How Do I Analyze a Business I'm Considering Buying?

The Need for Confidentiality

Confidentiality is critical to the successful transfer of a businesses. If word gets out that a business is for sale, several things start happening and none of them are beneficial to a prospective buyer. First, key employees start looking for other jobs, fearing that a new owner may not retain them. In the uncertainty, customers start looking around and begin shopping elsewhere. Suppliers get nervous.

This is why a business broker will ask you to sign a non-disclosure agreement. It’s sometimes called a confidentiality agreement. In this agreement, you confirm that you will not disclose the fact that the business is for sale -- except to your professional advisors. And yes, your spouse is considered a professional advisor. After all, he/she consults with you often on a professional basis, right? Just caution them on the need for extreme confidentiality.

If you show that you take the need for confidentiality seriously, you will be regarded as the professional that you are.

Now, let’s say you have identified a business that is for sale and you think you might be interested in it. What next?


The Anonymous Customer

If you’re working with a business broker, he will have furnished you with a one-page fact sheet (profile) on several different businesses. The profile will summarize all the salient points of the business including gross revenue and owner’s cash flow.

From the several profiles that your broker has given you, pick the ones that you would like to pursue. The first step for each business that you would like to explore is an anonymous visit posing as a customer. We call this a reconnaissance run.

As you visit, first, note the location. Is it appropriately located for the type business? As you’re driving into the parking lot, what does the business look like from the street? What about signage and street identification? Then as you walk to the entrance, what kind of an impression do you receive?

Once you’re inside, take a close look around. If it’s a retail establishment, are the shelves full? Is it clean and neat Are there customers there? Are the employees helpful?

What is the general feeling you received from your visit? If you decide this is a business you want to follow up on, make a list of questions for the owner. Make this list while your visit is fresh on you mind. Include anything and everything you’re curious about.

It’s great if the image is good, but don’t despair if it’s not. As one of my astute clients reminded me recently as I was lamenting the poor street image of my business listings, “It’s an opportunity for a new owner to make a difference.”

A word of caution: While on this visit, don’t talk to anyone in the business about the fact that the company is for sale. Chances are the employees don’t know it’s for sale. And even the owner would not be free to talk about it at this point within earshot of customers and employees. Chat pleasantly about the weather … or college football!


The Meeting With the Owner

The next step in this logical sequence will be a meeting with the owner. If you’re working with a business broker, he will set up the meeting at a time convenient with both parties. He will go with you to the meeting and facilitate the exchange of information.

Be sure to bring your list of questions. Ask anything you want to. However it’s usually best, at this point, not to discuss the selling price of the business or the possibility of owner financing. That comes later. But ask anything else that comes to mind. Nobody knows the business better than the owner. If you’re meeting at the business, ask for a tour of the facility.

It’s important that this meeting remain informal and cordial. Remember, you are both checking each other out. If the owner is going to finance a portion of the selling price, he’s looking at you as much as you’re looking at the business. It’s a two way street.

At the end of the meeting, you don’t have to express any commitment. Simply say something like: “Well this has been very informative. Thanks for your time. Let me consider this new information.” It might also be a good idea to covey to the owner that the information will be kept in the strictest of confidence. He’ll appreciate your sensitivity to that issue.


Computing Cash Flow

The next step, assuming you are interested in the business, is to determine the operation’s annual cash flow. After all is said and done, what you will be buying is the ability of the business to produce cash.

So first lets define cash flow. Some brokers refer to it as owner’s discretionary cash flow or ODCF. Owner’s discretionary cash flow is defined as that amount of cash that the business produces in a year’s time that is available (1) to pay back any debt that the owner of the business incurred to buy the business, and (2) for the owner’s remuneration.

Another way to express it is that ODCF is the amount of cash the business produces after all necessary cash operating expenses – and only the necessary cash expenses --have been deducted.

ODCF is not the same as net profit shown on the profit and loss statement. It’s not the same because of the bookkeeping practices of the large majority of business owners. Simply stated, business owners do not keep books to pay income taxes. Most business owners make strenuous efforts to reduce any taxable income.

