How to avoid heartbreak in the purchase of a business
During the past couple of years, I’ve written posts on the small businesses that are changing hands and will continue to do so in the next decade (thanks Baby Boomers) and shared tips on how to maximize the value of a sale. But… what if you have always dreamed about owning your own business and decide now is exactly the time to take the plunge? Owning a business is not for the faint of heart (says the bleary-eyed face looking back at me in the mirror every morning) but it is rewarding. So, what do you need to know as you walk down the road?
1. Have your financing in order. Just like when you do the financial legwork in advance of pre-qualifying for a mortgage, it’s wise to do so when looking at a business. You should familiarize yourself with terms like “seller carry back notes” and decide, based on your financial situation, if you have sufficient assets to secure a conventional loan (pretty uncommon) or if you have to look to the Small Business Association (SBA). Another option: there are companies that will help you turn your 401(k) into a down payment. Use caution, though, and don’t let the dream of business ownership and great opportunity blind you to the possible risks of losing what but you have already amassed. Make sure you work closely with your financial advisor to honestly assess if owning a business is right for you financially.
2. Get your team in place. Yes, you need a team. Make sure you have someone who can help you with “diligencing” (yes, this is a word) the businesses that appeal to you. You will need someone who understands finance, accounting, and taxes. You will also need a lawyer. The best process is to do a little bit of investigation, then write a term sheet or letter of intent, which is not binding, and head into more serious due diligence. I don’t care how small the business is but YOU MUST HAVE A CONTRACT. Please don’t let a broker (if there is one in the deal) give you real estate paperwork. You aren’t buying a house; the representations that need to be made when purchasing a business are much different.
3. Buy assets, not the shares. When purchasing a small business, it makes much more sense to buy the assets. You will want to set up an entity (likely an LLC) and have the LLC be the purchaser. This is important for liability purposes. There are also tax reasons why you might want to do this. However, if the industry has a lot of ongoing contracts (which can be a pain because of assignment and transfer clauses), then you should talk to your advisors about the risk versus the benefit of switching to a share sale.
4. Diligence the heck out of the business.
Dig into the financials for the last three to five years. Really dig. You can tell a lot about what is going on by looking at what I will call the “buckets” on the balance sheet. Look at the tax returns carefully---not only of the business, but the owner’s personal returns.
Look at all the contracts. Ask for any recent notices from customers, suppliers, or vendors.
Carefully review cash flow and accounts receivable.
Understand the inventory. Depending on the business, the level of the inventory and timing of paying for it matter a lot.
Ask about sales tax, payroll taxes, and environmental issues. Even if you only buy the assets you might have “successor liability”, so a tax clearance certificate is smart.
Search the Uniform Commercial Code (UCC) database. Are the assets encumbered in any way? Does the seller have a line of credit? These things need to be paid off and liens released before you close.
Find out what will happen with the lease. In most cases, landlords need to approve the assignment of a lease and, depending on the lease, this could trigger a renegotiation of the rent.
5. Look for red flags. Just like there are unscrupulous buyers, there are also unscrupulous sellers who have used their businesses as personal piggy banks and are looking to take advantage of someone’s desire to own a business and inexperience in the process. If the business has too much risk-- such as only a few “big” customers, high employee turnover, weird stuff on the balance sheet, litigation, a dispute with a broker-- run, don’t walk, in the other direction.
6. Make sure that the seller is willing to keep working in the business while you get your sea legs. We call this a “transition services” agreement. It can be 30-90 days. You can always do longer but if you use the SBA, it may have something to say about that. Also, you will want to make sure that you and the seller are on the same page regarding announcement of the sale to employees and customers. No one thinks about that, but it is crucial.
7. Please, please, please (yes, I’m not too proud to beg or repeat it twice) hire a lawyer to help you with a good agreement. A purchase agreement needs to have certain elements. Terms, promises about what you are buying (called representations and warranties), to-dos before closing (conditions), performance promises (called covenants), and indemnity for things that aren’t what seller said, etc. Don’t be penny wise and pound foolish. Spending money on a lawyer and accountant is an absolute cost of doing business.
I’m bullish on small businesses generally. They are absolutely the life blood of the economy. Buying a business should be a great adventure... but not the kind I remember from my first ride on the Tower of Terror at Disney (RIP and good riddance!). Preparation is key to avoiding any unwelcome surprise once the deal is closed.