It always sounds like the perfect way to get started in business. You simply buy somebody else's business. This may or not be a good way to go. To help you decide whether it is or not, we will talk briefly about some of the important issues involved.
List of Pros and Cons
There are numerous good reasons for buying an existing business, and you can probably think of most of them:
- Fewer headaches trying to organize and supply the business for an opening.
- Established customer base.
- Established supplier network.
- Goodwill exists already.
- All or most equipment will probably come with the business.
- Former owner may be willing to give you free advice (or for a small fee) on how to run the business, especially if he gets his payments over time. (Think about that when negotiating the terms of purchase!)
- No need to scout business locations, haggle with realtors or landlords over lease terms, etc.
- Experienced employees may come with the deal.
- Business may be profitable sooner than a start-up would be.
- Banks are more willing to lend to a purchaser who can show financial records of a successful business.
- Inventory needed for operation may come with the business, thus the purchasers can avoid the hassle of ordering everything they need (also, the inventory records may provide you with information about quantity and price that may be difficult to otherwise come by).
- Former owner may be willing to sell the business in exchange for a promissory note rather than cash up front (be careful!)
And there are some pretty obvious downsides to buying an existing business, and you can probably think of many of them as well:
- If the business has a bad reputation, it is now your business's bad reputation.
- Equipment may be outdated or useless.
- Former owner may misrepresent the business and get a higher price than what the business is worth. (And try suing a guy who moves to Tahiti!)
- Location may stink, requiring a move.
- Contractual relationships of business may be unfavorable and difficult to escape.
- Poor employees will come with the business unless you fire them.
- The industry or products offered by the business may be dying or obselete.
This list gets you thinking about the issues involved, but the actual determination of whether to buy a business is much more arduous and requires considerable thought and investigation by the potential buyer. Since even businesses in the same industry are often not equal, you need to know every possible thing about a business before buying it. Here are some factors you need to consider when deciding whether to buy a business or not and how much you should pay for it.
Visit the business. If the business is one that is generally open to the public, you do not have to be in contact with the owner of the business at this point. Using anonymity as an investigatory tool, check out the physical state of the business and gauge whether the owners have been taking care of the building and other property. Check out the customers of the place while you are there, see if they are the kind of customers you want to deal with. If possible, in a nonchalant manner, talk to the owner about the business and see if (s)he is enthusiastic about the industry. Obviously, if (s)he talks about grinding poverty and coming financial ruin, this should be a big warning sign (but not necessarily the end of your interest since businesses can be turned around). Try to get a measure of the owner as a person. The more honest the owner, the easier it will be to determine whether the business should be bought since the information you receive is more likely to be accurate and complete.
If the public cannot visit the business site at whim or your initial contact with a public business left you with some interest in purchasing, call the owner and, assuming he is interested in selling to you, ask to visit the business for a look at the premises. Inform him that this is a very preliminary examination of the possibility of purchasing the business, not an offer to buy it. (Note: Some people like to retain their anonymity during this initial phase, and so use a third party to contact the business owner. But this author believes in face to face dealings. Do whatever you feel is best.)
Find out why owner may sell. An owner looking to unload a profitable business may say the exact same things as one selling an unprofitable one. ``I'm selling it because I'm getting old." ``I'm selling it because I want to explore another opportunity." ``My health is failing." Etc. Do not believe it. It may be true, but people almost never sell a really successful business to a stranger. The real reason could be, and probably is, a reason which would cause you to think twice about buying the business.
Typically, the reason people sell businesses is because they are losing money, or they are going to lose money. Reasons businesses lose money are innumerable. Standard ones tend to be a change in the industry (e.g., Walmart gobbling up the retail trade), technological change (try to find a buggy whip manufacturer these days), increased competition, crucial personnel have left the business, or the business is no longer able to obtain credit necessary to operations.
