Owning your own business can be very rewarding both financially and emotionally. Business ownership provides innumerable opportunities to put ideas into action and reap the rewards (and sometimes the pain).
Buying a business, rather than starting a business from scratch, has many advantages:
The business should have established customers who will provide revenues for the business almost immediately. Unlike a start-up business that needs to find customers and take them away from another business, the business buyer must retain it’s existing customers. It’s always easier and less expensive to retain customers than to try to find new customers.
The business you buy will have systems in place that you do not need to invent. Although it’s rare for any business to have perfect systems, the business you buy will certainly have a certain way of doing things. Business buyers should always make certain they understand why the former business owner did things BEFORE changing it. The laws of unintended consequences are inescapable. Make sure you know exactly what effect changes will have before you make changes.
Financing the Purchase of the Business
Financing a business purchase is important and should be considered carefully. For businesses valued under $2,000,000 the primary financing options are the lenders who offer Small Business Administration (SBA) guaranteed loans or the business seller.
What are the advantages or disadvantages of each?
First let’s look at Seller financing.
Many books on “How to buy a business” claim that a buyer should not buy a business if the seller isn’t willing to finance the sale of the business. The books often say to offer the seller 25% – 40% as a down payment then pay the balance off over 5 -10 years. The theory is that the seller who finances the sale has confidence in the business and, since the buyer owes the seller money, the seller will “help” the buyer succeed.
Makes sense, right? Not so fast. Let’s look at seller financing from the perspective of a business owner who wishes to sell a good business. A seller who sells the business and finances the sale takes HUGE risks. What are the risks? First, what if the buyer ignores the seller and runs the business into the ground? What if the buyer changes the whole business operation to a model that doesn’t work? What if the buyer is terrible with employees and he loses some? The “experts” say so what, the seller gets the business back and still has the buyer’s down payment. Sellers of good businesses don’t want the business “back”. If they wanted the business back they wouldn’t be selling it.
Here is another reason why a business owner who wants to sell a good business shouldn’t need to finance the sale and why a buyer shouldn’t want the seller to finance the deal either. SBA lenders often receive a government guarantee on a business acquisition loan (7A) of about 75%. This means an SBA lender can’t lose more than 25% even if the business fails and the loan goes bad. If the seller finances the deal the seller does NOT have a 75% guarantee so seller’s who finance deals should charge a lot more for financing (or selling price) to account for the increased risk compared to an SBA loan. This increase in financing costs puts more leverage on the buyer and actually INCREASES the likelihood the business will fail. That’s bad for the buyer and the seller.
Another common reason for seller financing is many “experts” say that small business records are so bad that only the seller knows if the business is making a profit so a seller who is willing to finance is defacto saying the business is profitable. As always, two sides to the story. Here’s an example of why this is a fallacy. Let’s say Mary owns a business that does carpet cleaning and some customers pay by credit card, some by check and some cash. Let’s assume for whatever reason the cash income can’t be identified in the company books. The books show the business is making a marginal profit but Mary says she gets about $1,000 per week in cash that needs to be considered when judging the selling price.
The books show the business is making about $20,000 per year, Mary says she’s taking another $50,000 that can’t be identified in the books. That’s a total of $70,000 and Mary wants to sell the business for $140,000. She’ll take $64,000 down and a note for 5 years at 8%. Good deal? 2 times earnings is a good deal, seller financing is good, right? Wrong. What if Mary is lying about the $50,000? You bought the business, she has your $64,000 (which is more than the books show she makes in 3 years). So you stop making payments and Mary gets the business back. Who got the better deal, Mary or the buyer?
TIP: If a business has provable cash flow and a reasonable price AND a buyer whose financial circumstance is in order, there is an SBA lender who will provide financing. There are plenty of businesses available that have provable cash flow. Inexperienced buyers should be very, very cautious about purchasing a business where the earnings can not be ascertained with reasonable certainty.
Advantages of SBA financing
Understanding the steps in getting an SBA loan makes it clear why the buyer and seller are both generally better off if the seller does not finance a transaction.
Requirements of buyer to get an SBA loan: good credit, manageable debt relative to the ability of the buyer to service the debt, buyer income requirements BELOW that which can be provided by the buyer and business.
Requirements for business to be eligible to be purchased with SBA loan: provable earnings of business adequate to make debt payments and income to seller adequate to meet sellers’s personal needs, business will likely be appraised by bank to make sure what the buyer is paying for the business is reasonable.
A buyer benefits using SBA for financing because the SBA will likely add discipline to the process for the buyer and reduce the likelihood that a buyer will make a critical mistake.
Buyers – Before closing on the purchase of a business buyers should conduct adequate due diligence to ascertain if what they “think” they are buying is actually what they are buying. Due Diligence has 4 primary areas:
Industry – There is usually public information available for almost any industry. Buyers should do research to see if there are any industry issues that will positively or negatively impact the business.
Business Finances – Business buyers should retain an accountant to assist them in looking at the business books to confirm the business is earning what is claimed by the seller.
Business Operations – Before closing there is usually only so much that can be done. An important activity is to meet with the seller and discuss in detail what the seller does on a day-to-day basis so the buyer can get comfortable either filling that roll or bringing in people to fill that roll. If the seller is the guy who also repairs all the trucks then you either need to be able to repair the trucks or find someone who can!
Legal – Buyers should engage an attorney to review closing documents and make sure that the buyer understands their rights and obligations in any contracts. Good legal work BEFORE closing usually means smoother sailing after the business purchase.
Buying a business could be the best thing you ever do or maybe the worst thing. Many businesses are sold every year and the vast majority of those transactions turn out to be good for the buyer and the seller. Do your homework and you will likely be rewarded handsomely.