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Buying an Existing business

Starting a business is not confined to the process of building the company from ground up.
Purchasing an existing business is another option that can be explored by individuals who want to
run their own business without enduring the trials and tribulations of starting a new business from
scratch.
Most businesses are purchased by companies as a means of diversification or expansion. In
these situations several of the ingredients of success are usually present: the business has good
reasons for the acquisition, it has experience in the industry to be entered through long contact, it
has skilled people to evaluate acquisition candidates, it has the means to make the purchase in cash
or through contact with funding sources, and it has the ability to run the purchased business.
Nevertheless, many acquisitions flounder. Similarly, the prospective buyer may be a wealthy
individual with many years of business experience but presently no corporate base. Such an
individual is functionally equivalent to a company in means and in experience. Buying an existing
business is also one of the alternatives available to the would-be entrepreneur. He or she faces
the same decision manufacturers call the "make or buy" decision: Should we tool up to make this
product or buy it from someone else? To make some-thing from scratch usually takes longer but
offers opportunities to shape the product exactly as the builder intends it to function. To buy the
product usually gets the buyer to the starting line much faster but limits his or her choice to a
preexisting design.

The steps in acquiring a business

In any one year, very few of the many people trying to buy a business are successful in actually
buying one. The steps in acquiring a business are far from easy. Research shows that only three
percent (3%) of those potential buyers ever buy a company within any given year.
Most potential buyers spend a large amount of time looking at potential acquisitions. However,
most simply fail to go through the acquisition process correctly. Most have never made an
acquisition before.
The eight basic steps in acquiring a business are:
1. Criteria. Decide on the criteria for your acquisition. For example, your criteria may
include: geographical restrictions, type of business, sales, profitability, and personnel. Of
course, the amount of the available down payment and your own personal financial strength
are also import considerations.
2. Finding a business. This step can be the most difficult because there is no all-inclusive
list of businesses for sale like there is in the residential real estate industry. Many of the
web sites that list businesses for sale are shown on the "Acquisitions Available" page of
my web site. But, no one list is all-inclusive. More importantly, most business owners that
wish to sell their business tell no one except maybe their closest advisors.
3. Preliminary review and Pre-Due Diligence. The goal of the preliminary review
and Pre-Due Diligence is to identify deal-breaking issues before too much time and
expenses are committed. Examples of issues that would cause you to abandon a potential
acquisition candidate are: material misstatements in the financial statements, or uncertainty
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regarding customer or employee retention. You should have a reasonable level of comfort
that the potential acquisition candidates fit your criteria and have a reasonable chance of
being acquired successfully.
4. Valuation. There are several approaches to valuing a business and no one approach is
always right or wrong. One way is to use the Seller's Discretionary Cash Flow (SDCF).
This approach indicates how much benefit the business owner is realizing through profit,
salary, depreciation, interest expense, and perks. For the most part, the SDCF after an
acquisition should exceed the required debt payments and minimum owner's
compensation.
5. Negotiation. Negotiations will occur with the Letter of Intent and the Purchase Contract.
In the Letter of Intent, the basic terms of the acquisition are worked out. After the Due-
Diligence phase, the final terms are agreed upon.
6. Due-Diligence. Due-Diligence is a detailed investigation of all the issues that need to
be addressed before four simple questions can be answered. The questions are: Should I
make this acquisition? How much should I pay for the business? How should the
acquisition be structured? How should I deal with any post-acquisition operating,
accounting, and legal issues?
7. Financing. There are dozens of methods and sources for financing. According to
business broker industry data, sellers finance part of the acquisition price in about 85% of
all acquisitions. Each source has their own niche as to the type of financing, industry
preferences, collateral requirements, terms, and geographical preferences.
8. Closing. This can be the easiest step as everyone signs the closing papers, or it can be the
most frustrating step as everything falls apart at the last minute because one of the first
seven steps was not done properly.
A common mistake is trying to make an acquisition without professional help. If you have never
acquired a business before, do not use the process as on-the-job training. Successfully acquiring
a business is hard work, but you can do it. Commit yourself to being in the three percent (3%) of
those potential buyers that buy a company within any given year.

