Buying a business, big or small, is both exciting and daunting. The challenges of taking over an existing business include maintaining (and hopefully growing) revenues, expanding market share, innovating new product or service offerings, and finding new efficiencies. Before that, however, lies a gauntlet of different challenges that must be overcome if the acquisition is to be successful.
Most importantly, potential Buyers need to ask themselves several basic questions before pursuing the acquisition of an existing business. Here are KLC’s Top 5 Questions to Ask Before Buying a Business:
1. Why am I buying this business ?
Owning a business is both rewarding and challenging. Most business owners will readily tell you that the hours and demands are usually greater than having a job – even an executive position with a large company. There are several reasons: no support structure, no regular hours, and of course, no regular paycheck. All of that is the price of complete freedom – to succeed or fail, and often both – repeatedly – depending on the quarter or year.
Buyer’s motives vary widely. Some are entrepreneurs burned out by the corporate marathon, and some have a hidden passion they’ve always wanted to purse (singing ! or cupcakes ! or singing cupcakes !). Others may be reluctant entrepreneurs who’ve been laid off and just don’t want to be in that situation ever again. At a corporate level, companies usually buy other companies because the target is a competitor, or has products or assets that they Buyer believes will complement their existing business.
Honestly evaluating your own motives – money ? autonomy ? passion ? – is the first step in building a sound business plan and strategy.
2. What is my level of knowledge or experience with the business and its industry?
This seems obvious, but many Buyers – both entrepreneurs and larger companies – often overestimate their knowledge and ability to assess potential pitfalls. Some studies have found that many public company acquisitions are failures – meaning the Buyer did not achieve their acquisition goals, whether economies of scale, increased profits or revenues, or greater market share. Common reasons include integration challenges (e.g., combining two labor forces that may not want to be combined), different corporate cultures, misjudging market impact and perceptions, or simply failing to appreciate the complexity involved in combing two companies.
On a small, entrepreneurial level, it is critical to undertake an honest self-assessment of your ability to run the business you’re looking to acquire. While deep knowledge and experience within the industry is a key advantage, it does not follow that little or no experience is a deal-breaker. That deficiency can be compensated for, at least to some degree, with comparable experience in a different industry, or with hands-on support and guidance from the selling owners or other industry partners, or with sheer passion and will to succeed.
The point is that “fake it till you make it” usually doesn’t work when owing a business. Employees and customers have the final say in determining whether a business will flourish or wither on the vine. By honestly recognizing your own strengths and limitations, you will actually empower yourself to get the help you need to succeed.
3. How will I finance the purchase and future capital needs?
Every Buyer of a business understands the need to secure loans or other sources of capital to make the acquisition happen. Financing an acquisition can be done in four general ways: personal capital, bank loans, new investors, seller financing or some combination of the four. Except for very small businesses, or very wealthy Buyers, most business Buyers need some new capital for the acquisition. If the Buyer has insufficient personal capital and either doesn’t have or doesn’t want co-investors, and the seller is unwilling to finance the transaction, a bank loan is likely the only alternative (the Small Business Administration was created for that purpose, and SBA loans are usually an attractive option for Buyers). For smaller business owners, that usually means a personal loan guaranty and a lien on their home. That’s a frightening obligation to have, since failure of the business could have a drastic impact on not only the business owner, but his or her family as well. Therefore, before undertaking that kind of commitment, Buyers must carefully assess their likelihood of success, and what their “Plan B” (and C and D) is if the loan is called under default.
In addition to acquisition capital, Buyers must be mindful of the need to generate, maintain or secure operating capital for the foreseeable future (e.g., the next 12-18 months). If the business continues to perform at the same level, or becomes more profitable, then operating capital will probably be sufficient. But if the unexpected happens, business owners need both adequate cash reserves and a strategy to find new sources of capital.
