Having your own company is great. Building one from scratch? Hard.
This is why some entrepreneurs opt to buy an existent business outright. There are other reasons to buy a business too, like receiving an up-and-coming competitor or just creating your asset portfolio.
Whatever your reason, the process of buying a small business follows the same pattern. From locating and evaluating the right business, to closing the transaction, we’ll walk you through the whole procedure so you know what’s coming.
Step 1: Find a business to buy
The first step is not just finding an available business, but finding one that’s worth buying. There are a bunch of businesses for sale. But ones with financial security that holds your interest aren’t so familiar. You need to find a business that’s primed for profitability and isn’t hiding any skeletons.
When you’re ready to buy a business you should look for these things:
- Positive cashflow (or a trajectory that shows potential);
- An enterprise you’re familiar with;
- Diversity of customers (no one client should be more than 20% of revenue, roughly);
- A long-term development plan;
- A business that you could see yourself appreciating.
Where to find a business to buy
The wider your search, the more likely you are to find a gem. Don’t just stop looking when you’ve found a company that ticks all the boxes. Look in as many areas as possible before you start ranking your favorites.
Some of the rocks you can turn over include:
- Online broker sites like future4u;
- Local business brokers;
- Local attorneys;
- Local CPAs;
- Existing small business owners in your ideal industry.
Step 2: Value the business
Once you’ve determined a business you’re interested in, it’s time to figure out how much the business is worth. You’ll find a number of sellers that overestimate their business, and it’s important to make sure you don’t overpay.
When valuing a business you have two options:
- Do it yourself;
- Hire a professional;
The problem with hiring a professional is it can be expensive—up to $5,000 or more.
But if you’re not sure about your ability to make an objective assessment, we’d recommend this.
A business valuation is typically calculated through either company income, net income, or EBITDA.
We can’t give just one answer about how to value a business, because each type of enterprise is handled differently.
Step 3: Negotiate a purchase price
Once you’ve determined you want to move forward with the business acquisition and you think you have a good idea of what the company is worth, it’s time to negotiate the payment. You’ll typically do this by making an unbinding offer, either written or verbal. If your offer is close to what the seller is willing to sell for, they will start dealing with you.
With most business transactions, you’ll go back and forth, negotiating different buy prices and terms before you come to a tentative agreement.
These terms can be changed later if you find something during due diligence that transforms your opinion of the company’s value.
As part of the negotiation, you’ll decide whether you want to purchase the assets of the business or if you want to make it a stock sale.
A stock sale is preferred by most sellers for tax purposes. In a stock sale, you’ll be agreeing to take on any outstanding legal liability because the company operations will continue as is, just with a new owner. Some sellers will even give you a discount on the purchase price for agreeing to a stock sale.
Step 4: Submit a Letter of Intent (LOI)
Once you have a broad idea of the terms and structure of the business purchase, you’ll submit a letter of intent. This is a letter that outlines everything you’ve previously negotiated, including the purchase price, and states your intent to buy the company. This is a non-binding agreement that just furthers the business acquisition process. It shows the seller you’re ready to commit and move forward in the process.
The letter of intent will also typically give you complete rights to buy the business for some time, usually up to 90 days. This indicates that you’ll be the only one that can buy the business during the time frame, and the seller has to act in good faith to close your trade if you’re able to meet the terms of your LOI.
Step 5: Complete due diligence
When the LOI is signed by you and the seller, then you’ll get access to more information about the business. Typically, when you first show interest in buying a business you’ll get a basic outline of how the business is performing. But when you enter due diligence, you’ll get access to any financial or legal information that you feel is needed to close the transaction.
We suggest making sure you review the following documents, at a minimum, before you close:
- Corporate documents for the business (e.g. incorporation docs, certificates of good standing, business licenses, etc.);
- Previous 3 years of company tax returns;
- Current year income information, balance sheets, and cash flow statements;
- Revenue broke out by the customer for the last 3 years;
- Information on existing business debt;
- Customer lists with proprietary information are blocked out as necessary;
- Existing contracts—can these be assigned to the new owner;
- Commercial lease or other property documents;
- Rent rolls if the property has tenants;
- Uniform franchise disclosure document (if the business is a franchise);
- Employee and manager information;
- Marketing and advertising materials;
- Legal records for pending litigation, if any;
Step 6: Receive a financing
During due diligence, you should also be working on financing for the transaction. Most businesses are purchased with a combination of debt and equity, meaning you’ll come up with part of the purchase price and the rest through a loan. You’ve got lots of options here, including SBA loans, traditional bank loans, and using a Rollover for Business Startups (ROBS). If you have a strong 401K, going for a ROBS is the best explanation, as you can finance the purchase without having to pay back debt or interest.
Before you enter due diligence you should know whether or not seller financing is an option, which could alleviate some of the financial burdens of finding a loan. Seller financing is a loan provided by the owner of the business instead of an outside lender. This typically takes a lot of documentation from you as the new business owner and from the business itself. That is why it’s important to work through this process during due diligence. You’ll want to make sure your lender is ready to fund when you need to close the transaction.
Step 7: Complete the transaction
If there were no surprises during due diligence, then it’s time to close the transaction. This is where you’ll draft a final purchase agreement and agree to every term of the deal with the seller.
You should always hire a lawyer to help you negotiate this part of the process. At the very least, they can review the purchase agreement to make sure you’re getting what you negotiated through the contract.
After both parties sign the purchase agreement, you’re ready to choose a closing date and have your lender fund the purchase. Your funds will typically go into escrow (meaning a bank or law firm will hold the money for sake keeping) on the day you’re supposed to close until all documentation is final. Once both parties give their approval then the money will be given to the seller and you’ll own the business outright.
As soon as the closing is finalized, you’ll need to apply for any necessary business licenses to make sure your business operations have a smooth transition. Some states will let you operate with the existing licenses during the transition period, but don’t let it slip out of your mind. If your business acquisition is a stock purchase then you may not have to worry about this at all since the business entity won’t change.