Evaluating an existing business

8 Points in Evaluating Buying an Existing Business

1. Why is it being sold? A friend of mine is retiring so it’s a legitimate exit strategy but
he is 66 and others I know are in their 30’s and 40’s. Why are they selling? Is it because
the money is not there, is it poorly managed, a bad mix of product and owner, a bad product
or worse?

2. Legal Considerations: Are there existing contracts or encumbrances owing on the

business? Is there a lot of debt outstanding? A friend was all ready to buy a great business
on paper until I told him about a silent shareholder who had criminal history and certainly
brought bad karma to the deal. The $5 million deal stalled soon after my conversation.

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3. Is it financially sound? Have you seen the books, the real ones? Has the owner taken
a salary or had the company pay all his expenses? Are there strange entries in the books
given to you? I had a friend who paid his 2 year old son to valet park cars for his butcher
shop, looked great on his tax return. I’ve also seen clients with 2 sets of ‘books’ hundreds
of thousands apart in numbers.

4. Market Value: Many consider the value of a business at 2-3 times net profit. I have a
client who sees a very, very liberal $50k in net but is trying to sell his business for $600K.
He is listing it at what he thinks it is valued without considering a realistic price. It’s only
worth $200k.

5. Is it Right for You? I have another client considering buying a bakery/cafe in a remote
part of the country, not knowing the market, the area or the product. Would it not be more
prudent to buy a business you enjoy, have knowledge of, have a passion for or use the
product?

6. Assets: Are those assets listed in the books old and need replacement? Are the assets
enough to manage growth or will you need to upgrade or add to existing assets to increase
sales?

7. Leases: I have a client who wanted to purchase a very exciting coffee shop well
established in a good location in New York City. The price is right but the lease upon
scrutiny shows only a few months left on the lease. The owner assured him the owner will
renew for 5 years plus 5 extension. What he didn’t say was that Starbucks was eyeing the
property and was willing to up the rent by 20% to get the lease. Ouch!

8. Balance Sheet: Goes hand in hand with number 3 above. You can see the chart of
accounts of a business, see their journals and spreadsheets but have you seen the profit/loss
sheets? Make sure you see all the documents even more so if you have fallen in love with
the property.

The due diligence process

When buying a business, “due diligence” refers to the process of reviewing all of the available
information related to that business. The goal of due diligence is to make sure that all legal and
financial issues pertaining to the business are in order and that there are no unpleasant surprises
should you decide to go through with the purchase. Due diligence means digging deeper. You’ll
need the help of your business banker, accountant, and attorney to do a thorough job of due
diligence. Due diligence should cover the following:

Finances: Ask for the company’s audited financial statements. Request balance sheets, income
statements, and cash flow statements, as well as business tax returns for the past three to five years.
You and your accountant should review them with the following in mind:

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 Is the business collecting its accounts receivable in a timely manner?

 How much bad debt does the business write off each year?
 Is the business paying its debts in a timely manner?
 What is the business’s profit margin?
 Does the company have any outstanding liens?

Legal issues: Ask for copies of the business’s professional and consulting agreements;
insurance policies; licenses and permits; any documents related to intellectual property, such as
patents or trademarks; and any documents related to lawsuits the company is involved in. You and
your attorney should review them with the following in mind:

 Are the agreements enforceable?

 Does the company have the rights to its intellectual property?
 Is the business adequately insured?
 Are the company’s licenses and permits current?
 Is the company involved in any litigation, and if so, what are the potential risks, costs, and
damages?

Employees: Request organizational charts, employee handbooks, employment agreements,

wage and salary information, benefits plans, non-compete agreements, and confidentiality
agreements. Review them with your attorney, keeping in mind:

 Do any employee policies put the business at risk of lawsuits?

