versus creating it.
You may be prepared to pay a premium for a business because of its quality or location, or staff that will stay on.
Initial assessment before buying existing businesses
Because of the commitments that will need to be made it is important that prior to buying a franchise, you should do the following;
- Assess your own reasons for wanting to own a business.
- Assess the lifestyle and income implications of owning and operating a business.
- Assess the opportunities available consistent with 1 and 2 above.
- Visit Business Brokers to see what is available.
- Visit trade shows to broaden your outlook on various opportunities.
- Be familiar with the sales process to minimise your risk and protect your investment.
- Contact the Chamber of Commerce in your country for advice.
- Narrow your search to a few opportunities, then request further information.
- Ensure you have adequate borrowing capacity, including working capital, to successfully run the business.
- Be sure you receive and evaluate all disclosure material.
- Be sure you receive legal and accounting advice from lawyers and accountants with practical business experience before making any final commitment.
- Use any cooling-off period to check and determine if you still want to proceed.
Things to know about yourself before buying existing businesses
In buying an established business there may be some long-term commitments and it might be difficult to get out of, which makes it important to take the emotion out of your decision-making and address questions like the following:
- Will my family be behind buying the existing business?
- Do I like doing the work the business is doing and am I good at it?
- Will the business provide the income level I am looking for?
- Will you become bored with the work involved?
- How do I feel about dealing with the public?
- How do I feel about being stuck in one place perhaps for years?
- Do I appreciate the business model, and will it work well for me?
- Can the business operate without my day-to-day involvement?
- Will I really like the type of people I would be involved with?
- How will I be able to get out if I find I don’t like it?
- Do I have other priorities in your life that could conflict?
- Is this the best investment I can make for my future?
Traps to watch out for when buying existing businesses
- The Business Broker involved in the sale – Is the broker working for you or the seller, it is hard to serve two masters.?
- How long has the business been for sale – If it has been for an unusually long period, be sure to understand the reasons, it could be because it is a bad business?
- How many times has the business changed hands – If this seems excessive again, it could be because it is a lousy business, poorly located or in too small a market.
- Poor business performance – Be wary of sellers who are subject to pending litigation, have a record of customer complaints, talk up the cash trading and drop the sale of their products or services to bump up gross sales before selling the business.
- Failure to disclose information – You should be wary of a seller who is failing to communicate important information such as why they are selling, the lease, licences and permits, and staff.
- Intellectual Property (IP) – Be sure you know where you stand. Who will own the rights to copyright or other intellectual property, check carefully with your legal advisor?
- Valuations – Make sure the business you buy is not overvalued by completing financial due diligence. Have an accountant analyse the financial information provided by sellers to see if a company is indeed worth the money.
- Sellers misbehaving – Watch out for sellers who won’t allow a trial period, won’t introduce you to suppliers, the landlord or estate agent,
- Landlords – Who only give short leases that are inappropriate for the type and location of the business.
Beware of sellers
If the seller makes the deal seem too good to be true, then it probably is. Beware of sellers keen to close the deal quickly or give in too easily to your first offer.
When leasing a business – Leaseholders who have an excellent location can offer the company at an excessive premium. Today your business can be located anywhere.
Inadequate inventory and debtors – It will be essential to ‘age’ both the inventory and the debtors. Ensure there is no ‘dead’, obsolete or excessive stock. All plant and equipment are in good working order and appropriate to the work which needs doing. Be careful to identify slow paying debtors and bad debts and discount accordingly. Sometimes the seller will retain their outstanding debtors and pay up all outstanding creditors.
So, you have decided buying existing businesses is your best option.
Before you make an offer, complete a preliminary ‘due diligence’ to ensure the business has no major problems. A good idea is to ask yourself this question, “If the business is as wonderful as they make out, why they are selling”?
The first thing to do is to create a one-page action plan. A plan where you can set goals for the proposed business and note down actions you will need to take.
Keep the plan simple in order to communicate your thoughts to family, supporters and possible financiers. Once you have completed it, post it up somewhere where you can see it regularly. The goals and actions should be front of mind for everyone involved in the decision to buy the established business.
Before you sign the contract
Following your assessment, manage the risks of buying the business by reading and checking the documentation with your legal advisor:
- Ensure the seller provides you with the contract of sale along with a copy of the lease and other agreements.
- Check if a performance clause can be inserted into the contract which specifies minimum takings of the business over an appropriate period before final settlement.
- Insist on the right to work in the business, preferably before entering into a binding contract or at least before settlement. It helps you to assess the reliability of the seller’s claims.
- Checking the financial records carefully with your financial advisor.
- Inserting a performance clause into the contract that specifies the minimum takings of the business over an appropriate period leading up to settlement.
- Make the transfer of existing critical contracts a condition of the purchase.
- Structuring a payment plan. A part of the purchase price could be retained for a certain period and if necessary, placed in trust with a solicitor or agent
- Including a restraint of trade clause in the contract. It will restrict the previous owner from operating a similar business within a certain distance for a period.
- Inserting any other clauses, you and your advisors think are appropriate.
- Ensuring any representations made by the seller, whether written or otherwise, are guaranteed by the seller as correct and this guarantee becomes a condition in the contract.
When you sign the contract
Once the preliminary steps have been taken, upon signing, you should:
- Ensure the seller provides the signed contract.
- Return a signed copy of the contract to the seller.
- Pay the preliminary or full deposit and seller to supply a receipt for deposit.
- Once the contract has been signed, you should:
- Lodge applications for transfer of registration of the business name.
- Transfer all necessary permits, licences, registrations and certificates.
For some, buying an existing business represents less of a risk than starting a new business from scratch. While the opportunity may be less risky in some respects, you must perform due diligence. This will ensure that you are fully aware of how the business works, the good, the bad and the ugly along with the exact terms of the purchase.
Preparation for the transfer when buying existing businesses
Prior to the transfer, you should:
- Prepare the proposed assignment of lease
- Search the name of the existing business to ensure that the seller has free and clear ownership of the business and has full rights to transfer the business to you.
- Register the business name
- Know if the seller owns the business premise and is transferring the title to you. Use a search service to ensure that the seller has free and clear ownership of the premises.
- Ensure that existing contracts are transferred to you as part of the contract terms.
“I see many a disappointment when people jump into buying existing businesses based on their emotions. If you think you will be too emotional, seek some advice to give you objectivity and perspective”. Peter Sergeant
“Too many people never connect with their true talents and therefore don’t know what they are capable of achieving”. Ken Robinson
“Business is not about money. It’s about making dreams come true for others and for yourself”. Derek Sivers