By Dr. Amanda Crowe | 09/09/2024
The purchase of a small business may be the most important financial decision you make in your lifetime outside of the purchase of a home. Consequently, it is important to know what to consider before you make this huge decision.
According to Michael Dean of Investopedia, many new businesses fail within the first few years, which creates a buyer’s market for other business owners. The purchase of an existing company is attractive for aspiring business owners because they can avoid the pains of a startup. As with any opportunity, there are benefits and drawbacks to think about before embarking on this journey.
The Benefits of Buying an Existing Business
An existing business entity comes with an infrastructure that will save you the time and effort of setting everything up from scratch. Also, there is an existing customer base, which means there will be immediate revenue that you can build on.
In addition, an existing business has an established financial history that can be helpful in securing funding for updates or growth. There are more opportunities to fund the purchase of an existing business because of the availability of its financial history, especially if it shows a track record of success.
The Drawbacks of Buying a Business
Buying a business entity can come with some issues. For instance, the business may have issues that may not become evident during the purchase process, such as:
- A high number of debts
- Low employee morale
- A poor reputation in the community
The costs tend to be higher when you buy a business. Purchasing an existing business often requires a higher initial investment up front than starting a new business.
Existing businesses provide an established blueprint with existing operations that may be inefficient and outdated. Replacing outdated technology and redeveloping inefficient processes may be costly.
As a serial entrepreneur, I have designed, planned, and launched businesses in various industries and sold them. As a seller, I encourage potential buyers to thoroughly inspect the business from top to bottom and ask questions until they feel completely comfortable with their decision.
Being thorough and doing your due diligence not only helps you identify potential drawbacks, but also ensures that you protect yourself and secure the long-term success and stability of the business.
When I purchased a small insurance agency, for instance, the previous owner passed away and the family lacked the knowledge and licensure to carry on. On the surface, buying the business appeared to be an obvious slam-dunk.
However, I still analyzed the financial health and trends of that agency for the previous five years, pending legal obligations, brand reputation in the community, and the current relationship with customers and employees. Through the evaluation of the relationships with customers and employees, I learned a lot about what to change and what should remain the same when I became the new owner.
Understanding the Seller’s Motivations When You're Buying an Existing Business
When purchasing an established business, be sure to understand the reason that business is for sale. Understanding why the current owner has chosen to part with a business can provide valuable insights into potential opportunities and the risks involved with the purchase.
There are many reasons for owners to sell businesses. Many small business owners sell their businesses as part of their retirement plans. Other business owners may decide to sell if:
- Their lifestyles or personal interests change.
- They want to pursue a new passion.
- Their partnership agreement terms may no longer be agreeable.
Some business owners face health challenges that make owning a small business too difficult. Emotional, mental, or physical exhaustion, also known as burnout, may lead a small business owner to sell.
The goal of understanding the seller’s motivations is to identify any potential red flags and make the best-informed decision. Make sure you learn as much as possible about the successes, failures, and challenges of the business by speaking with the existing owners, existing customers, and existing employees.
Business Valuation
While sellers have an idea of the selling price of their business, it is still important to conduct your own business valuation. During the valuation process, you should use a business valuation professional. However, business brokers can also provide insights and help guide you through the valuation process.
To assess the worth of the business on your own, you can also use a cash flow analysis, asset valuation, or industry multiplier techniques.
Financial statements such as the cash flow statement, balance sheet, income statement, and tax returns will be a great help with your financial review as well. Be sure to review the financial health of the business for no less than the previous three to five years to analyze business profitability for each year.
Cash Flow Analysis
A cash flow analysis examines the cash, or money that flows into a particular business. This analysis is done by reviewing the cash flow statement.
This statement tells large and small businesses where money comes from and where it goes by breaking transactions down into operating activities, investing activities, and financing activities. This analysis ultimately tells you whether the business earns enough income to cover financial obligations as well as any income or shortfall.
Asset Valuation
Asset valuation is the process of determining the fair market value of a business. The fair market value reflects the value of assets and the revenue in annual sales.
Using the asset approach, you need to look at the value of all the assets used in the operation of the business. Be sure to review the net working capital, tangible operating assets, real property, and intangible assets.
The asset valuation should start with a review of the balance sheet, which includes all assets, liabilities, and owners’ equity. Business assets may can be divided into two categories:
- Tangible physical assets such as cash, a building, vehicles, inventory, and equipment
- Intangible assets such as intellectual property
Liabilities are any debts that are owed by the business. The share of the company’s assets that can be claimed by the owner is accounted for as owner’s equity.
Industry Multiplier Techniques
There are various industry multiplier techniques that are effective for the valuation of a business. Market capitalization, for example, is one of the simplest measures; however, it should only be used for publicly traded companies.