4. Why is the Seller selling ?
Understanding fully the Seller’s motives is important since it helps the Buyer frame the transaction properly. For a family-owned business, a common reason is a retiring owner whose children can’t or don’t want to take up the mantle. Another Seller might wish to exit when business is good to pursue different opportunities. Larger businesses may have several partners, and some may be more motivated to sell than others. On the other hand, some Sellers are under financial or personal pressure to exit because the business is doing poorly, or they have family or health issues. Performance is based on a large number of factors, some of which are beyond the control of the business owner. Therefore, it’s important for the Buyer to assess an under performing business with humility. Simply assuming you can do better is a risky way to analyze a business before you buy it. A Buyer must carefully consider such factors as the businesses strength in the market, customer base, the durability of its relationships, and whether a change in ownership will be viewed positively or negatively by customers and employees.
Two other important considerations are seller financing and transition consulting. Some sellers are willing to accept the purchase price in part cash, part debt. This is sometimes called “seller financing” since the Seller effectively acts as a bank, or lender, for the Buyer. In almost all cases, a seller who accepts a note as part payment for the business will require a lien on all assets of the business, and a personal guaranty (and probably a lien on the Buyer’s home). In some respects, this makes things easier on the Buyer, since there is no need to go through the burden and delays associated with mortgage lending from a bank. But it also has a higher risk of tension or even litigation if the Buyer experiences cash flow problems before the note is paid off.
Transition consulting is an arrangement in which the seller agrees to stay on for a certain period of time post-closing to assist the Buyer. This period can be anywhere from a few weeks to a few years, but typically lasts under 6-12 months. The Seller may or may not demand additional compensation, but especially for Buyers of smaller businesses in which they may have little experience, transition consulting can be a critical boost to a new owner.
5. Do I understand all of my risks and obligations?
It’s human nature to be optimistic (or at least to want to be optimistic), but successful business owners are constantly asking “what if X happens”, and “what about Y?” Healthy skepticism is a good defense against complacency, assumptions and insufficient due diligence.
When evaluating risks and obligations, Buyers need to focus on two big baskets: risks and obligations in the acquisition itself, and risks and obligations in owing and running the business in the future.
The first basket includes the Buyer’s relationship with the Seller. The Buyer’s main obligation to the Seller is paying the full agreed-upon purchase price, some of which may not be due until after the closing. In all business sales, the Seller’s first and last concern is receiving the full purchase price. Therefore, if there’s even a temporary payment default, a Seller may become aggressive and possibly interfere with the business until full payment is made.
While a Buyer has one primary obligation to the Seller, payment of the purchase price, Sellers typically have multiple obligations to the Buyer. The first is to accurately and completely disclose all relevant information about the business that the Buyer requests. In a typical purchase agreement, the Seller will make multiple “representations and warranties” about the business, and if any of them prove to be wrong or incomplete, the Buyer may be able to sue the Seller for damages (or, in rare cases, even unwind the purchase). The Seller may also have post-closing obligations to provide transition support, and some Buyers actually hire back the Seller for some period of time to work on the transition or as part of management.
The second basket is comprised of all of the risks and obligations inherent in owing and operating any business. This includes macro risks, such as the Covid-19 pandemic and the national economy, and micro risks, such as a key sales employee who might quit and take customers with her. A Buyer must also carefully consider the many obligations that come with running a business, including obligations to employees, regulators, customers, vendors, lenders, investors, and partners, among others.
Finally, as part of the second basket, Buyers should ask their attorney to clearly explain what pre-closing liabilities or obligations of the business, if any, the Buyer is assuming. Generally, the liabilities of a business remain with it regardless of a change of ownership. These liabilities can include everything from wages owed to employees, to unpaid invoices from last year, to liability for a breach of contract claim filed by a vendor before the closing. Unless these liabilities are addressed in the purchase agreement, the Buyer will probably be assuming them on closing. Therefore, Buyers should be sure to discuss with their attorney what pre-closing liabilities, if any, the Buyer will be assuming. And of course, if any such liabilities are assumed, that risk should be reflected in the purchase price and the Seller’s representations and warranties. Doing so will give the Buyer at least some protection if it turns out the liabilities were different or larger than what the Seller promised.