How to Buy a Small Business: An Aspiring New Owner’s Guide
While big corporations may have the lion’s share of the headlines, small businesses are the true engine of the American economy. And there is nothing little about the level of competition among small businesses! Forbes magazine has estimated that the total number of U.S. small businesses is around 27 million, and the Small Business Administration has put that number even higher at over 28 million.
Starting a business from scratch can be tough because of existing competitors and new ones arriving every quarter. Just on the first quarter of 2014, close to 63,000 new establishments opened in the State of California alone. This is why buying an existing small business can be an attractive option for entrepreneurs. Reduced risk in some aspects, proven business model, and an existing customer base are some of the potential benefits that come with buying a small business. Let’s walk through important tasks to consider when buying a small businesses, as well as financing options to consider before submitting your purchase bid.
Determine the Value of a Small Business
Cash is king and the Cash Flow Statement is its messenger. Any reputable business owner putting up his company for sale would offer you an insight into incoming and outgoing cash flows. Keep in mind that you may be required to sign a confidentiality agreement to have access to a small business’ financial documents, including its cash flow statement. Use our guide on using a cash flow statement the right way to analyze this document and determine whether or not the business is sustainable in the long run.
Going back three to five years, here is a sample of some key questions to ask:
- How many times out of the year does the business have to tap into financing to cover cash crunches? Are those gaps predictable?
- Are there any cash flows from investing activities (e.g. sale of equipment that wore out or acquisitions of real estate to expand retail space)? If no, then are there any that need to take place in the near future?
- Are there any outstanding loan balances? What is the pattern of repayment of loans based on incoming cash flows?
- Does the current level of financing allow the business to bulk up inventory or hire extra help during periods of high customer demand?
- What is the historical level of cash surplus throughout the last five years?
- What is the level of accounts receivable? What percentage of those accounts are collected within 30 days? 60 days? 90 days? Are there any losses due to uncollectible accounts?
Depending on the nature of the business, you will have additional questions. Do your due diligence by checking the amounts from the cash flow statement against those from the balance sheet and income statement.
Seek the help of a certified accountant if you lack the accounting chops to properly interpret these documents. A reputable certified public accountant (CPA) can guide you to the rest of necessary financial documents, such as schedule of inventory, description of depreciation and amortization methods, and company’s general ledger, and provide a proper interpretation of those documents. Using a CPA will also help you to have more accurate figures when filing your own tax return and its necessary forms, such as Form 8594, Asset Acquisition Statement Under Section 1060.
Make sure that all financial statements include an audit letter from from a CPA individual or firm. As nice and friendly as the owner may be, don’t just take his word for it.
The Importance of the Owner’s Discretionary Income
One key question that you have to ask yourself is whether or not you can live on the owner’s discretionary income (ODI). This would be your take-home check after paying your suppliers, employees, business expenses, and taxes. A large mismatch between the ODI and your total budget for living expenses can create a real financial burden. Depending on your level of management experience, you may think that you have what it takes to increase that ODI to a number that you’re comfortable with. Still, keep in mind that founding a startup or managing a small business is not the same as turning around a declining small business.
Identify any patterns in the ODI and ask the current owner questions about those patterns, particularly when you see a large, one-time drop or a downhill trend. Inquire with the seller if she’s willing to put in writing to back up those numbers. That’s a good sign that you can trust those numbers.
Another important step is to plan ahead and start budgeting for when you would take over. Use our free budgeting template to evaluate potential changes that you would implement, such as increases in advertising to announce that business is under new management, cuts in labor expenses as you bring in your own team, or inventory purchase savings from switching suppliers. By using numbers to calculate the effects of your decisions, you’ll have a more accurate picture of the potential range of the ODI of your new business. Running a check on the credit history of the small business can allow you to spot any instances in which a high ODI created a challenge to meet payments to suppliers or other creditors.
Reviewing Legal Documents & More
In addition to the financial statements, there are plenty of other documents that you will have to review. No matter the size of the small business, hire the services of a qualified attorney to review the legal and organizational documents that you’re planning to acquire. Working together with your CPA, the attorney will provide a thorough evaluation of the overall condition of the small business, help you draft a sales agreement, and go over important steps before closing the sale.
An attorney can also help you interpret any documented issues, such as a claim of wrongful termination by an employee, a grievance procedure to settle a dispute with a supplier, a dispute of intellectual property, or an environmental investigation.
Don’t forget to gather all applicable documents to complete a successful transfer of property from the previous owner to you. This includes physical assets (fixed assets, vehicles, and leases of equipment), real estate (including deeds, mortgages, title policies, surveys, zoning approvals, variances or use permits), and intellectual properties. Make sure that the company is up to date in all of its necessary licenses, permits, taxes, filings with applicable regulatory agencies, and fees for those items. Whenever possible, ask your attorney to get certificates that you’re cleared of any responsibility of amounts that the seller owes, particularly any kind of federal and state taxes.