For this reason, most business owners in an effort to reduce their taxable income run some expenses through the business that are not purely business expenses. This practice reduces tax liability but it also oftentimes masks the true earnings record of a business.

As an example, take the sale of a restaurant that I recently handled. The profit and loss statement from the business was actually showing a small loss. However, the owner’s wife drove a Lincoln Navigator which was listed on the books of the business as a company vehicle. The company also paid for all her gas and maintenance on the Navigator although she has no role in the operation of the restaurant. Same for the daughter’s Honda which she drove back and forth to college. The daughter was also on the payroll as an employee of the restaurant which furnished her with spending money at college, although she never actually worked at the restaurant. The family ski vacation to Colorado was charged to the business because the owner attended a business meeting for a couple of hours while in Aspen. You see where I’m heading here, don’t you? By the time all these items plus any non-cash expenses were accounted for, the restaurant was actually producing a nice yearly cash flow for the family.

In considering a business, your challenge is to determine its true cash flow. This process is referred as the recasting or normalizing of income. If you are using a business broker, he has probably already prepared a recasting worksheet on each business he presents to you.

Remember our definition of owner’s discretionary cash flow (ODCF). It is that amount of cash a business produces that is available for debt repayment and owner’s remuneration. In recasting a profit and loss statement, this is the procedure that is used to compute ODCF:

1. Start with the company net profit (or loss) as shown on the profit
and loss statement or tax return.

2. Add any non-cash deductions that have been taken such as
depreciation and amortization. (These are “paper deductions” allowed by the

IRS for which no check is written.

3. Add any interest expense (because you will be buying the assets
free and clear so you will not incur this expense. It will be available to you for

your debt service, if any.)

4. Add the owner’s salary and perks (because this amount will be
available to the new owner for his own living expenses.
5. Add any family perks (cars, vacations, non-working employees, etc)
that have been run through the business as a business expense.
6. Add any one-time, extraordinary expense items that will not be routinely
incurred again (such as a major repair bill).

The total of these items will give you a more accurate assessment of the cash producing ability of the business and is referred to as owner’s discretionary cash flow (ODCF).


To Pursue or Not to Pursue

After computing the ODCF of the business, the next step is to determine if the cash flow is enough for you.

To do this, you need a fairly close approximation of what your debt service will be on the amount borrowed to buy the business. After all, it’s the amount left over after debt service that will be available for you and your family to live on.

Your broker will have amortizations tables available for debt calculation. Business loans without real estate generally run seven to ten years. With real estate, the term of the loan can be up to twenty years.

An increasingly popular type loan where the seller is offering financing is called the balloon loan. It solves the problem of the seller wanting his money long before a ten or fifteen year term us up and the buyer wanting to keep his payments as low as possible. It works this way. After the down payment, the seller finances the sale of the business with a note from the buyer. The payments are calculated on, say, a fifteen year amortization schedule (to keep them low) but the note calls for a payoff of the balance due (the balloon) at the end of fifth year. During the five years, the new owner builds up a track record and establishes a relationship with a bank. At the end of five years he is in a position to refinance the balloon with the bank and pay the seller. It’s a win-win situation for both parties.

Your worksheet should show:

Annual Owner’s Discretionary Cash Flow $_____________

Less Annual Debt Service $_____________

Cash Left Over to for Owner’s Living Expenses $_____________

It probably should be mentioned that the above calculations do not consider any increases in revenue and cash flow resulting from new ownership. Historically, a business will experience a revenue increase of between ten and fifteen percent due solely to a change in ownership. Nor dies this calculation account for any new products and services or other changes that a new owner may plan to introduce.

Now it’s decision time. If the business is of interest to you, and if it returns the amount of cash flow you need (or can be made to do so), and if you can envision yourself successfully running the business, then you may be ready to move on to next logical step of making a CONTINGENT offer. MY next post will discuss how the offer should be made fully contingent on several things for your protection.