 Are there any ongoing grievances with employees?
 Are employees attempting to unionize, or is a third party trying to unionize them?

Business structure: If the business is a corporation, ask for a copy of its corporate charter and
bylaws as well as all minutes of meetings held with the board of directors and/or shareholders.
Have your attorney review this with you, considering:

 Is the business in compliance?

 Is the business structured properly for your growth plans, or will you need to change its
structure?
 Will you need to buy out shareholders, and if so, what will that cost?

Operations: Ask for a list of customers, lists of suppliers and vendors, and an operations
manual. Review this information while considering:

 Does the business have adequate inventory systems in place?

 Is the company’s supply chain diversified so that the business isn’t overly reliant on one
supplier?
 Is the company’s customer base diversified and growing?
 Does the company have necessary equipment and infrastructure in place for continued
growth?

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At the end of the due diligence process, you should have a clear picture of where the business is
today, where you can take it in the future, why the owner is selling, and whether the asking price
is fair.

The methods for determining the value of a business

What is business valuation?
Quite simply, business valuation is a process and a set of procedures used to determine what a
business is worth. While this sounds easy enough, getting your business valuation done right takes
preparation and thought.

Business valuation results depend on your assumptions

For one thing, there is no one way to establish what a business is worth. That’s because
business value means different things to different people.
A business owner may believe that the business connection to the community it serves is worth
a lot. An investor may think that the business value is entirely defined by its historic income.
In addition, economic conditions affect what people believe a business is worth. For instance,
when jobs are scarce, more business buyers enter the market and increased competition results in
higher business selling prices.
The circumstances of a business sale also affect the business value. There is a big difference
between a business that is shown as part of a well-planned marketing effort to attract many
interested buyers and a quick sale of business assets at an auction.

Expected selling price and business value

Hence, business value is really an expected price the business would sell for. The real price
may vary quite a bit depending on who determines the business value. Compare a buyer who wants
the business now because it fits important lifestyle goals to a buyer that purchases an income
stream at the lowest price possible.
The selling price also depends on how the business sale is handled. Contrast a well-conducted
business marketing campaign and a “fire sale”.

Three business valuation approaches

There are three fundamental ways to measure what a business is worth:
 Asset Approach
 Market Approach
 Income Approach

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Asset approach
The asset approach views the business as a set of assets and liabilities that are used as building
blocks to construct the picture of business value. The asset approach is based on the so-called
economic principle of substitution which addresses this question:
What will it cost to create another business like this one that will produce the same economic
benefits for its owners?
Since every operating business has assets and liabilities, a natural way to address this question
is to determine the value of these assets and liabilities. The difference is the business value.
Sounds simple enough, but the challenge is in the details: figuring out what assets and liabilities
to include in the valuation, choosing a standard of measuring their value, and then actually
determining what each asset and liability is worth.
For example, many business balance sheets may not include the most important business assets
such as internally developed products and proprietary ways of doing business. If the business
owner did not pay for them, they don’t get recorded on the “cost-basis” balance sheet!
But the real value of such assets may be far greater than all the “recorded” assets combined.
Imagine a business without its special products or services that make it unique and bring customers
in the door!
Market approach
The market approach, as the name implies, relies on signs from the real market place to
determine what a business is worth. Here, the so-called economic principle of competition applies:
What are other businesses worth that are similar to my business?
No business operates in a vacuum. If what you do is really great then chances are there are
others doing the same or similar things. If you are looking to buy a business, you decide what type
of business you are interested in and then look around to see what the “going rate” is for businesses
of this type.
If you are planning to sell your business, you will check the market to see what similar
businesses sell for.
It is intuitive to think that the “market” will settle to some idea of business price equilibrium -
something that the buyers will be willing to pay and the sellers willing to accept. That’s what is
known as the fair market value:
The business price that a willing buyer will pay, and a willing seller will accept for the business.
Both parties are assumed to act in full knowledge of all the relevant facts, and neither being under
compulsion to conclude the sale.
So the market approach to valuing a business is a great way to determine its fair market value
– a monetary value likely to be exchanged in an arms-length transaction, when the buyer and seller
act in their best interest. Market data is great if you need to support your offer or asking price –
after all, if the “going rate” is this much, why would you offer more or accept less?
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Income approach
The income approach takes a look at the core reason for running a business – making money.
Here the so-called economic principle of expectation applies:
If I invest time, money and effort into business ownership, what economic benefits and when
will it provide me?
Notice the future expectation of economic benefit in the above sentence. Since the money is
not in the bank yet, there is some measure of risk – of not receiving all or part of it when you
expect it. So, in addition to figuring out what kind of money the business is likely to bring, the
income valuation approach also factors in the risk.

