We have business sale and purchase agreements available for immediate download. Here’s some of the key things you should know before buying an existing business. We also have some information available in relation to the process of buying a business.
“Caveat Emptor” – Buyer Beware
1) A Business is only worth its value in actual cash flow
Valuing the business is not as hard as you think, but you should never rely on a broker’s or seller’s estimate as to what a business is worth. Remember that buying a business is fundamentally an investment and consequently the business is worth only as much as its ability to generate a profit for you based on how much money you must put into it. If you’re going to work in the business as most people do, then the business should also pay you a fair wage in addition to the profit that it produces. The best way to determine a business’s value is to work backwards from the available profit that a seller can prove to you. This will at least get you to a point where serious negotiations can then take place.
For example, let’s say that a business has a total of $100,000 pre-tax profit (proven by IRS tax returns for at least the latest full year of operation), before allowing for an owner/manager’s wage. You plan to work full time in the business (and believe me, you probably will!), and a fair wage for the work if you were to hire someone to do it is $40,000. That leaves $60,000 of available profit to work with. But don’t forget to allow for the income taxes that you’ll have to pay on this. The taxes will probably be about $18,000 depending on the state and city the business is in, plus other personal factors (figure at least 30%). That gets you down to about $42,000 of profits left to be able to either pay off the debt you incur to buy the business or to provide you with a reasonable return on your cash investment (if you’re lucky enough to have enough cash to buy the business outright!).
There are many ways to work with this $42,000, but most people and organizations who lend money to buy a business, whether they’re the sellers themselves or others, want to see a relatively short payoff term (let’s say 5 years) and a fair interest rate on the money (let’s say 10%). When you do the math to determine the value of $42,000 worth of yearly payments for 5 years at 10% interest, the amount turns out to be about $165,000. During negotiations you can vary the value of the business up or down fairly significantly by changing the time period used and the interest rate paid. However, this is the approximate total value of the business and a good starting point for negotiations.
2) Most Sellers “Stretch the Truth”
One of the biggest problems in the valuing of small businesses for sale is the frequent claim by the sellers that they are taking large sums of unreported cash out of the business and therefore, the “profits” won’t support the asking price of the business. But “trust them” they say, the cash will be there for you! My advice is to ignore all claims of unreported cash income!! How do you know the seller is telling you the truth? If the seller will cheat the IRS, why won’t he cheat you? And do you really think the seller will admit to you, a stranger, that he is committing what could be a criminal felony if he thought that it could be proven? If the business’s reported sales and profits as evidenced by the IRS income tax returns don’t support a reasonable asking price for the business, walk away. Find another business to buy that is run on the up and up. It’s your money and time you are about to risk — don’t risk it foolishly.
3) Assume There are Skeletons in the Closet
Other things that you must watch out for are the “skeletons in the closet.” These are hidden problems that many businesses have and which may be motivating the seller to unload. You’ll have to be sort of a detective to find these, but I’ll list a few here so you get the idea of what to look for:
credit problems with banks and/or suppliers
personal affairs of the seller that may affect his ability to sell the business (e.g., divorce, death of a partner, argument with a partner, etc…)
historic downward business trends in the seller’s particular industry
downward business trends for this business in particular
recent bad publicity, bad reports at the Better Business Bureau, etc.
expiring patents, licenses, franchise agreements, etc…
changing franchise terms that will increase operating expenses
an impending or actual zoning change that will hurt business expansion
major new competition (such as a new shopping center)
increasing difficulty or expense in getting raw materials, products, or services
the potential non-renewal of a major sales account
significant increases in rent to be expected (if the business space is leased)
unapproved existing variances in violation of zoning regulations
leases that are non-assignable or non-renewable
legal claims, encumbrances, and liens against the business
pending litigation against the business
state and/or federal law violations that will require a major expense to correct
poor management of capital assets requiring near-term replacement
obsolete machinery, overvalued inventory
partner and/or shareholder who may not concur with the seller’s desire to sell
unpaid taxes (income, sales, FICA)
potential major increase in product liability insurance
potential labor union or other employee related problems
inability of a buyer to replace a “superman” employee
non-compliance with environmental and/or safety requirements
recent suspension of a liquor license for regulation violations
need to hire a policeman to handle rowdy customers at certain times
We have business sale and purchase agreements available for immediate download.