Here’s an instructive riddle for prospective business buyers: How can you be a winner and a loser at the same time? Answer: You’re the winning bidder for a company that is worth much less than what you pay for it.
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Unfortunately, this scenario is common. First-time buyers want to own a business so much that they skip the tire-kicking process (called “due diligence”) and never challenge the seller’s purchase price. They assume that they can fix nagging issues after closing the transaction without thinking about the mounting costs. This is how successful business buyers become unsuccessful business owners.
In contrast, smart business buyers don’t buy on sentiment or lifestyle considerations. They don’t buy businesses as a way to create a salary either.
Buying a business is an investment — it has to have reasonable financial upside to make the purchase worthwhile. Of course, this means negotiating to buy extra low in order to one day sell at a much higher price.
So how can you buy a promising business at a bargain price?
Establish escrow offsets. I wouldn’t buy a privately held small business without setting aside at least 10 percent of the negotiated purchase price to cover unexpected post-acquisition bills and seller misrepresentations. As the buyer, your job is to negotiate the widest possible scope of potential escrow offsets and the longest possible period before final escrow settlement. Six months is a great target — one year is even better.
Ignore owner projections. Smart business buyers conduct their own analyses of future revenue and earnings performance. Sure, you can use the seller’s projections as a guide — but chances are they’re inflated beyond reason.
If you have to borrow money to fund the acquisition, don’t forget to add debt-related interest and principal payments to your projections to reach a more accurate picture of future cash flow, profitability and target acquisition price. Experienced business buyers assume a stingy, worst-case scenario in their projections, too.
Ignore “recasts.” A common tactic of business sellers is to re-invent their company’s historical income statements to make the company seem more profitable. They add back owner salaries and other expenses that would be a part of any ongoing business operation.
Challenge inventory value. Don’t agree to buy all inventory at “cost.” It could be old, damaged or have no salable value in the marketplace. Look closely at when inventory was bought for clues to its real value. You don’t want to pay the cost of dumping bad goods. Offer to let the seller keep anything you don’t want.
Confirm all assets. I once conducted acquisition-related due diligence on a manufacturing company that grossly misrepresented its asset register. The sellers never thought anyone would really check to see if the equipment list really matched what was on the factory floor and in administrative offices. I did. Also, don’t buy equipment that isn’t in good condition or fully necessary for your future business operations.
Customer longevity. Some customers are more valuable than others. For service-oriented businesses, if your purchase price is based on a multiple of monthly or annual revenues, look closely for customers who bought solely on deeply discounted specials or other one-time promotions. Force the seller to prove the future value of one-time customers.
Replacement cost test. Can you put together a similar business for less than the seller’s asking price? Work the numbers to compare.
My best advice is to avoid paying for a prior owner’s mistakes. Every business has them. Consider every potential problem as an opportunity to lower the final purchase price. That’s how to buy low, in order to sell high. You can do it.
Susan Schreter is a 20-year veteran of the venture finance community and a university educator in entrepreneurship. She is the founder of TakeCommand, a community service organization that offers the largest centralized database of startup and small-business funding sources in the U.S.