How to Buy a Business

As a prospective entrepreneur, what do I need to do before I buy a business?

1. Perform due diligence

When you find a business, you want to buy, the first thing you will want to do is perform proper due diligence. Learn everything you can about its financial and legal situation as well as its outlook. You should use the services of in-house and outside experts to do this.

This will allow you to understand the strengths and risks of the transaction and clarify where you will need to focus your efforts after the transaction and through the transition.

Understanding the cash flows of the company is key, most importantly to help you plan accordingly, but also for your lenders and potential outside equity investors who will be looking to structure their loans and investment based on your forecast.

Creating an overly optimistic forecast will not help you, as you could end up in trouble if you are not hitting your targets and your financial payments have been tied to those targets. Building flexibility into your financing structure is key, as is having a patient financial partner or partners support you through the turbulence of a transition.

2. Choose Your Capital Partners Wisely

“Do your homework on the lenders and investors who show an interest in financing your transaction, some investors may become your board members and will want to govern alongside you, bringing their own strategies and ideas into the future of the company, so it’s integral you choose individuals who align to your own personal values, goals and situation before aligning on your shared business objectives.

Related: How to Recession-Proof Your Business

3. Be Prepared with Answers for Your Potential Capital Partners

Before accepting to finance a transaction, your investors and lenders will need to see a business plan detailing where you want to take the business as well as financial projections for the next 12 to 36 months. Here are some questions your investors and lenders may ask.

• Why is the owner selling the business?
• What is the motivation for the sellers to sell to you?
• What does the seller know that you do not know about the business for sale?
• Is there any cause for concern in the sellers’ motivations?
• Are you contemplating a share purchase or asset purchase?
• How was the selling price established?
• What is the business worth and how did you determine that value?
• Did you get an expert third-party to conduct a thorough valuation of the business?
• What is included with the purchase price? Any tangible assets or is it all goodwill?
• What is your experience in this industry?
• What is your experience managing an income statement and or balance sheet?
• Have you ever worked in the company being acquired? If so, in what position?
• Do you have access to the financial statements of the company being acquired?
• Did you get an expert third party to produce a quality of earnings report?
• What is the financial health of the company?
• Do you understand how the company’s financials compare to rivals in the industry?

4. Have Your Capital Needs Identified?

4.1 What is your investor groups down payment?

A good rule of thumb is for the down payment to cover 20% to 40% of the purchase price. Even then, lenders will often take it into account that a seasoned entrepreneur is likely to have different financial means than someone who is just getting started, so the percentage can vary.

When you are buying a business, like everything else, the size of your down payment matters because it has an impact on your finances for years to come.

A lot of parties are being asked to take a risk on you—lenders, investors, employees, suppliers, regulators and even the seller. The best way to show your commitment to these parties is to have a significant down payment as an investor group. While there is no simple formula for calculating the “right” size of a down payment, it is important to show you personally have some “skin in the game”. Overall, stakeholders are looking for a meaningful commitment in some tangible form from you.

Someone who has worked in a company for many years and now wants to buy the company or a part of it, for example, will sometimes be able to purchase the company with a smaller down payment. In this situation, you could argue you are less risky than a pure outsider. This could sway stakeholders to lower their requirements for your investment.

If stakeholders do not want to proceed with a new shareholder who does not have significant funds to invest, one solution can be for you to purchase the company over time. In these situations, the vendor will slowly sell off shares to you and gradually exit the business.

4.2 Where does the rest of the money come from?

If your investor group is putting down 20% to 40% of the purchase price, the remaining funds can come from a few diverse sources.

4.2.1 Senior Debt

this is a common way to cover a portion of the purchase price. This kind of loan usually has a set repayment schedule and low interest rate compared to other options. The terms and conditions will depend on a variety of factors, including the size of your equity groups down payment, available collateral, and expected business performance.

4.2.2. Mezzanine financing

Also called “junior debt” or “subordinate debt,” this is a more flexible type of loan that can be structured in many ways—and sometimes even treated as equity, effectively increasing the size of your investor groups down payment.

This type of debt offers repayment terms adapted to a company’s cash flows and targets a return on investment that will be more expensive than senior debt but will have flexibility in how that return is achieved (i.e., a mix of a lower interest rate plus a variable return, such as a bonus or a portion of royalties). Mezzanine loans rank below secured debt in repayment priority in case of default.

Related: Unlocking Success: Strategies for Employee Retention and Growth

4.2.3. Vendor takeback

Also called “seller financing,” this is an attractive option when you want to add flexibility to your financial structure. In this case, the person selling the business takes a portion of the price upfront and agrees to be paid the balance later, often after all your senior debt is paid off.

That balance is usually secured through a lien on the property and assets of the company. If the buyer defaults on their payment obligations, the seller can step back in and take over the business, in some cases. Often, seller and bank financing are combined. In this case, the seller’s lien is subordinate to the banks.

4.2.4. Earnout

Another type of seller financing involves conditional payments, such additional payments also called an earn-out, if specified performance objectives are achieved. These provisions help keep the seller actively involved in the day-to-day management of the company and its future success, which can be useful to ride out the usual surprises that arise during the early transition years.

5. What are your Contingency Plans?

The first few years of a business transition can be challenging. There are always surprises. If a key member of the team, a customer or supplier decides to sever their relationship with the business after your acquisition, revenues go down or a key piece of infrastructure or supplier fails, you will need cash, time, and personal resilience to resolve the issue without putting the whole enterprise and all its stakeholders at risk.

6. Surround yourself with experts

The more you know, the better. It is always important to have assembled an advisory board and to have discussed with your trusted strategic, financial, legal, accounting and business advisors about you buying a business. They can help think through the opportunities and possibilities, make key introductions, leverage their own connections, and ensure you have thought out various scenarios and planned for contingencies.

7. Understand the opportunity cost of the buy-side acquisition process

To the uninitiated the buy-side acquisition process can take anywhere from 24 to 36 months (given recent delays due to the pandemic) with only some entrepreneurs closing an acquisition over that period. In the Stanford Graduate school of business study of 2020, it reports on the key qualities of search funds formed in the United States and Canada since 1984. and the percent of Entrepreneurs without an acquisition increased, from 31% to 33%.

For the reasons stated in the Stanford study, sophisticated serial entrepreneurs have learned to engage buy-side advisors. Outsourcing the acquisition process to an expert who is well positioned in the geography, industry, with long established relationships and contacts to reduce an entrepreneurs fixed cost, lost time, missed opportunities of a buy-side search.

The Shaughnessy Group Aiding owners, entrepreneurs, and executives; selling your business, buying a business and or financing business growth. With our collective experience, access to industry data and resources we can confidentially examine a company to provide a realistic value range. Request your free report: https://shaughnessy.group/business-valuation-guide.