William Bruce in a business broker in the Gulf Coast region.

His Linked-In profile can be viewed at http://www.linkedin.com/in/williambruce

and his website at http://www.williambruce.net/

Despite Economy, Sales of Privately Held Businesses Are Up Significantly

According to this CNN Report, the sales of small and medium size businesses are up substantially over last year, even in this economy. But there are logical reasons for this. See the CNN Report at http://money.cnn.com/2008/08/29/smallbusiness/smallbiz_sales_up.fsb/index.htm.

What is Due Diligence?

Due diligence is a fancy term. In practical use, it can be summarized as that phase in the purchase of a business, after you and the seller have come to an agreement on price and terms, when (1) you verify the accuracy of the information that you’ve previously been furnished and (2) you make sure that there are no serious, undisclosed problems with the business.

In this step, you will inspect the books and records of the company, including the tax returns, to verify the financial information. You will also check whatever appropriate sources are necessary to make sure there are no undisclosed problems lurking around the corner that would seriously affect the business in an adverse manner.

You are entitled to all the books and records of the business including the balance sheets, profit and loss statements, tax returns, and bank statements. At this point, you can ask the seller any questions you want about information contained in any of these records. In fact, you will probably need his assistance in interpreting some of these financial reports. Don’t be shy. Ask for any clarification you need.

You may also want to look at other documents such as the monthly sales tax reports if there is a question about sales revenue or the seasonality of sales during different times of the year. Also the quarterly payroll reports should be available for your inspection if there is any question about wages.

Again, this is the time for you to satisfy yourself as to the accuracy of the information you were previously given and upon which you based your offer to purchase the business.

The other issues that you should satisfy yourself about include any possible litigation, environmental concerns and regulatory issues.

Now if everything checks out – and in the majority of cases it does – then you are almost to the finish line of owning your own business. You can safely approach the closing of the transaction with confidence and enthusiam.

What Type & Size Business Should I Buy?

WHAT TYPE BUSINESS SHOULD I CONSIDER?

You may already have a pretty good idea. If your family or some of your friends own a business, you probably have some familiarity with that type of business. Is it the kind of business that you can see yourself operating?

What are your preferences on hours worked, management of employees, physical labor, and interaction with customers? Do you prefer to stay in one place or would you rather be on the road in your new business? Do you prefer to stay indoors or are you’re the outdoor type? Are you a people person? Are you service oriented? Your preferences in these and other matters will give you some direction as to the category of business.

However, the decision really boils down to this question that you should ask yourself as you consider any type of business: Can I see myself happily and successfully operating this particular business? If the answer is “yes,” then that may the business for you – assuming, of course, that the company checks as you take a closer look in the steps that are explained in the subsequent chapters.

Some more words of advice: Keep an open mind as you look at different businesses. Don’t become so inflexible as to type of business that you would automatically rule out an excellent business for sale in your price range producing the income that you desire.

An interesting statistic from my business brokerage practice is that over half of my clients wind up buying a business in a category different from the one that they initially contacted me about. So, stay flexible as to type with your eyes wide open for a jewel of a business in a category you may not have considered.


WHAT SIZE BUSINESS CAN I BUY?

The answer to this question is dependent on the amount you have to invest. Down payment requirements for buying a business range from approximately 20% to 50% of the purchase price of the business -- with the average being about one-third.

Let’s say you have $40,000 to invest in the purchase of a business. I don’t advise my clients to use their total available investment as a down payment because they are going to need (1) some working capital in the new business and (2) a contingency amount put aside in case of unforeseen personal or business needs.

The amount of working capital needed depends on the necessary monthly operating expenses of the business. Let’s say the business you are buying has operating expenses of $3,500 per month which includes rent, insurance, utilities, payroll and the other items needed to keep the doors of the business open. If you have determined that the business has good cash flow and there are no major problems, you could probably get by with one month’s expenses figured in as working capital. However, to be safe, I usually recommend two months expenses held back for working capital. In this example that would be, of course, $7,000.