Understanding the seller’s side

As market activity increases, it is helpful to examine what makes some companies successful
with acquisition strategies while others can't seem to get a deal done. Within any transaction, I
always recommend that negotiating parties look at the transaction from the other side of the table
to gain a balanced perspective and facilitate a successful closing.

 Selling is optional, not mandatory. We often hear a seller say, "I don't need to sell." In many
ways this is a defense mechanism and can be a way of dealing with the emotional resistance to
selling a closely held business that has been the seller's life for years, if not decades. For many
sellers, however, regardless of their desire to sell, the statement is true. Savvy buyers understand
this and recognize that a seller is willing to compromise only up to a point. Pushed too far, the
seller can easily reconcile keeping the business, and the buyer will have acquired nothing and
expended significant time and money on a failed attempt to out-negotiate the seller.
 Understand seller transaction economics. It is important for buyers to fully understand the
financial outcome to the seller resulting from the transaction. Sellers must retire debt, pay capital
gains taxes on the transaction, satisfy other outstanding obligations at closing (working capital),
and fund CAPEX adjustments as well as transactional costs out of gross transaction proceeds.
What is left in the form of net proceeds represents only a fraction of the purchase price. Too often
in their negotiations, buyers fail to recognize that a small change in purchase price can have a
huge impact on the net proceeds to the seller. So when a buyer seeks a 10 percent price reduction
in a transaction, or comes to the table with an offer 10 percent below market, the result often has
a substantial impact on the seller's proceeds and changes the deal from a viable one to a non-
starter. Keep in mind that the seller is deriving far greater annual income from keeping the
business than he would reinvesting the after tax proceeds in an unlevered manner.
 Emotional process. For many sellers, this is their one transaction of a lifetime. As such, it is a
highly emotional process filled with stress and anxiety. Eliminate the unnecessary complications.
There always will be points of contention that must be resolved in any transaction. Buyers that
create drama and stress throughout the acquisition process will often wear down a seller to the
point where it makes it easy to justify walking away from the transaction. Buyers that minimize
these issues are often most successful.
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 Time is evil. This is critical. Time is your enemy. The longer the process takes, the less likely it
is to close. Get your resources together and manage your process in the most efficient manner
possible. This includes taking control over your third-party resources (attorneys, advisors, lenders,
etc). Remember you are the client; expect timeliness from your professionals.
 Prearrange capital. Don't wait until you have a transaction identified or negotiated to start
securing your capital. Equity capital should be committed well in advance of negotiating
preliminary terms of a deal. Obviously, if the source of equity capital is from an external source,
it will not be fully committed without the specifics of the transaction. However, the buyer should
make sure that the external source is on board with the strategy and the general parameters of the
deal. This will facilitate a quick turnaround when the right deal comes along. Sophisticated sellers
and their advisors give little credibility to buyers who do not come to the table with committed
equity in hand. The same is true for debt capital. Consult your debt providers and start establishing
your relationships before securing a specific transaction. A buyer able to approach the seller with
an established lender ready to complete underwriting in a timely manner will gain additional
credibility and provide the seller with preliminary comfort (no small feat).
 Familiarize market multiples. Successful buyers always have a handle on current market
multiples and understand the dynamics of what it will take to secure a deal. If you are serious
about making an acquisition, set your pricing expectations accordingly. Too often we see would-
be buyers set their pricing expectations unrealistically low and then be surprised when they never
succeed in making a deal. We don't advocate overpaying for opportunities just for the sake of
winning the auction, but don't approach every deal with a 20 percent discount to market hoping
that one day you will find your deal. If you are an "opportunistic buyer" and looking only for
below-market situations, make this known up front so as not to misrepresent your intentions and
to better match your objectives with the right opportunities.
 CAPEX adjustments are a very real part of the acquisition process. It is almost impossible to
specifically define the scope of CAPEX adjustments required at the early stages of negotiations.
To avoid a significant challenge later in the process, smart buyers will agree with sellers early in
discussions regarding the philosophical nature of CAPEX items that will be considered as
adjustments. There can be a big difference in perspective regarding this topic. If left unresolved
until late in the process, this can turn into a last-minute deal killer. Decide the standard you are
going to apply in the determination of adjustments early in the process and avoid problems later
on.
 Seller's employees. Sellers are always very concerned about the future of their key employees in
an acquisition. Likewise, savvy buyers understand that the strength of a company lies in its
employees. The sooner the buyer can communicate their intentions to the seller, the better for
everyone. The key is reducing the stress level on all parties by dealing with this decision as early
as possible. Whatever the decision, it gives the buyers, sellers, and employees ample to time to
craft a solution and continue focusing on closing the transaction without the shroud of uncertainty.
 Business is a long-term asset. Experienced buyers understand they are acquiring a long-term
asset and view their target company accordingly. Too often, we see inexperienced buyers become
overly focused on the most recent financial and operating data and lose sight of what they are
seeking to acquire: the long-term value of the business. We do not advocate ignoring relevant
trends occurring in a business or the economy, but we do recommend taking a step back to
consider the big picture. Take a longer-term view of the situation; don't be too anxious to make
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your assessment based solely on the immediate past. While sellers are cognizant of short-term
results, they are not a defining factor in how they look at, operate, and value their businesses.
Once buyers become sellers, they too adopt a longer-term perspective.