You determine the value of a business by multiplying the share price by the number of shares. For a company that is not publicly traded, multiply the revenue or profits by a factor derived from what similar businesses in the industry have sold for.
Do Your Due Diligence
Doing your due diligence involves gathering as much information as possible about the existing business by digging through records, checking references, making sure everything checks out, and searching for hidden red flags. The diligence process should be thorough and involve reviewing and analyzing a large amount of information about the business to be purchased.
You can complete this process on your own. However, it is advisable to conduct your due diligence, including reviewing financial documents and legal agreements, with the help of an accountant and attorney.
What Should You Review during Due Diligence?
Due diligence should cover several aspects of the prospective business, including:
- Financial documents
- Legal issues
- Operations
- Employee relations
- Assets
- Company products and services
- Customer data
The due diligence process is a complex process and should not be conducted without the assistance of your attorney and accountant.
Financial Documents
Analyzing the financial condition of the business for the past few years should provide a good indicator of the potential of future earnings and the company's potential. Review and verify all financial information and financial documents for several years and be careful to go over:
- Income statements
- Cash flow statements
- Balance sheets
- General ledgers
- Tax returns
Operations
Review the company's financial performance, verify its business structure and operational processes, and determine how the organization is set up and how it makes money. You should analyze:
- Articles of incorporation
- The company’s bylaws
- Summary of investors and/or shareholders
- Company names and trademarks
- The company logo, website, domain, and social media accounts used to create an established brand
- All products/services and their profit margin
- Any environmental regulations that could potentially have a financial impact on the business's reputation
Contracts and Legal Information
Prior to purchasing the company, review and verify all relevant material contracts with an attorney to find out the outstanding obligations of the business. Typical business contracts include:
- Legal documents such as non-compete agreements or nondisclosure agreements
- Partnership or joint-venture agreements with other companies
- Distribution agreements, sales agreements, and subscription agreements
- Loan agreements and promissory notes
Check for any outstanding legal issues. This information may or may not be available at the company's location. In the event of information about outstanding legal issues not being available, work with an attorney to verify the city and state(s) where business is conducted so they can check court records and dockets.
Legal issues related to a new business may include:
- Information on all attorneys and law firms representing the business
- Pending litigation or threats of litigation
- Any unsatisfied judgements
- All insurance policies and coverages
- All professional licenses, business licenses, and permits
Customer Data
Review customer lists and databases for the last two or three years. Identify the largest customers and reconcile their purchase histories.
Also, gather information about advertising and marketing programs, as well as copies of standard communications and correspondences. This information will be useful in understanding the customer base and market presence and will give insights about the company's reputation.
What’s Next
Once you decide to purchase an existing company, the transition and handover process is the next logical step in buying an established business. This process involves several key actions, such as creating a transition plan, understanding the day-to-day business operations, and establishing clear communication with employees and customers. You'll also need to carefully examine the sales agreement and review the final purchase price.
But whether you are acquiring a small business or another type of established organization, a well-informed approach will help you make the best decision and set the foundation for the future success in your new company. In addition, it will also provide you with greater peace of mind.
Entrepreneurship Degrees at American Public University
Whether you want to buy a business, start your own company, or develop your professional skills, American Public University (APU) offers two degrees:
Both programs provide practical insights and strategies for effective business leadership and innovation. They are also accredited by the Accreditation Council for Business Schools and Programs (ACBSP®), ensuring that these programs have met high standards of quality.
Online Bachelor of Arts in Entrepreneurship
The bachelor's degree in entrepreneurship is designed for aspiring business owners and innovators who want to turn their ideas into real-world ventures. This degree provides a comprehensive foundation in essential business practices, emphasizing the skills needed to launch, manage, and grow a business.
Courses like “Foundations of Entrepreneurship” and “Practical Law for the Entrepreneur” delve into the fundamental aspects of entrepreneurship and business, and they have a focus on innovation, entrepreneurial processes, and ethical decision-making. Students will explore how various decisions impact outcomes and gain an understanding of the strategic requirements, regulations, and legal considerations essential for launching a new venture.
Online Master of Arts in Entrepreneurship
For those students who seek more advanced knowledge and strategic expertise, the master's degree in entrepreneurship offers a deeper dive into the complexities of running a business. This graduate program is tailored to experienced professionals who aim to refine their entrepreneurial skills and take their ventures to the next level.
“Legal Practices for Entrepreneurs” and “Fundamentals of Business Analysis” will provide crucial insights into the legal environment entrepreneurs must navigate, including areas such as intellectual property, contracts, and regulatory compliance. Additionally, these courses are designed to equip students with the essential skills to interpret, analyze, and leverage data in the business world.
For more details about APU’s entrepreneurship degrees, visit our program page.
ACBSP is a registered trademark of the Accreditation Council for Business Schools and Programs.
