Buying A Business

What to look for when reviewing a business your interested in buying.

The cycle from employee to entrepreneur is transforming the framework of the economic picture. Corporate down-sizing is providing the incentive for more people to invest in existing businesses without heeding the essential warning of Caveat Emptor.

The reasons to purchase an existing business vary greatly. Some simply wish to buy the real estate, not knowing how to start a business. Some buy out the existing lease for lack of viable real estate options. Still others find advantages dealing with the existing product and the loyal customers that patronize the business.

Buyers find sellers through classified ads, trade journals, associations, casual conversations, business brokers, vendors, franchisers and networking with lawyers, accountants and other professionals. Rarely does the seller want to publicize that his business is for sale fearing loss of customers and employees.

While this discussion is not intended to be an all-inclusive checklist for the purchase of every business, its intent is to begin a thought process for potential purchasers. Data base searches indicate numerous articles on selling a business (suggested reading), but few on the purchase. Professionals should be utilized to minimize risk, but reality tells us the buyers usually prepare their own analysis.

As with real estate, all business brokers work for the sellers and have a fiduciary responsibility to them. All representations, which are made by the broker, must be verified to insure accuracy of the information.

All agreements should be in writing and insured with escrows where possible. It is for this reason professionals such as accountants, lawyers and building inspectors must be utilized to insure your interests are maximized.

Be Informed

Informed purchasers are buying assets, not corporations. Proper structuring of the transactions will minimize the cost and time caused by hidden or unrecorded liabilities, undisclosed or yet-to-be-filed lawsuits, unknown product liabilities, and past or hidden environment problems. Also, the Revenue Reconciliation Act of 1993 provides additional capital gain incentives for all newly formed corporations.

Asking prices are developed by the values placed on real estate, inventory, processes, profits, cash flows, reputations and egos. This is a beginning point for the seller who should develop values based upon their own analysis and projections, then counter offer. The asking price only indicates the seller's willingness to discuss a sale, and conversations should be utilized to determine the motivation for the sale (most commonly personal liquidity) need for capital elsewhere, personal problems, divorce, age, health and boredom.

To determine the reasons, get to know the seller. Have him think of you as a friend who will nurture his business and answer his questions. Build a trusting relationship by familiarizing with the management. Ask questions about market share and growth potential. The purchase of commercial real estate must utilize the services of professionals: appraisals, building inspectors, engineers for the building, lawyers for zoning compliance, and environmental consultants for septic review, hazardous waste and ground surveys are all involved.

A beauty salon's septic problems and hazardous waste water illustrates the depth of this subject. A separate septic tank for wastewater of shampoo, hair dies and other chemicals had to be installed and the wastewater periodically removed. Using only "biodegradable" products, there was no clear law determining the environmental hazards posed by the salon's waste. The Salon's owner complied at his expense, after assuming the previous owners' lease in a shopping center.

Another potential problem is lack of knowledge concerning boundaries. For example, New Jersey relies on the Army Corps of Engineers to define wetlands. Fines in excess of $20,000 are frequently levied for leveling and filling small areas of wetlands. Ignorance of their delineation is no excuse and the service of professionals is invaluable. Insurance companies and state laws are becoming increasingly opposed to buried holding tanks for oils and other liquids.

Diligent detective work and negotiation before a purchase is prudent. It is not infrequent the sellers themselves are unaware of the risks and the cost to remedy a problem.

There is no alternative for a budget of sales and expenses. Budget a year, month by month. Be lucid in your estimates and debate the figures with professionals. Include customer counts and average sales per customer.

For example, don't list "Utilities", do list "Electric," "Gas," "Heating Oil", and "Telephone". Even "Telephone" should be detailed to "Telephone", "Pager", "Fax", "800 Service", etc. List sales, by product group, region, and salesman. As salesmen tend to be overly optimistic, be sober in your allocation by month and season. The benefits of this exercise include expected financial results, familiarization with overhead, and a bench mark against which to immediately measure monthly results. Detailed schedules of inventory should be available yet reviewed with skepticism. Calculate the turn of the entire inventory, samples of the inventory and the individual items. Document when the items were purchased and when they were last sold. Beware of and look for "dead" inventory and negotiate a lower price.