Find out everything about the business. Start by asking other businesspeople in the same industry what they think about the industry and about the particular business in question. They will give you some good information. If possible, make sure that you talk to competitors of the business. Business owners are often surprisingly frank even with competitors. (But you may still want to listen to competitors with a dash of sodium.) Employees (past and present), suppliers, creditors, customers, banks, local government officials, and neighbors of the business are all useful sources of information capable of offering valuable information. You should also contact Dunn & Bradstreet to see if they have information about the business.
The most crucial component in gauging the business's worth is determining its future profitability. Of course, future profits can never be measured precisely, but a rough estimate of what to expect is possible. Past profits of the business are a starting point. To get a sense of past profits, obtain the tax records of the business for the last five to seven years. You should also look at the bank records and any available auditor's reports. Compare the performance of the business against industry performance. If the business being sold is behind the rest of the industry, you need to find out why. The ``why" is crucial since you will make money, break even or lose money depending on how well you can determine how to improve a business's performance.
Also look closely at the business' expenses and capital improvements at the same time. Low expenses and/or negligible capital investment may mean that the owner has not been putting money back into the business, a sign that the owner saw it as a bad investment. High expenses may indicate poor management or that the business is expensive to run.
Financial information like this tells you what happened in the past. The future profits, however, are what you are primarily interested in. You should use the past as a foundation for developing your projections about how well the business will do in the future. Judge how much value you could add to the business with your ideas. This is where you find out whether you are a good businessperson. A good businessperson is judicious and level-headed; their predictions will be a good estimate of the business' future performance, not pipe dreams. Have an accountant, lawyer or other serious-minded professional look at your final projections. They may help you find flaws in your thinking if any exist.
The projection of future profitability will form a large part of not only your decision about buying the place, but it will also help you determine an acceptable price. Depending on the industry there are numerous other items that must be investigated. Some common items on business balance sheets and other assets of a business are listed here as a sort of checklist of things to consider when investigating a business. We have included another checklist of items to investigate, but this is more akin to what an attorney would use to perform an investigation of a business than what a buyer may want to consider.
Determining Price. There are many methods for determining the price of a business. No one method works best in all situations, but some industries have formulas they typically rely on to value businesses, so you may want to check into whether this is true for the industry you are considering.
Asset Appraisal: An appraiser comes in and places a value on the business' assets, usually using book value rather than replacement value. Book value is the original value (typically the cost) of the asset minus the depreciation. Obselete, non-useful or nearly useless assets are not counted as being worth anything. Intangible items such as goodwill and are added to the total (but they should only be 10-20% of the total, and certainly not more than 50%) at the end. Liabilities are then subtracted from the total asset value. Then you have a reasonable approximation of the business' worth.
Future Earning Capitalization: Future profits for an agreed upon period (e.g. four years from date of sale) are estimated by the parties. Then, using an estimate of the risks involved, you discount the future profits for the agreed-upon period. There is no reduction of the profits for taxes before the discounting for risk. Clearly the two variables are open to a lot of guesswork. The owner will try to get a high estimate of future profits and a low estimate of the risk. The buyer seeks the opposite. When determining the risk-factor discount, think about the alternative uses for your money and how risky they are. Judge that risk against the risk of losing money in the business. This should give you a rough estimate of the risk (assuming that your business judgement is good). To estimate future profits, see our earlier section.
Excess Earnings Method: The assets of the business are valued and the annual future profits are estimated. Then the number of years required to establish a similar business is estimated. Next a return on investment is calculated (ROI). (A return on investment is the money a person earns from their investment, for instance a share of stock purchased for $100 dollars and sold for $200 offers a 100% ($100) ROI.) The ROI you use can be the one you expect from the business or one from another investment you may pursue in lieu of the business.
- Multiply the ROI by the value of the assets of the business. Add this product to the amount of money you expect to draw as salary (or skim from the top, heh, heh, heh.) This final sum will give you the expected pre-tax profits from the business. (PTP)
- Next, subtract the PTP from the annual profit forecast, and then multiply that number times the number of years required to start a similar business. This product is the value of the goodwill.