Negotiating the Deal

Listen and understand the other party’s issues and point of view. Some of the worst
negotiators I have seen are the ones who do all the talking, seeming to want to control the
conversation and expound endlessly on the merits of their position. The best negotiators tend to be
the ones who truly listen to the other side, understand their key issues and hot buttons, and then
formulate an appropriate response. Try to gain an understanding about what is important to the
other side, what limitations they may have, and where they may have flexibility. Refrain from
talking too much.

Be prepared. Being prepared entails a whole host of things you may need to do, such as:

 Review and understand thoroughly the business of the other party by reviewing
their website, their press releases, articles written about their company, and so
forth. A thorough Google and LinkedIn search is advisable here.

 Review the background of the person you are negotiating with by reviewing any
bio on the company’s site, the person’s LinkedIn profile, and by doing a Web search

 Review what similar deals have been completed by the other side, and the terms
thereof. For public companies, some of their prior agreements may be filed with the
SEC.

 Understand the offerings and pricings from competitors of the party you are
negotiating with.

Keep the negotiations professional and courteous. This is also known as the “don’t be
an asshole rule.” Nobody really wants to do business with a difficult or abusive personality. After
all, even after the negotiations are concluded, you may want to do business with this person again,
or the transaction may require ongoing involvement with the representative of the other
side. Establishing a good long-term relationship should be one of the goals in the negotiation. A
collaborative, positive tone in negotiations is more likely to result in progress to a closing.

Understand the deal dynamics. Understanding the deal dynamics is crucial in any
negotiation. So be prepared to determine the following:

 Who has the leverage in the negotiation? Who wants the deal more?

 What timing constraints is the other side under?

 What alternatives does the other side have?

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 Is the other side going to be getting a significant payment from you? If so, the
leverage will tend to be on your side.