Every attempt possible to verify sales should be made. Verify the "Z" totals on the register tapes and reconcile them to the daily cash/sales reports and deposits. Verify the daily reports against income tax returns and sales tax returns.

Before viewing such financial material, signing a confidentiality statement may be required. Spend time sitting outside the store recording customer count and comparing this to register tapes of previous periods. Review the average sale per customer and know how many items must be sold to pay the rent and utilities.

Office environments provide the opportunity to spend time in the sales office to gather data on inquires and sales.

If liabilities are assumed obtain or develop a list of all vendors and creditors, including those listed as zero balance. Confirmations should be sent to the entire list to verify amounts due, or the absence of amounts, and due dates, Receivables, like payables, should be confirmed and tested for aging. Procedures should be performed to test the validity of invoices. Has the setter re-invoiced customers who are slow to pay to appear as current?

Shipping logs, sales reports, inventory records and old invoices to the customer are all important records to review. Here too, a history of late payment may indicate a troubled industry, late invoicing, ineffective collection techniques or personnel, quality control or internal control problems. Insure the purchase of receivables with the seller's personal guarantee of the uncollectibles and/or funds in escrow. While reviewing receivables and sales, review records for new customers. Can the seller document customer growth rates? Do details include how the new customers found the business: referrals, direct mail, advertising? This information may save thousands of dollars by not repeating the seller's past costly lessons!

Tracking Payments

A review of payroll records will reveal the number of employees, total hours, rates and the employee turnover. Reviewing the timeliness of tax payments will also indicate cash flow information. Question the relationship of employees to the seller, vendors, competition, and each other.

Track the payment of payroll taxes for the last 18 to 24 months to confirm payroll data.

When buying equipment, verify the existence and ownership, review maintenance records and condition of the equipment. Ownership can be verified by having a title search of court house records.

The assumption of pre-existing leases can be either fortuitous or problematic. First review the existing lease and determine the current annual cost per square foot, the use clause, and components of common area maintenance costs.

If your plans are to renovate the leasehold improvements, you will want to assure the plans are acceptable, the lease will be renewed, and any additions to the services or products you are planning are acceptable under the use clause, and if not, whether the landlord is amicable to any changes. This is also the time to review physical design of the property to assure conformity with the Americans With Disability Act, zoning and insurance requirements.

There are five major components of a non-compete agreement: duration, geographic area, nature of activities in the agreement, family members subject to the agreement, and use of family names during and after the period of agreement. Be sure to have the signatures of family members subject to the non-compete agreement.

It is to the buyers tax advantage to allocate the maximum dollar amount to this portion of the overall purchase contract of the business. A buyer and seller could agree that as much as 50% of the purchase price was compensation for approximately three to five years when the seller would not open a competing business. The seller would claim this portion of the sale when the cash is received. The buyer, however, deducts the payments over a fifteen-year period per the Revenue Reconciliation Act of 1993.

Purchase of a franchise offers additional opportunities and problems. Talk to other franchise owners and correspond with the Franchise Owners Association. Ask the complaints of other owners as well as what benefits exist. How many other franchisees have their franchise for sale?

Review the local library's Reference Department's collection on franchising. Check with computerized data bases available at the libraries for articles to determine whether there are or have been any litigation involving the franchisor, the franchise owners association or customers. Correspond with the Federal Trade Commission.

For a small fee Dun and Bradstreet will provide a background report on a franchise detailing lawsuits, bankruptcies and liens.

Bulwer-Lytton wrote "Business dispatched is business well done, but business hurried is business ill done." Research your opportunity and take the time to insure the success of your business venture.

Originally published in the July 1995 issue of Small Business Opportunities.