As to contingencies (some call it a “rainy day” fund), I like to include at least one month’s personal living expenses. In this case, let’s say your home mortgage, car note, groceries and other expenses all total $3,000 per month.

After deducting the two months business operating expenses (working capital) and the contingency fund (one month’s living expenses) from the available $40,000, we have $30,000 to offer as a down payment on a business.

Which brings us back to the question: What size business can I buy?

The answer is a matter of simple arithmetic. With the $30,000 and the fact that some businesses can be bought with a 20% down payment, this would project a maximum price for a business of $150,000. With the more likely one-third down payment, the maximum purchase would be $90,000. So somewhere in this range of $90,000 to $150,000 is the size business you can afford.

And from my experience as a business broker, there are lots of attractive businesses out there of this size that produce a very nice profit for their owners. Your job is to find them!

Business Acquisition Financing. Or Where Do I Find the Money to Buy a Business?

There are five places to find money for the purchase of a business. We’ll discuss each below.

FAMILY

Many times the older generation in a family will loan the down payment or the entire amount needed to a promising member of the family’s younger generation. If your family is willing to loan you the money, one word of advice is in order. Have a very clear understanding as to how the debt is to be handled and put it in writing in the form of a legal note. And even though it is family, I also suggest that the note carry a reasonable rate of interest. The written note with a reasonable rate of interest will not attract the attention of the IRS who otherwise might try to reclassify the loan as a taxable gift or income. Also, note that earns interest can keep peace in the family, particularly among other family members who might be a tad jealous.

BANKS

Although most people seeking a loan to buy a business will think first of banks, I can tell you from years of business brokerage experience that banks generally do not make business acquisition loans.

That statement will surprise most people. Once you’re in business, banks will compete for your patronage, but most will not stick their necks out in the beginning to make you a business acquisition loan. Bank advertising would lead you to believe they would do so, but in more than 90% of the cases, they will find some reason to decline the business acquisition loan application.

The exception might be if you have a strong, years-long relationship with a bank and you can offer some other collateral such as Certificates of Deposits. Or if the bank participates in the SBA loan program, they might be able to approve a SBA guaranteed loan (see SBA below).

So if a bank turns you down, don’t take it personally. And don’t take it as a reflection on the business. It’s just the way things are.

Now this is the humorous part of the situation. It’s ironic but it has happened more than just a few times. After you’ve been in business for a number of months or a year or so, the same bank that turned you down for a loan to buy the business may come calling on you soliciting your banking business! One of my clients in this situation said to the banker in all seriousness, “Well now Mr. Banker, we’ll be happy to consider your application for our business. Let’s see, we’ll need your financial statement and a list of references and your business plan for five years into the future. Once we have your completed application, I’ll be glad to take it before my committee and let you know of our decision.”

The banker was taken aback. I thought it was funny.


SBA

The SBA, through its approved lenders, provides business acquisition loans. The SBA generally does not make direct loans, but rather guarantees the loan that is made by the approved lender. It’s known as the SBA 7(a) program.

The SBA list of approved lenders includes some banks and many non-bank lenders such as CIT, GE Small Business Lending, and AT&T Finance. Some of these lenders will include an amount for working capital in addition to the price of the business in the loan amount. Down payment requirements range from 15% to 25% plus there are usually up-front fees involved for various requirements. Interest rates are competitive with the marketplace.

The SBA guaranteed loan requires a lot of detail and documentation. If you go this route, be patient. And stay on top of the SBA requests for information. The quicker you can get the information and documentation to the SBA underwriter, the quicker your loan will close.

The SBA route for a business acquisition loan is sometimes frustrating because of the time and detail that is involved. However, keep in mind that the SBA will approve loans that others have turned down and will usually approve them with a smaller down payment. In most cases, it’s worth the wait.


THE SELLER

In the majority of the business transfers that I handle, the owner of the business finances a portion of the purchase price for the buyer. Some sellers cannot offer owner financing for a variety of reasons, but when they can, it conveniently solves the problem of financing.

