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Advantages of Buying an Existing Business

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Photo Credit: morebyless via Compfight cc

Photo Credit: morebyless via Compfight cc

1. Established.

An existing business is a known entity. It has an established and historical track record. It has a customer or client base, established vendors, and suppliers. It has a physical location and has furniture, fixtures, and equipment all in place.  The term “turnkey operation†is overused, but an existing business is just that, plus everything else. New franchises may offer a so-called turnkey business, but it ends there. Start-ups are starting from scratch.

2. Business Relationships. 

In addition to the existing relationships with customers or clients, vendors, and suppliers, most businesses also have experienced employees who are a valuable asset. Buyers may already have established relationships with banks, insurance companies, printers, advertisers, professional advisors, etc., but if not, the existing owner does have these relationships, and they can readily be transferred.

3. Not “A Pig in a Pokeâ€. 

Starting a new business is just that: “a pig in a poke.†No matter how much research, time, and money are invested, there is still a big risk in starting a business from scratch.  The existing business has a financial track record and established policies and procedures. A prospective buyer can see the financial history of the business — when sales are the highest and lowest, what the real expenses of the business are, how much money an owner can make, etc. Also, in almost all cases, a seller is more than willing to stay to teach and work with the new owner — sometimes free of charge.

4. Price and Terms.  

The seller has everything in place. The business is in operation and a price is established. Opening a new business from scratch can be the proverbial “money pit.â€Â  When purchasing an established business, the buyer knows exactly what he or she is getting for his money. In most cases, the seller is also willing to take a reasonable down payment and then finance the balance of the purchase price.

5. The “Unwritten†Guarantee.

By financing the purchase price, the seller is saying that he or she is confident that the business will be able to pay its bills, support the new owner, plus make any required payments to the seller.

Five Kinds of Buyers

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Buyers are generally categorized as belonging to one of the following groups although, in reality, most buyers fit into more than one.

The Individual Buyer

This is typically an individual with substantial financial resources, and with the type of background or experience necessary for leading a particular operation.

The individual buyer usually seeks a business that is financially healthy, indicating a sound return on the investment of both money and time.

The Strategic Buyer

This buyer is almost always a company with a specific goal in mind — entry into new markets, increasing market share, gaining new technology, or eliminating some element of competition.

The Synergistic Buyer

The synergistic category of buyer, like the strategic type, is usually a company. Synergy means that the joining of the two companies will produce more, or be worth more, than just the sum of their parts.

The Industry Buyer

Sometimes known as “the buyer of last resort,†this type is often a competitor or a highly similar operation. This buyer already knows the industry well, and therefore does not want to pay for the expertise and knowledge of the seller.

The Financial Buyer

Most in evidence of all the buyer types, financial buyers are influenced by a demonstrated return on investment, coupled with their ability to get financing on as large a portion of the purchase price as possible.

Almost all the purchasers of the smaller businesses fall into the individual buyer category. But most buyers, as mentioned above actually fit into more than just one category.

© Copyright 2013 Business Brokerage Press, Inc.

Why Deals Don’t Close

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Sellers

  • Don’t have a valid reason for selling.
  • Are testing the waters to check the market and the price. (They are similar to the buyer who is “just shopping.â€)
  • Are completely unrealistic about the price and the market for their business.
  • Are not honest about their business or their situation. The reason they want to sell is that the business is not viable, it has environmental problems or some other serious issues that the seller has not revealed, or new competition is entering the market.
  • Don’t disclose that there is more than one owner and they are not all in agreement.
  • Have not checked with their outside advisors about possible financial, tax or legal implications of selling their business.
  • Are unprepared to accept seller financing or now unwilling to accept it.

Buyers

  • Don’t have a valid reason to buy a business, or the reason is not strong enough to overcome the fear.
  • Have unrealistic expectations regarding price, the business buying process, and/or small business in general.
  • Aren’t willing (many of them) to do the work necessary to own and operate a small business.
  • Are influenced by a spouse (or someone else) who is opposed to the purchase of a business.

Seller Financing: The Basics

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Seller financing has always been a mainstay of business brokerage.  Buyers don’t have the capital necessary to pay cash, are unable to borrow the money, or are reluctant to use all of their capital.  Buyers also feel that a business should pay for itself and are wary of a seller who wants all cash or who wants the carry-back note secured by additional collateral. What sellers seem to be saying, at least as perceived by the buyer, is that they don’t have a lot of confidence in the business or in the buyer or perhaps both.  However, if you look at statistics, it’s apparent that sellers usually receive a much higher purchase price if they accept terms.

