How To Buy a Business

How to buy a business in 7 steps

Sweet spot:

• Operates in the home services sector

• Prices its services competitively and has strong reviews

• Has a healthy employee culture

• Is more than five years old

• Has respectably weathered at least one recession

Nice-to-have:

• Owner is selling because they’d like to retire

• Located in a growing city

• Has at least 10 employees, two of which are managers that will be staying on

• Solid growth projections

• Offers services in several categories

From this thesis, we can discern that the investor wants to buy a decently-sized home service business in a growing city from an owner that is ready to retire. Because the investor has been so specific about what they want, they won’t be distracted by a business that is completely unrelated to their objectives.

Tips for creating your investment thesis

You may be wondering how such an investment thesis gets made. For example, how does the sample investor above know they’d like to focus specifically on home service businesses.

As with every aspect of buying an existing business, this involves systematization. Specifically, as a savvy investor, you should create your investment thesis by carefully considering what type of business you’re most likely to run successfully. Ask yourself the following questions:

• What existing connections do I have? If you’ve built up connections in a particular industry, that makes it a strong content for you to buy a business within. It’s very difficult – especially for first-time investors – to break into a new space with zero connections and so much money on the line.

• What type of business am I most interested in for reasons other than money? Novice entrepreneurs often make the mistake of buying businesses based solely on the amount of money they foresee making. For example, they may watch a YouTube video talking about how much money someone makes operating an elevator business and then say, “Hey – I want that,” despite having absolutely no interest in running an elevator business. This is a mistake because it’s next to impossible for anyone to systematize and grow a business without having at least some passion for what it offers.

• What skills have I developed as a result of prior experiences that may help me as a business owner? This question is related to the first in that your most meaningful professional experiences will likely have occurred in an industry in which you also have strong connections. However, it forces you to think beyond connections alone and consider the actual skills you obtained in that industry. For example, if you’re skilled with HVAC repair, that would be very valuable for helping you revamp a business struggling in that department.

Step 3: Do your due diligence

At this point, you’ve likely identified a good business for sale and are ready to get serious. Before you send a letter of intent, however, you’d be wise to do some due diligence. This may involve requesting some more information about the business than is readily available but it still happens prior to the actual purchase process.

We recommend breaking the due diligence process into a few key categories, which we’ll explore now.

Market-based due diligence

Market-based due diligence involves evaluating the company’s position within its industry. Here are a few important pieces of information to gather. It’s not uncommon for business owners to enlist the help of a market consultant when gathering this information.

• Size of the serviceable market: This figure will represent the dollar value of the market being serviced. For example, if you were offering HVAC services in a specific city, it would be the value of that city’s HVAC industry. You’ll want to be methodical when it comes to identifying this number. If the city in question is large enough, data might be readily available. Otherwise, you’ll have to identify the number of potential customers seeking services the company offers and then calculate the total revenue up for grabs in the market.

• Growth of the serviceable market: Is the serviceable market expanding? By how much? This will help you set reasonable expectations regarding the company’s growth prospects. If the serviceable market is shrinking or stagnant, you may want to consider looking for companies in a more promising region since you’ll have a hard time generating a positive return on your investment, no matter how well you optimize the business.

• Market-based positive trends and opportunities: Here’s where you need to ask yourself why the market is poised for growth. Ideally, you want to identify key reasons people need to purchase the products or services offered by the small business you’re looking to buy.

• Market-based negative trends and threats: With this point, you need to think critically about potential shortcomings in the industry. For example, is the product or service something people only buy every decade or so? Is it difficult to collect payment?

• Alignment with your thesis: As you address the points above, you may find that the business no longer aligns with your investment thesis. In this case, you’ll want to keep looking. The right business will be one that still aligns with your thesis even after you’ve conducted thorough market-based due diligence.

• Barriers to entry: What are the difficulties a newcomer to the industry might face? For example, is there any specific licensing that can be tricky to get? Are there major competitors in the area offering competitive wages and benefits that make it difficult to attract quality workers?

• Industry growth: While this may seem similar to the point on market growth, there’s actually a very important distinction. Specifically, it involves looking beyond the immediate area in which the business you’d like to buy operates and its prospective customers, instead focusing on the industry’s growth on a national or even international level. If the industry is growing rapidly, this means you can count on continued innovation that will provide new opportunities. If the industry is shrinking, however, this may hint at trouble coming down the pipeline.

• The company’s outlook in a recession: How badly would the company struggle during a recession? Would its revenue loss represent an insurmountable problem?