- Add the goodwill to the tangible asset value and this offers a rough estimate of the business' value.
Note that you may get a negative numner when you subtract the PTP from the annual profit forecast. This means that the goodwill value is a negative number, and the goodwill value must then be deducted from the tangible value of the assets.
Each of these three methods is just a way of determining what a good businessperson would pay for the business. If you think you are smarter than other people and can run the business in a better way than anyone else, it may be worth slightly more to you.
Tax Aspects of Purchasing an Existing Business
Asset Purchase and Stock Purchase
There is no federal tax directly imposed on the purchase of a business but there may be state or local taxes imposed. Therefore, before purchasing a business you should contact a local tax professional to determine what local and states taxes may need to be paid. You could also contact the local and state goverments yourself and try to determine whether there any taxes owed; it is not that difficult to obtain such information.
Before we otherwise begin, some important points to remember are:
- The buyer and seller must jointly assign a value to all the business assets transferred and then report this value to the IRS on their respective tax returns. Note that if the buyer and/or seller is a entity rather than an individual, then the entity, must report the value on its return.
- You absolutely must perform a search of the public tax lien filings to make sure that there are no outstanding tax liens on the business and its assets. And regardless of whether there are any tax liens, the seller should indemnify the buyer for any tax liens attached to the assets as a result of the seller's ownership, whether existing at the time of sale or not.
There are two ways to purchase an existing business. First, you can buy all or nearly all of the assets of the business. This is referred to as an asset purchase transaction. Second, you can buy the outstanding capital ownership interests (i.e., stock). This is known as a stock purchase transaction.
When you engage in an asset purchase transaction, you generally will not take on the liabilities of the prior owner of those assets. This generally holds true for tax debts of the former owner as well. But if a tax agency such as the IRS or a state tax agency has filed a notice of tax lien against that business in the public records, then any assets you purchase are still subject to that lien. So make sure that the seller has paid all tax liabilities and/or obtained a release of all tax liens before you purchase the assets. Part of making sure is performing a search of the public records concerning liens. This search is described in our section describing the ``due diligence inquiry" into a business.
Unlike in the case of asset purchase transactions, tax liabilities will pass to the new owner of the business when you engage in a stock purchase transaction. (Additionally, any other debts of the business will pass on to the new owners.) In a worst case scenario, you could buy the shares of an incorporated business but after the sale, the business undergoes an IRS audit, an audit that uncovers significant, and previously unknown, tax liabilities. (For example, the former owner could have erroneously calculated his net income and underpaid his tax bills for several years prior to your purchase of the business.) As the current owner of the business, these pre-sale tax liabilities are now your problem, even though you had no control over the business at the time such liabilities were created. (Please note that this is a general rule. There are complex rules governing tax liability and not all taxes are treated the same. For instance, failure to deposit federal payroll deductions can result in personal liability for corporate officers, liability which remains in effect even after a business is sold.)
Since there is this risk of undiscovered tax liability involved in stock purchase transactions, buyers of stock almost always demand, and receive, from the seller a promise to pay any tax liability or other debt of the business incurred prior to the sale of the stock to the buyer. While these promises, known as ``indemnities", are legally binding, as a practical matter an indemnity is only as good as the willingness and ability of the seller to pay it. If the seller moves to Tahiti after the sale and spends all of his money, you obviously cannot expect to get repaid for any tax liabilities discovered after the stock sale. In such a case the corporation (i.e., you) will have to pay the tax liability.
The unpredictability of tax indemnities lead buyers of corporate stock to insist on an additional clause in stock purchase contracts: a ``holdback and setoff" provision. Typically, these clauses will funnel a certain amount of the purchase price (30-50%) to a special escrowed account controlled by a neutral third party. This escrow account will then be used to pay any tax liability which is discovered after the sale. As you can imagine, sellers typically dislike these provisions. But if the ``holdback and setoff" escrow account pays market interest to the seller on the escrowed money, sellers may be more inclined to accept the arrangement.