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.
Know how to do the proper due diligence when buying an existing business. Here are the pitfalls and gotchas when buying a small existing business or a larger business acquisition.
How to Value a Business for Sale when You Buy a Business
Know Your Target Business’s Value, Risk, and Pitfalls
Sorting through the 100,000+ businesses for sale as a business owner
Use a 3rd Party Business Valuation when Buying a Business.
Owning and operating a growing business can be extremely rewarding. For some, it represents the opportunity to create an enterprise with growth potential. For others, it represents the chance to build a valuable asset for themselves and generations to follow.
A corporate career path seldom leads to wealth. Taking the risk and reward of entrepreneurship can build wealth when you start or find the right business to buy.
Regardless of your motivation for entering business ownership, you should remember that you can do so without launching the new 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?
As the current owner, have you received an unsolicited offer to sell your business? Read this blog about setting the business purchase price and controlling the process.
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 widespread 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 business loan 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.
Business Acquisition Steps when Buying an Existing Business
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 that matches your skill set.
Usually, we advise you to purchase a business in an industry you know. It may be challenging to succeed in an industry without business or professional licenses or industry experience before the sale. Matching the business type with your skill set is a critical first step in the business buying process. Take your time reviewing the many business categories.
You may also consider working with a consultant, certified public accountant, or law firm to determine what industries are thriving in your local market and narrowing your search based on 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 how you know value when buying a franchise.
When our sister company, Bankers Advocate, markets a business for sales, it uses bizbuysell.com, which the Wall Street Journal owns. Bizbuysell.com is an excellent source for finding companies for sale by NAIC code, geographical area, sales per year, and cash flow needs.
2. Understand why the business is being sold
Once you have an industry in mind, you can 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.
Although various simple reasons—like retirement or an upcoming move—may motivate an individual to sell their business, troublesome reasons may also spur the transaction. For example, a business owner may sell their business to avoid existing business debts or inventory difficulties. The due diligence you do is critical.
When considering purchasing a business, ask the current owners what problems the enterprise faces or what you should expect to encounter. Consider whether you have the skills, abilities, and business licenses to overcome those challenges if you purchase the firm or buy a business. Understand their customer base. Is it growing? Shrinking? Diverse? Will the customer demand be there in 3 years? 5 years?
No matter the purchase price, when business buyers’ skill sets don’t match those of the purchased company, significant problems can arise. A small business acquisition is not for everyone compared to a start-up or franchise purchase with a proven business model.
3. Analyze the business’ worth
Most importantly, you must consider the business’s true economic worth 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 a business’s financial health by considering its team, assets, earnings, market presence, brand reputation, growth prospects, cash flows, and losses within the context of the firm’s specific industry.
We can help you see if the target business qualifies for a business acquisition loan from an SBA lender.
Appraisers often employ several approaches to evaluating an existing business and determining its fair market value. Is there enough income 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, raw materials, and intangible items. Next, assign a monetary value to each asset. We then sum each asset’s value before any subtracted debts or liabilities. Balance sheets must be “right-sized” to reflect their true market value.
This approach yields a much lower valuation than the business’s 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 a business’s value by considering the market prices of similar assets or companies that have recently been sold or are in the process of selling. It also considers the value of the business based on geographical location and area. This approach is constructive if you want to determine the price a business should purchase or sell 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 tangible assets and intangible 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 the worth of small businesses 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 generate a forecasted return growth from 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 as an investment. Many less sophisticated business owners run their business off the income statement, not their balance sheet. However, fixing their balance sheet will adjust their income, so be careful.
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 important documents from the seller to control the purchase price before you move forward as the new owner:
Business Valuation Checklist
Business financial statements, including Balance Sheets & Income Statements.
Cash flow statements with details on operating expenses.
All organizational documents.
Is seller financing available? Most sellers will take back a small note.
Type of business entity and the seller’s down payment expectation.
Sanitized customer lists with business credit scores, if applicable.
Asset sale or stock purchase for the business purchase?
Tax Returns with detailed net income analysis.
The asking price justification for the business sale.
A/R and A/P aging, if applicable.
Working capital needs and financial projections.
Business asset lists include tangible and intangible assets, like websites and intellectual property.
Professional licenses, business licenses, and permits are needed to own the business.
The company’s 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 are in compliance, and the corporation is 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 and obtain financing.
Any partner ownership agreements.
Business plan, if available.
Owner’s reason for selling your business.
Personal assets do not stay with the business as part of the business sale.
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. Smoothly controlling the due diligence process and the steps to a letter of intent will help buyers and sellers during business acquisition.
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 in Excel format, financing options, and a sample business valuation that meets SBA standards.