Employee-based due diligence

Employees are the soul of any company. Owners rely on them to deliver quality products and services to customers. Here’s a checklist of the information you need when conducting employee-based diligence prior to sending a letter of intent:

• names, salaries, roles, and – if possible – performance reviews for each employee

• a list of essential employees that would be difficult to replace

• an organizational chart

• the names of any employees that are poised to rise within the organization

• details of any labor or union issues the company has faced in the past

• details regarding who handles key aspects of the business (these aspects will depend on the business itself but may include things like payroll, customer complaints, etc)

Financial due diligence

Financial due diligence, as you can imagine, is incredibly important to do before you agree to hand over hundreds of thousands of dollars for a company. Prior to submitting a letter of intent, we recommend seeking the following information about the company’s finances:

• revenue growth

• expense growth

• major financial risks (i.e. seasonality, customers excessively concentrated within a single demographic, etc)

• habits concerning the company’s cash flow management practices (specifically, accounts payable and receivable)

• whether the company’s add-backs are reasonable

• whether the company’s expenses leave it with enough room to comfortably operate

Here’s a detailed breakdown of the factors that will help you conduct financial due diligence on a company prior to beginning negotiations on it.

Assets

It’s very important that you look into the company’s assets since they can play a major role in determining a fair price for the business. Specifically, ask yourself these questions:

• What is the current market value of these assets? How did the company determine this market value? How does the market value differ from the replacement value of the assets?

• Which assets will be necessary for operating the business in the way you intend? If an asset is unnecessary for fulfilling your vision, you may want to look into excluding it from the sale price and having the company sell it separately.

• What is the cost of maintenance for the assets? When the assets are being maintained, how does this affect business operations?

• Which assets are liquid, which would allow you to sell them promptly if you ever experienced the need to?

• Are there any liens on the assets? We’ll address this further in the legal due diligence section. However, it’s still important to be aware of liens and their value when looking at a company’s finances.

When looking into buying an existing business, keep in mind that you don’t have to accept their evaluation of their asset values. As with everything else, you can negotiate these prices. In fact, you should absolutely do so if you notice a major discrepancy between the market value of these assets and the value the company is claiming.

Tax returns

Tax returns can tell you quite a lot about how the business operates. For one, while some companies, unfortunately, stretch the numbers in documents provided to prospective buyers, doing so on their tax returns would be a crime. 

As such, tax returns generally (but not always) provide a more accurate picture of the company’s financial situation than other documents you may receive during the shopping process.

You’ll want to have a tax professional look at these returns and point out any potential red flags. Acquira uses an external accounting firm for this, which is generally the best way to go unless you happen to be a business tax professional yourself.

Financial statements

Accounts payable

Reviewing a company’s accounts payable will give you a very practical view of its financial situation. If the majority of its invoices are overdue, the company may be experiencing cash flow issues.

Additionally, pay attention to any payments that may be coming due within the timeframe you anticipate taking ownership of the business if all goes well. How will this affect its cash reserves?

Legal due diligence

When you purchase a company, you will likely inherit any major legal issues facing it. The solution? Avoid buying a company with extensive legal issues! As part of your legal due diligence prior to submitting a letter of intent, you should look into the following:

• whether the company has had any lawsuits filed against it and what the outcome of those suits was; an excessive number of lawsuits and unfavorable judgments relative to competitors can be a sign that something is fundamentally flawed regarding how the company in question does business

• whether the company holds any patents, copyrights, trademarks, or other intellectual property

• whether the company is violating anyone else’s intellectual property rights

• potential issues with lease agreements and other key contracts; specifically, you’ll want to determine whether there will be any issues transferring those contracts to you as the new owner

• whether long-term contracts with vendors represent a disadvantage (i.e. the company you’re looking to purchase has an agreement to buy materials at an unfavorable rate)

• any liens that might exist on the company or its assets; you’ll want these to be cleared before you take ownership of the company

• whether the company requires any particular licenses to operate legally; if so, you’ll want to see if these licenses can be transferred to you and, if not, what the process of getting them yourself might be

Here are the factors that will help you evaluate the aforementioned items.

Liabilities

When buying an existing business, you will typically inherit many of its liabilities. These can include debts taken out against assets, which can limit your ability to sell or use those assets fully as you intend.

Another type of liability novice investors often overlook is the warranties that the company offers. You’ll want to determine exactly what these warranties are along with the percentage of claims that ultimately get filed.

If the company sells a notoriously faulty product, for example, you’ll want to keep in mind that you may be liable for warranty claims well into the future despite never having had the opportunity to use the funds from the initial sale of the product as you saw fit (i.e. setting a certain portion of the profits aside to account for warranty claims, which the current owner may not have done).

Failing to be aware of liabilities like these can result in severe legal consequences down the road.