Studies reveal that, on average, a seller who sells for all cash receives only about 80 percent of the asking price.  Sellers who are willing to accept terms receive, on average, 86 percent of the asking price. The seller who asks for all cash receives, on average, a purchase price of 36 percent of annual sales while the seller who will accept terms receives, on average, 42 percent of annual sales.  These are compelling reasons for a seller to accept terms.  Business brokers have long been aware that reasonable terms are necessary if sellers are serious about selling their businesses.

The primary reason sellers are reluctant to offer terms is their fear that the buyer will be unsuccessful.  If he or she should stop making payments, the seller will be forced to take back the business, hope that the buyer can resell the business, or forfeit the balance of the note.  Another reason is that sellers feel that they can do more with cash than with the receipt of monthly payments. How often do sellers say that they need cash so they can buy another business?  That is probably not the real reason, but selling their business (or house) may be the only time that they can get a “chunk of cash.â€Â  A business broker can help alleviate these fears by pointing out some of the ways sellers can protect their investment and by explaining some of the advantages of carrying the balance of the purchase price.  Equally important is how the deal itself is structured.

Let’s first take a look at the advantages to the seller of financing the sale:

  • The chances of the business actually selling are much greater with seller financing.
  • The seller will achieve a much higher price for the business with seller financing.
  • Most sellers are unaware of how much the interest can increase their actual selling price. For example, a seller carry-back note at 8 percent carried over nine years will actually double the amount carried.  $100,000 at 8 percent over a nine year period results in the seller receiving $200,000.
  • With interest rates currently low [at this writing], sellers can get a much higher rate from a buyer than they can get from any financial institution.
  • Sellers may also discover that, in many cases, the tax consequences of accepting terms are a lot more advantageous than those on an all-cash sale.
  • Financing the sale tells the buyer that the seller has enough confidence that the business will, or can, pay for itself.
  • The seller may be able to borrow some cash using the note and security agreement as collateral.  It may not be as easy as borrowing against real estate notes, but it’s still better than nothing.

What Would Your Business Sell For?

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There is the old anecdote about the immigrant who opened his own business in the United States. Like many small business owners, he had his own bookkeeping system. He kept his accounts payable in a cigar box on the left side of his cash register, his daily receipts – cash and credit card receipts – in the cash register, and his invoices and paid bills in a cigar box on the right side of his cash register.

When his youngest son graduated as a CPA, he was appalled by his father’s primitive bookkeeping system. “I don’t know how you can run a business that way,†his son said. “How do you know what your profits are?â€

“Well, son,†the father replied, “when I came to this country, I had nothing but the clothes I was wearing. Today, your brother is a doctor, your sister is a lawyer, and you are an accountant. Your mother and I have a nice car, a city house and a place at the beach. We have a good business and everything is paid for. Add that all together, subtract the clothes, and there’s your profit.â€

A commonly accepted method to price a small business is to use Seller’s Discretionary Earnings (SDE). The International Business Brokers Association (IBBA) defines SDE as follows:

Discretionary Earnings – The earnings of a business enterprise prior to the following items:

  • income taxes
  • nonrecurring income and expenses
  • non-operating income and expenses
  • depreciation and amortization
  • interest expense or income
  • owner’s total compensation for one owner/operator, after adjusting the total compensation of all other owners to market value

Here are some terms as defined by the IBBA:

  • Owner’s salary – The salary or wages paid to the owner, including related payroll tax burden.
  • Owner’s total compensation – Total of owner’s salary and perquisites.
  • Perquisites – Expenses incurred at the discretion of the owner which are unnecessary to the continued operation of the business.

Developing a Multiplier

Once the SDE has been calculated, a multiplier has to be developed. The following (just as a guideline) should be rated from 0 to 5 with 5 being the highest. For example, if the business is a highly desirable business in the current market, “desirability†would be rated a 4 or 5. If the business is in an industry that is quickly declining or nearly obsolete, “industry†would be given a 0 or 1 rating.

  • Age: Number of years the seller has owned and operated the business.
  • Terms: Is the seller willing to offer terms?  For example, will the seller accept 40 percent as a down payment with the seller carrying back 60 percent at terms the business can afford while still providing a living for the buyer?
  • Competition: Consider the local market.
  • Risk: Is the business itself risky?
  • Growth trend of the business: Is it up or down?
  • Location/Facilities
  • Desirability: How popular is the business in the current market?
  • Industry: Is the industry itself declining or growing?
  • Type of business: Is the business type easily duplicated?

The average business sells for about 1.8 to 2.5. Obviously, if the SDE is solid and the multiple is above average, the price will be higher. Keep in mind that the price outlined includes all of the assets including fixtures and equipment, goodwill, etc. It does not include real estate or saleable inventory. The price determined above assumes that the business will be delivered to the buyer free and clear of any debt.