The fact that the business owner is willing to finance the sale of his company provides more than a convenient finance plan. More importantly, it provides a strong validation of the owner’s belief that the business will support the owner and earn enough cash to pay back the loan. You can’t get any better recommendation on the business than this.

Owner financing also keeps the owner “in the boat” for the duration of the loan. If the new owner experiences any problems, the seller has a vested interest in assisting.

The normal down payment for owner financing ranges generally from around 25% to 50% of the purchase price of the business. Interest rates are generally market driven but there is more flexibility here than in other forms of financing.

Of course, the owner is going to want to know a little about you before making a commitment to finance. If you’re going to ask him to finance the business for you, be prepared when you meet him to give him some background information on yourself and your business or work experience. Remember, you need to sell him on your qualifications as much as you need to be sold on his business. In future meetings with him, assuming you are seriously interested in buying the business, it would be an act of good faith on your part to give him your personal financial statement, a list of references and a copy of your credit bureau report (if it’s good). That shows professionalism.

Most owner financing – though not all -- is in the form of a balloon note. The balloon note solves two opposing desires. The buyer of the business wants to keep his payments low; however, the seller usually wants his money as soon as possible. By amortizing the note (calculating the payments) on, say, a 12-year payback schedule, the payments are kept low. But the inclusion of a 5-year balloon requires that the balance be paid off at the end of five years. After the new owner has been in business for five years and has built a track record for himself at this bank, he should have no trouble going to the bank and refinancing the balloon. In the low interest rate environment of recent years, I’ve seen new owners refinancing the balloon even before it came due to save money. The balloon note has been a win-win vehicle for both buyers and sellers.

401(K) FUNDS AND IRA ACCOUNTS

The use of these funds to buy a business, without tax penalty, is a recent development. Several national CPA and attorney firms have developed a plan, approved by the IRS, which allows you to use your funds for business acquisition.

There are legal and accounting fees involved, but they are a small fraction of the tax penalty that would be assessed for cashing in these accounts. For additional information on this option, call your CPA, attorney or business broker.

In my business brokerage practice, we have developed a relationship with a couple of firms that specialize in this area and we can make a referral for you.


A Trifecta

The above five sources of financing are not mutually exclusive. I recently handled a transaction in which three of the five sources were used to buy the business.

It’s called creativity!

What is a Business REALLY Worth? Qucik Appraisal Methods.

As president of the American Business Brokers Association and as a full time business broker, I’m often asked how one can determine the real market value of a particular business.

Nothing causes company owners or the buyers and sellers of privately held businesses more anxiety than the problem of business valuation. In a transfer of business ownership, the question of selling price haunts both parties to the transaction. The seller doesn't want to price his business too cheap and “leave money on the table”. On the other hand, the buyer of the business is afraid he’ll pay too much and not get the best possible deal.

The appraisal of privately held businesses is not an exact science but there are guidelines and rules-of-thumb that can be used for a close approximation of value. And formal business appraisals are now readily available. Professional appraisal firms can produce a quality report on the business with the conclusions of value thoroughly supported and documented, all done for a fee of around $1,500.

Certain situations require a formal business appraisal including the larger merger-acquisition transactions, SBA loan applications, management performance tracking, estate planning, divorce -- or the most dreaded of all -- IRS issues. After all, a professional, fully documented appraisal certainly takes the guesswork out of the situation.

However, what we will discuss here is not a formal appraisal but rather the informal methods of quickly approximating the value of a business entity. All of the guidelines we’ll quote are averages derived from thousands of completed transactions reported to national and regional databases.


Let’s First Define What We’re Appraising

Most small business transfers are asset sales and the appraisal guidelines that follow assume an asset sale. This means that the buyer of the business buys certain assets of the business – usually the furniture, fixtures, equipment, inventory, the business name, and goodwill. These assets are transferred to the buyer at closing free and clear of any encumbrances. Generally not included in an asset sale are the cash on hand and the accounts receivable. These two assets are usually are retained by the seller of the business.