Insurance

Most businesses require insurance. Companies operating in specific sectors may require coverage that goes beyond addressing general liability concerns. You’ll want to be aware of any such requirement and whether the company’s premiums are in line with industry norms.

If the premiums are excessive, you’ll want to determine whether the company has any liability concerns that may affect you once you take ownership beyond simply higher insurance costs.

Stakeholder and customer due diligence

This due diligence entails looking at all parties involved in the operating of the company, including its customers and stakeholders such as vendors and other key business partners.

Here’s the information to gather when conducting this due diligence:

• a list of all crucial vendors and business partners

• who holds these relationships (i.e. if these are the current owner’s contacts and, if so, whether those parties are prepared to cooperate fully with a new owner)

• a list of all crucial customers and associated data, such as their lifetime value and how often they place orders; this is primarily important when you’re purchasing a company that operates in the B2B realm

Red flags to look for include proprietary relationships that are unlikely to be passed onto you as the company’s new owner. This can severely affect your ability to operate the business well.

Risk-based due diligence

One last area you need to pay attention to during your initial due diligence is the company’s risk level. Risks generally fall into one of two categories:

1. Disastrous risks: These are issues you’ll need to address on day one of taking over the company. The consequences of inaction include potentially severe damage to the company’s reputation and ability to operate. These risks include things such as:

a). insurmountable limitations regarding seasonality and cash-flow

b). vulnerabilities to an economic recession, which can happen rapidly with relatively little warning

c). industry-specific vulnerabilities (i.e. a change in technology or legislation that has favored major players at your prospective company’s expense)

d). a decline in the viability of a key revenue stream

e). the threat of crucial employees or managers leaving; it would be expensive to recruit and train replacements

2. Embers: These are issues that require prompt attention yet don’t threaten to burn your business down imminently. That said, they’re still a few steps away from becoming disastrous risks. This can include things like:

a). shortcomings in management processes that would make it easy for fraud to occur at the company

b). a relatively unfavorable reputation, which can manifest itself in the form of bad reviews online if you’re purchasing a B2C company

c). the threat of lesser employees leaving; you’ll still need to replace them but it won’t be particularly difficult or disruptive to operations

In addition to identifying risks that fall into either of these categories, look into what it would cost to address them. You’ll want to keep this in mind when you progress to the negotiation stage.

Step 4: Determine a fair price for the business

Here’s another step in which investors often rely on consultants. In the previous three steps, you’ve assembled many pieces that will help you ultimately determine a fair price for the company you intend to purchase. How you utilize those pieces, however, can mean the difference between ending up with an accurate valuation and missing the mark completely.

The latter outcome can completely derail the negotiation process, costing you money if you’ve aimed too high or shutting discussions down if you’ve approached the seller with a lowball offer. Here are a few of the most common methods for determining fair valuations of small businesses.

Disclaimer

The key thing to remember when working with multipliers is that savvy investors rarely use this method for anything other than producing a rough estimate of a company’s valuation. The other methods on this list are generally more reliable for producing a fair and accurate valuation.

Fair market valuation

This method is perhaps the most intuitive for valuing a company. It involves looking at what comparable companies have sold for recently. A comparable company will be one that serves the same market (which often means occupying the same geographical area) and is of a similar size.

You may need to work with a business consultant to figure out the exact details of these other deals.

Asset-based valuation

Entrepreneurs looking to value companies in capital-intensive industries (i.e. real estate) will often use this method. It involves simply determining the fair market value of those assets and whatever intangible benefits will be transferred along with them.

Return on investment

This method relies on your ability to accurately predict how your money will grow after you use it to purchase the business. As such, it’s typically only useful when you have a high degree of confidence in the company’s projected earnings and growth.

For example, you might use this method when pricing a business that’s been around for decades and proven itself capable of growing within a certain percentage range through thick and thin.

If you’re going to use a business valuation service, choose wisely

There are three credentials generally considered to construe the authority required to deliver accurate business valuations. These include:

• CBA: A certified business appraiser passes a peer review that verifies their expertise when it comes to valuing companies.

• ABV: Those accredited in business valuations have completed 75 hours of training related to the craft. They’ve also passed an exam and hold CPA certification.

• ASA: Lastly, an accredited senior appraiser has more than 10,000 hours of experience appraising companies.

Step 5: Line up your financing

You have a few options for financing a business purchase. These include:

• Cash: Cash is simple and fairly self-explanatory. Keep in mind, though, that businesses can be quite expensive. Depending on your target industry, you may need to have hundreds of thousands of dollars in cash to fund a purchase entirely. You should also remember to leave enough cash in reserves to cover unexpected expenses that tend to pop up within the first year of ownership. In other words, if you spend all or even most of your cash buying a business, you may be stretched too thin.