Veteran Wisdom

When all else fails, the words of a veteran business broker will work.

Asking Price is what the seller wants.

Selling Price is what the seller gets.

Fair Market Value is the highest price the buyer is willing to pay and the lowest price the seller is willing to accept.

Sellers should keep in mind that the actual price of a small business is about 80 percent of the seller’s asking price.

Time to Sell Your Business?

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Sell my business?  Many business owners like you are asking: “When is the right time to sell my business?â€Â  To Empire Business Solutions, a M&A Business Broker in Orange County, California, the answer often relies on three factors, which I will explain below.  However the correct question should be: “When is a good time to take some money off the table?â€Â  These days, with all the private equity (PEG) activity and options, business owners should look at not just the ultimate exit, but whether a partial exit makes sense.

Today it is possible to sell a portion of the company to take advantage of favorable market conditions and diversify your net worth, yet continue to run your company.  So let’s consider whether now is a good time to seek liquidity—either partial or full liquidity.

The three considerations for evaluating the timing of an exit are:

  1. Is the overall market for selling companies favorable?
  2. Is the company’s recent performance strong enough to attract a favorable price?
  3. Am I emotionally prepared and motivated to either exit my company or willing to bring a partner on board to help me take the business to the next level?

It is not likely that you will experience the perfect storm where all three of these considerations are good simultaneously.  Rarely do all the stars line up.  Those who wait for that perfect moment typically wait too long to exit; they are forced to continue in the business longer than they desire or to accept a sub-optimal price.

But the answer to all three questions needs to be acceptable, or the timing might not be right.

In 2012, the answer to the first question is that the market for selling most private companies is getting more favorable.  The prices being paid today are not quite as aggressive as they were at the peak in 2007 and early 2008.  But they are close, and as good as we can expect to see in this new era of limited leverage for the foreseeable future.

Today U.S. corporations have more cash on hand than any time in history.  They are anxious to put it to work, and acquisitions are the most expedient way for many of them to do so.  Additionally, private equity firms have an unprecedented level of cash (often called “Dry Powderâ€) to acquire businesses.   There are over 5000 firms that have to invest in private businesses to justify their existence.  A private equity firm cannot survive unless it invests all of its capital because its investors will ask for their money back—with a return—in either 8 or 10 years from the commencement of the fund.  Today there is a significant pent up demand among both the strategic (corporate) buyers and financial (private equity) buyers.

Moreover, when selling a business, the concern should not be: How much do I get?  Rather, it should be: How much do I keep?  And that is a function of the tax code.  Late last year Congress extended the Bush tax cuts.  That means capital gains rates will remain at 15% until the end of 2012 and hopefully longer.  Our current budget deficit is unsustainable, and tax rates will go up after 2012 and probably never be this low again in our lifetime.

So that leads us to the next question: How is your company performing?  A surprising number of my clients did well in 2012.  If you are in that boat, 2013 should be a superb time from a market standpoint.  The field will get very crowded next year.  But some businesses did not fare as last year.  If you are in that boat, look at 2013 as a time to maximize your bottom line so you can cash out in the coming years.

The final question is whether you are mentally, emotionally and financially ready to exit.  Let’s just summarize some key considerations.
First of all, give up the notion that you can sell your business and invest all the proceeds in Treasury securities with no risk and maintain the same income.   A low risk diversified portfolio of liquid securities will never yield the same return as a private company.  You may think your company is low risk because you are in control.  But from a pure finance perspective, it is not.

If you are not financially or emotionally ready to fully cash out today, you should consider selling part of your business to a private equity firm now, continuing to own a meaningful percentage and operating the business.  Then you can set aside enough cash to take care of most or all of your family’s financial needs and sleep a little better the next time we have a financial or political crisis.  It is not a question of if, but when.  And you can have access to the expertise of professional investors who are trained in how to build business value.  Out of over 5000 funds, surely there is one or two which you could get along with.  Perhaps not.  But to take your company to the next level, having some outside counsel usually helps.  Then in 3, 4 or 5 years you can exit fully—have your second bite at the apple—and provide a nice return to your investors and yourself (and not have all your eggs in one basket in the meantime.)

If you are the type that does not think you could function with a partner in the mix, and you know you want to retire in the next few years, you should target the end of 2013 as the time to be safely out of the business and hope the tax rates have not increased.  And since it generally takes up to 12 months to complete a sale transaction, you need to get busy looking for the right team.  To get the best deal, you need to have an advisor who will pro-actively approach every logical buyer out there and make sure you have several parties to negotiate with.  A competitive process is the only way to assure a successful outcome.