The opposite of an asset sale is a corporate stock sale. In this case the purchaser buys the outstanding shares of stock in the corporation, thereby taking control of all the assets and debts of the business.

And a basic word on business value might be in order here. An on-going business entity that is earning a profit is worth more than the sum of its tangible assets. What is really being transferred in the sale of a business is an income stream. Business appraisers seek to put a value on that income stream.


The Two Appraisal Guidelines

There are two formulas for business appraisal guidelines. The first one -- and the easiest to use -- says that a business should be worth a certain percentage of its annual revenue. The other formula -- and generally the more accurate of the two -- uses a multiple of the cash flow that the business produces. These guidelines assume all furniture, fixtures and equipment needed to do business. The cost of current inventory on hand should be added to the formula results to obtain the business value. And as stated above, the sellers of most small-to-medium size businesses do not include in the sale any cash or accounts receivable. Hence, the guidelines do not include these items.

Nor do the guidelines include any allowance for real estate. The guidelines assume that the business is in a leased location at a competitive lease rate. If real estate, cash or accounts receivable are to be included in the sale of a business, their value should be added to the guideline results.

And these guidelines assume that the business is making a net profit percentage that is within the average range for the type of business. If the business is above or below average in profit percentage for its category, the resulting values would need to be adjusted accordingly.


Value as a Percentage of Annual Revenue

First, almost all privately held businesses with annual sales under $5 million are worth somewhere in the range of 20% to 80% of the company’s annual revenue. In one large database, the average price in the year 2000 of 3,8000 transactions was 44% of revenue.

Exactly where in this range of 20% to 80% of revenue the value of a specific business falls depends on the kind of business. The range in valuation percentages is reflective of the many differences in the various categories of businesses. For example, some types of businesses require more expensive equipment that others. And some categories of businesses historically take a higher percentage of total revenue to the bottom line as net profits. This is why convenience stores, for example, are at the low end and dry cleaners are at the high end of the range when business value is expressed as a percentage of total annual revenue.

If you’re looking for an auto parts retail store, as another example, you should expect to pay about 45% of revenue to purchase the business. Let’s say you are looking at a tire store with auto service. You should be able to buy it for somewhere around 40% of sales. Other examples: dress shops sell at around 20% of sales, coin laundries at 75%, franchised fast food outlets at 50%, print shops at 50%, vending routes at 65%, video stores at 55% and restaurants at somewhere between 25 to 35% of sales depending on type. Manufacturing operations sell for somewhere in the neighborhood of 65% of revenue depending on the product and other factors.


Value as a Multiple of Cash Flow

The other set of guidelines seeks to approximate the value of a business by applying a multiple to the annual cash flow that a business generates. This second guideline states that most companies will sell for between one to six times the discretionary cash flow produced by the business. Exactly where in this range that a specific business falls, again, depends on the type of business.

From the database of completed transactions, we know that an air conditioning/heating contractor would sell for somewhere around 1.5 times cash flow. Beauty salons go for about 1 times cash flow. Day care centers that are licensed for 100+ students sell for around 4 times. A hardware store is worth approximately 1.2 times. Other examples: Home health care is 3 to 5 times, janitorial services are 1.5 times, jewelry stores are 4 to 6 times. Manufacturing operations will sell for between 3 to 5 times, depending on size and quality. Wholesale distributors in general can be bought for 1.5 to 2 times cash flow.



But You Are the Ultimate Judge of Value

However, you as the owner, seller or buyer of the business are the final arbiter of what the business is worth to you. Remember, these guidelines are only averages. And the guidelines certainly don’t take into account any special considerations or any future plans that an owner might have for the business. What a particular business might be worth to you may be more or less than it’s worth to the next person who looks at it.

One final observation: There is little geographic deviation in the value of businesses. A gift shop in Alabama is worth about the same as a similar one in California. What really counts more than anything is how well the business is performing financially.