• Seller financing: This involves the seller agreeing to accept payment in installments. It can convey their confidence in your ability to turn a profit from the company, especially since seller financing repayments often take a back seat to repaying other types of loans.

• Employee financing: You may also have the option of selling shares of the company to employees. Most investors who do this sell non-voting shares to ensure they retain ownership of the organization’s direction. Employee financing still offers many benefits to workers, including the opportunity to share in the profits. 

• Borrowing against company assets: If the company owns considerable assets free and clear, you may also be able to finance a significant portion of the purchase against them. Because this type of loan is secured, it may come with a lower interest rate. However, keep in mind that failure to repay the loan can result in that collateral being seized, which may impact your ability to operate the business.

• Traditional bank financing: If you have solid credit and are confident in the company’s financial viability, you may be able to secure traditional financing from a major bank. This financing will typically come in the form of a term loan you’ll need to repay in installments.

One of the most popular financing methods for buying an existing business, however, is the U.S. Small Business Administration Loan. Let’s take a closer look at how that works.

information about yourself, including:

• a statement of personal history

• personal financial statements

• an SBA loan application form

No matter what type of financing you intend to secure, get the ball rolling before you send the current owner a letter of intent. This will help the process flow much more smoothly with no last-minute surprises or disappointments.

Step 6: Send the current owner a letter of intent and begin the process of purchasing the business

By this point, you’ve done a tremendous amount of legwork sorting through numerous business options and doing your due diligence. Now, you’re ready to begin closing in on a business you’ve identified as worthy of your investment.

The first step is to send the company’s current owner a letter of intent. This will communicate your commitment to engaging in negotiations to purchase the company.

A letter of intent is generally not legally binding unless you include specific language in the document confirming your commitment to purchase the company if the seller agrees to the terms outlined in the letter.

More commonly, however, the letter will simply open dialogue and highlight any conditions you as the prospective buyer are hoping for. The letter will usually include the following parts:

• A confidentiality agreement applying to all future negotiations: The process of taking a closer look at the company will undoubtedly reveal much sensitive information. Including a confidentiality agreement in the letter of intent can put the seller at ease and make your job of conducting further due diligence easier.

• Clauses: Often, the buyer will have certain conditions they’d like to govern the negotiation process. A common clause is that the prospective buyer can walk away at any point in the negotiation without being liable for perceived commitments (barring, of course, an actual notarized commitment to purchase the company).

Step 7: Conduct post-letter of intent due diligence and purchase the business if everything looks good

Once you begin the negotiation process, you will likely have access to more information than was previously available. This is your chance to conduct further due diligence and confirm the company’s suitability.

Here are some areas to revisit during the post-letter of intent due diligence stage.

Employee due diligence

This advanced due diligence should involve:

• identifying which employees you would let go or promote upon taking ownership of the company

• evaluating the company culture and verifying that it is a good fit for your personality and leadership style

• planning how you will address any key parties that seem intent on leaving the company due to issues you may be able to solve

• determining whether the current owner was truthful regarding employee roles and salaries

Stakeholder and customer due diligence

Here, you should use your increased access to:

• verify contact information for the key vendors, customers, and clients

• directly assess existing contracts with the help of a lawyer

Financial due diligence

There’s no reason you shouldn’t have access to the company’s financial books at this stage. This should allow you to:

• verify transactions and compare them with things like the contracts and agreements you should have collected during your post-letter of intent stakeholder and customer due diligence; make sure the numbers add up

• inspect the physical assets that will be transferred along with ownership of the business

• revise your financial forecasting for the company based on the more accurate numbers you now have

Don’t ignore the importance of revisiting due diligence!

It’s very common for novice investors to get excited at this stage. After all, they’re closing in on buying a business they’ve probably been watching and analyzing for months.

This closeness is exactly why we recommend revisiting the aforementioned key areas of due diligence. Once you commit to buy a company, it can be very hard to back out, even in the face of eleventh-hour surprises. Double-check everything and don’t be afraid to involve professionals to ensure everything looks good.

Once you’ve verified everything, the process is fairly straight forward. A purchase agreement will be produced covering just about everything anyone could want to know about the sale, including what is included and any specific clauses.

The purchase agreement will also contain contingencies in case things don’t go as planned (i.e. financing falls through or either party fails to uphold their end of the bargain).

One key aspect of the purchase agreement will be the seller’s representation and warranties, which constitutes their verification that all information they’ve provided you is accurate. This will be your basis for legal recourse if it’s determined anything was grossly inaccurate.

You’ve bought the business! Now what?