Always draft the first version of the agreement. An absolutely fundamental principle
of almost any negotiation is that you (or your lawyers) should prepare the first draft of the proposed
contract. This lets you frame how the deal should be structured, implement key points that you
want that haven’t been discussed, and gets momentum on your side. The other party will be
reluctant to make extensive changes to your document (unless it is absurdly one sided), and
therefore you will have already won part of the battle by starting off with your preferred terms.
Having said that, you want to avoid starting the negotiations with an agreement that the other side
will never agree to. Balance is key here.

Keep in mind that time is the enemy of many deals. You have to understand that the
longer a deal takes to get completed, the more likely that something will occur to derail it. So be
prompt at responding, get your lawyer to turn documents around quickly, and keep the deal
momentum moving. However, that doesn’t mean you should rush through negotiations and make
concessions that you don’t need to make. Understand when time is on your side and when time
could be your real enemy.

Don’t fixate on the deal in front of you and ignore alternatives. In many situations
you want to have competitive alternatives. This can enhance your negotiating position and allow
you to make the best decision as to how to proceed. For example, if you are engaging in a process
to sell your company, the best thing you can do is to have several potential bidders at the table.
You want to avoid being locked up into exclusive negotiations with one bidder until you have
reached a meeting of the minds as to the best price and terms available. Similarly, if you are
looking to buy a product, lease office space, or acquire a loan for your business, you will often be
better off if you have alternatives—and the other party knows it has viable competitors. By
negotiating simultaneously with two or more parties, you can often obtain better pricing or better
contractual terms.

Don’t get hung up on one issue. You want to avoid getting stuck on a seemingly intractable
issue. Sometimes it’s best to suggest that an issue be set aside for the moment and both parties
move on to make progress on other issues. A creative solution may come to you later outside the
heat of the negotiation.

Identify who the real decision-maker is. You want to understand what kind of authority
the other person that you are negotiating with has. Is he or she the ultimate decision-maker? I
recently went through a long and fruitless set of negotiations with a person who kept telling me
that he didn’t have the authority to agree to a number of points we were negotiating. He could tell
me “no” to my requests but didn’t have the ability to tell me “yes.” My solution (because I had
leverage) was that I ended the conversation and said that for us to make any progress, I needed to
negotiate with the person who was authorized to make decisions and concessions.

Never accept the first offer. It’s often a mistake to accept the first offer from the other side.
For example, if you are selling your home and you receive an offer, consider countering at a higher

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price or better terms (even if there are no other offers). If you don’t counter, the other party will
be concerned that they offered too much and may end up with buyer’s remorse and attempt to get
out of the deal. And buyers expect that there will be a counter as they expect that their first offer
will likely be rejected. Most buyers will leave room in their first offer to go up by at least 5%-15%
in price, depending on the situation. Counter-offers and some back-and-forth negotiation will most
likely lead to the two parties being satisfied that they struck the best deal they could, and thus be
more committed to closing the deal.

Ask the right questions. Don’t be afraid to ask the other party many questions. The answers
can be informative for the negotiations. Depending on the type of deal, you could ask:

 Is this the best pricing or offer you can give me?

 What assurances do I get that your product or solution will actually work for me?

 Who are your competitors? How do their products compare?

 What else can you throw in to the deal without cost to us? (A particularly useful
question to ask car dealers.)

 What is your desired timing for the deal?

 How does our deal benefit you?

 We want to avoid unreasonable forms of contracts or unreasonable lawyers on your

end. How do we ensure that?

Get the help of the best advisors and lawyers. If it’s a big or complicated deal, you want
real expertise on your side helping you in the negotiations and drafting the contract. For example,
if you are selling your company, it is usually worth the money to hire an investment banker who
knows your industry and has relationships with prospective buyers. If you are doing a real estate
deal, you want an experienced real estate attorney who has done many deals like the one you are
working on (and not a general practitioner lawyer). If you are doing an M&A transaction, you want
a lawyer that has done 50 or 100 M&A deals (and not a general business lawyer). These advisors
don’t come cheap, but are worth it if you get the right one.

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