Summary
Know how to do the proper due diligence when buying a small business. Here are the pitfalls and gotchas when buying an existing small business or a larger business acquisition.
How to Value a Business for Sale
Know Your Target Business’s Value, Risk, and Pitfalls
Sorting through the 100,000+ businesses for sale as a business owner
Table of contents
Use a 3rd Party Business Valuation when Buying a Business
Owning and operating a small business can be extremely rewarding. For some, doing so represents the opportunity to create an enterprise with growth potential. For others, it reflects the chance to build a valuable asset for themselves and generations to follow. A corporate career path seldom leads to wealth, like the risk and reward of entrepreneurship can.
Regardless of your motivation for entering business ownership, you should remember that you can do so without launching the business yourself. You can still benefit as an entrepreneur by buying an existing business. But how do you sort through all the business brokers’ listings of businesses for sale?
Received an unsolicited offer to sell your business? Read this blog about setting the business price.
Safely Buying an Existing Small Business
Buying an existing business from a small business owner is a common and popular option among potential entrepreneurs. The practice has become especially common as millions of baby boomers retire and sell their businesses. The Small Business Administration (SBA) will even help you buy an existing small business using a 7a loan and/or seller financing.
By buying an operating company, potential entrepreneurs can avoid startup costs and growing pains. Problems that often accompany you when creating businesses from scratch. Still, finding a business for sale to execute the deal can be complex, risky, and overwhelming. Weigh the pros and cons of starting a business, buying a franchise, or buying an existing small business.
Here are a few initial steps you should consider making to effectively launch your search for an existing business, wherever it is in the United States.
Buying a Business Steps
1. Determine what kind of business you want to purchase
With so many industries and evolving business sectors emerging, you should determine the type of business you want to buy. Usually, we advise you to purchase a business in an industry you know. This is because it may be difficult to succeed in an industry where you have had little exposure to or experience before the sale. Matching the business type with your skill step is a critical first step to the business buying process. Take your time reviewing the many business categories.
You may also consider working with a consultant or law firm to determine what industries are especially thriving in your local market and narrow your search around that insight when drilling down by business categories.
For example, a business that includes real estate, like gas stations, may be important to you. You may want to buy a franchise because the procedures are in place. Please read our article on know value when buying a franchise.
2. Understand why the business is being sold
Once you have an industry in mind, you can proceed with the search by researching online business marketplaces or working with a business broker to identify what businesses are for sale. Either way, you should understand why a business is being sold.
This is because although various simple reasons — like retirement or an upcoming move — may motivate an individual to sell their business, there may also be troublesome reasons spurring the transaction. For example, a business owner may sell their business to avoid existing business debts or inventory difficulties.
When considering purchasing a business, be sure to ask the current owners what problems the enterprise faces or what you should expect to encounter. Consider whether you have the skills and abilities to overcome those challenges if you purchase the firm or buy a business.
When the skill set of business buyers doesn’t match those of the purchased company, significant problems can arise.
3. Analyze the business’ worth
Most importantly, you must consider the true economic worth of the business and understand the steps taken to maximize value. You and the seller can seek independent valuators, like BA FL|GA|HI, to help you determine which appraisal service best suits the situation.
Although the valuation methods used to conduct the appraisal may vary, the factors included in such analysis remain the same. Often, we assess the financial health of a business by considering its team, assets, earnings, market presence, growth, and losses within the context of the firm’s specific industry.
Appraisers often employ a few approaches to evaluate an existing small business and determine its fair market value. Is there enough income stream to fund your lifestyle?
Those Valuation Methods include:
Asset Approach to Valuation
Although imperfect, this method determines the value of a business by taking the difference between the company’s assets and liabilities. Assets analyzed include physical items like machinery, property, and raw materials, in addition to intangible items like intellectual property. Next, assign a monetary value to each asset. We then sum each asset’s value before any subtracted debts or liabilities.