Request your attorney to draft a covenant not to compete in which the seller agrees not to compete against the business.
Analyzing Reputation & Competition
Go beyond the quantitative data and check the pulse of the state of affairs of the small business within its community. Here are some places to check the reputation of a small business and its owner(s):
- Local office of the Better Business Bureau
- Local police station
- Local SBA office
- Customer reviews on Yelp page(s) of the small business
- GlassDoor page of current and past employees
- Mentions in social media, such as Twitter and Facebook
- Mentions in local newspapers, websites, and blogs
Having a better sense of the overall level of customer satisfaction can put the numbers from any projections into perspective and allow you to pair back any over optimistic estimates. To have a comprehensive picture of any situation, allow the owner to provide his side of story. However, a lack of any mention about a major event that received major local media coverage is a red flag.
Supplement the sentiment of the community about the small business with research on plans of large competitors, such as large franchises and big box stores, to move into the area. What would happen if you buy a hardware store and a Home Depot would move into the area next year? During your research, inquire directly with franchises and big box companies about their plans to move into the area. Despite the lack of a physical store, some corporate moves are ongoing and well documented. For example, Whole Foods has already announced the location of 16 new 365 by Whole Foods Market stores in several cities, including Akron, Ohio; Decatur, Georgia; and Gainesville, Florida. These stores are scheduled to open in 2017 and beyond and may affect the operations of many local small business operating in the same industry.
Financing the Purchase of a Business
When you’re seeking financing to complete the small business purchase, don’t forget to check all of your available options.
SBA 7(a) Loan Program
If your target small business meets the requirements of the SBA’s 7(a) Loan program, you can use the proceeds from the loan for the acquisition or expansion of that existing eligible small business. Through an SBA-approved lender, you can qualify for up to $5 million in financing. The SBA sets no minimum loan amount. In 2015, the average 7(a) loan amount was $371,628. SBA 7(a) loans are available in all states and are common than you may think: in fiscal year 2016, 382 of these loans were approved just in Hawaii.
The key benefit of using a 7(a) loan is that the SBA incentivizes the lender to approve the loan by guaranteeing 75% of the loan that the lender makes to the borrower. You have to come up with the remaining 25% of the loan but that money can come from a wide variety of SBA-approved sources, including seller credit, gift from your relatives, or venture capital. (Note: SBA can guarantee as much as 85% on loans of up to $150,000 and 75% on loans of more than $150,000.)
For example, the 252 small business sales that took place on the third quarter of 2014 included an average seller carryback of 18% of the deal. This means that a buyer using a 7(a) loan would only have to come up with 7% of the deal’s total on her own, bringing the purchase closer to reality. To learn more about the 7(a) loan program, including fees, interesting rates, and terms, visit the SBA’s website.
Bond Street’s Term Loans
An alternative to a loan from a SBA approved lender is a term loan from Bond Street with an interesting rate starting at 6%. A key advantage of a Bond Street term loan is the speed to process your application, providing you a decision within 48 hours, an offer within three days, and a deposit of funds in your account within one week. On the other hand, SBA loans have a long review time, leaving applicants waiting up to 14 weeks to receive their loan proceeds. Speed matters in the acquisition of a small business and Bond Street’s streamlined loan decision process could give you the edge over competing bidders to close on a deal.
Loans from Bond Street are from $50,000 to $500,000 and repayable in one to three years. Using the latest cash flow statement from the small business and making your own cash flow projections for the next three years, you can determine whether or not a term loan is the right financing option.
To get pre-qualified, you’ll need your name and address, income and revenue amounts, social security and Tax EIN, and approximate loan amount. Get pre-qualified today.
Other Online Lenders
When speed is of essence, you could also opt for an unsecured personal loan from an online lender. However, there are three disadvantages of these types of loans.
The first one is that unsecured personal loans are often capped under $50,000, which would only cover a small portion of your small business acquisition. The second one is that unsecured personal loans often charge much higher interest rates (as much as 80%!) than other types of loans. The third one is that unsecured personal loans have several fees, such as an origination fee of up to 5%, a service charge, a late payment fee, and, sometimes even, a prepayment fee.
Additionally, some online lending sites are just aggregators of several lenders and don’t generate the loans themselves. So, you’ll have a hard time finding out in advance which fees will be attached to your loan or which APR rates will be offered and making a timely comparison of your financing options.
When done right, buying a small business allows you to become your own boss faster and gives you a leg up on the competition with a proven business model. Spend some time evaluating your options and doing the necessary legwork to back up any claims. Be patient throughout the entire process and be willing to try alternatives particularly when it comes to finding financing.
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