The valuation that this approach yields is a lot lower than the business’ true worth because it fails to consider expected revenue and earnings. Regardless, it is a great starting point for appraising an established business.
Market Approach to Valuation
The market value approach determines the value of a business by considering the market prices of similar assets or businesses that have been recently sold or are in the process of selling. It also considers the value of the business based on geographical location and area. It is especially helpful if you are interested in determining at what price a business should be purchased or sold for within your local market.
Publicly available data regarding company comparisons and transactions are usually utilized for this method. Adjustments should be made for different customer bases, quantities, qualities, or sizes when comparing assets. Please read our article on how to buy an existing business.
Price-To-Earnings Ratio (P/E)
The P/E ratio, or multiples of profit method, is often used to evaluate small businesses’ worth with an established annual record. Confirming the cash flow or seller discretionary earnings is critical for business buyers. You should understand the cash flow method used for the buy-side valuation.
Expert valuators use this method to inform forecasted return growth through prior profits. A higher P/E ratio would be used for companies with high forecasted return growth or repeat earnings. For example, if the P/E ratio of three is used for a company that makes $500,000 in post-tax earnings, the enterprise would be valued at $1,500,000. Please read our article on how to buy a business when you buy an existing business.
Although the calculations used to reach the valuation are straightforward, expert valuators like BA FL|GA|HI can suggest the correct number for your P/E ratio. This is because the P/E ratio often varies from business to business. Startups, for example, often have high ratios because they are high-growth companies. More established companies, on the other hand, like auto shops or local insurance agencies, experience less drastic growth and will have a lower P/E ratio but a stable cash flow.
Data You Need to Value a Small Business to Buy
We have a comprehensive list to value a business. However, at the very least, you should gather the following to control the purchase price before you move forward:
- Business financial statements, including Balance Sheet & Income Statement
- Cash flow statements with details on operating expenses
- Type of business entity and down payment expected
- Sanitized customer lists with credit scores, if applicable
- Asset sale or stock purchase for the business purchase?
- Tax Returns with detailed net income analysis
- Asking price justification
- A/R and A/P aging, if applicable
- Working capital needs and financial projections
- Business asset lists, both tangible and intangible assets, like websites and intellectual property
- Professional licenses, business licenses, and permits that are needed
- Track record and brand recognition
- Client acquisition strategy using social media, websites, and advertising
- Client or Customer Base and Vendor Concentrations
- All operating and management processes
- Sales pipeline and sales agreement
- Business DNB report or credit score
- Zoning laws in compliance and the corporation in good standing
- Copies of any leases or rental agreements
- Business loans or bank loans
- Secretary of state UCC filings on the business’s assets
- The capital structure if you buy a business
- Any partner ownership agreements
- Business plan, if available
- Reason for selling your business
- Personal assets not staying with the business
Using a Valuation When Buying a Business Conclusion:
Purchasing a small business can help you avoid the costs of launching a business. Start-ups typically have a burn rate and no market share. However, buying an existing business also imposes unique risks and challenges. Understanding a company’s true value and worth can be extremely helpful as you strategize and execute a potential sale to you. Don’t rely on a business broker’s back-of-the-napkin valuation when you buy an existing business.
A Small Business Valuation Protects You
Starting with the proper due diligence, a certified business valuation, and an SBA pre-financing letter when you buy a business can put you in control of the business-buying process. Many small business owners you will deal with will only sell a business once in their lives. Smoothly controlling the due diligence process and the steps to a letter of intent will help both buyers and sellers during the business acquisition process.
Closing the deal can run smoothly and safely with our help.
We want to help you safely buy a small business with the proper due diligence steps and a third-party certified business valuation. Contact us today for your due diligence checklist, ideas on selecting a business attorney, a sample letter of intent, a sample confidentiality agreement and non-disclosure agreement (NDA), a sample purchase agreement, business assets Excel, financing options, and a sample business valuation that meets SBA standards.