How to buy a small business

Written by Paul on December 7th, 2008

For certain people, entrepreneurship is less about some high-tech idea put together by some college engineers and more about doing something tangible — like running a car wash or buying a bar. After all, what’s better than waking up and collecting cash from people that want to have their car cleaned every day or just want to hang out at your little dive bar?

Unfortunately, it isn’t quite that simple.

The economy is in shambles, real estate valuations are tanking and most “brick & mortar” business models depend on unpredictable things like weather and fuel prices — add all that up and you’ve got a recipe for tight margins and bankers that are unlikely to lend to you. No big deal though, keep reading to get my best advice for first time buyers — though not easy, it is possible to make a good deal on a business, even in today’s market.

KNOW THE LOCAL CONDITIONS

You don’t need me to tell you that the real estate market is — how should I put this — shitty. The same thing that happened in subprime home lending happened in the commercial property sector, the property values were (and, in some cases, still are) inflated. Take a brief look at BizBuySell and you’ll notice that a ton of businesses are for sale. As someone who has been checking the site regularly for months, I can tell you that the number of listings on there have steadily increased over the past few months.

You can spend $15 million to buy a chain of pizza shops in the DC Metro area or $400,000 for an equivalent business in rural southwestern Virginia. The key is to understand that virtually every sale is happening at a steep discount from the list price, just as in the housing market. There’s plenty of inventory and lots of time to shop around for the right fit. In one case, I called up a car wash listed for sale at $5 million — the current owner dropped the price to $1.7 million on the first phone call. (If you know of a better way to save $3.3 million in 15 minutes, I’d love to hear it.)

The best strategy for a first-time investor is to buy a business in a familiar geographic area and be wary. Have a realistic understanding of the business’ competitors, challenges and potential. If the seller’s (or your) business plan calls for substantial improvements or, more commonly, raising the current prices, make sure the business is still appropriate for the area. (e.g. Don’t buy a car wash 30 miles outside a big city, build the most luxurious customer waiting area and expect customers to come running.) Most importantly, make sure that your business plan makes sense even if you’re not getting as many customers as the current owner is.

One more thing: More isn’t always better. An attached retail store, gas station or anything else along those lines is just an added complexity that the first time buyer should avoid like the plague. You’ll probably pay higher property taxes, more insurance and have the headache of dealing with more than you can probably handle the first time around. (It’s common practice in gas stations and laundromats to have other businesses sub-leased inside the main property — if you encounter this, run the other way. A good example of this: laundromats that sub-lease space inside the building to a tailor.)

JUMP THE FINANCING HURDLE

First things first: there is no such thing as 100% financing in the commercial world — plan on putting in at least 20% down on most deals. Taking today’s credit markets into consideration, first time buyers should be ready for bankers to ask for up to 50% down payments on some deals. Yes, it sucks, but it does two things:

  1. If your business plan turns out to be too aggressive (i.e., you’re not as successful as you anticipated), having the additional equity gives you a smaller debt service payment while you work out the issues.
  2. Lenders are more likely to give you the loan because you’ve got more of a stake in the business.

Fight the urge to borrow more than you need, even if the lender wants to give it to you. (Yes, this happens more often than you would think.) Start conservative — you can always re-do the marketing materials or buy more advertising later. The key here is to simply get into the business first and get a handle on what you’re actually working with. You don’t want to put yourself in the position where you spend $25,000 on some huge improvement but you’re still underwater in terms of revenue.

Rule of thumb: Always, always, always keep the seller’s skin in the game by asking them to privately finance some portion of the deal. Of course you’ll want a lawyer or accountant to review the terms of the deal, but you’ll thank me later if you find out that the previous owner “massaged” some of the revenue or expense numbers. Believe me, this happens much more than you think. (A friend of mine bought a service company in the DC area a few months ago. Three months after taking over the business from the previous owner, she realized that the revenues were nowhere near what the previous owner had disclosed. Luckily, the previous owner had financed 20% of the deal — when my friend had her lawyer contact the previous owner to understand why the revenues weren’t adding up, the guy simply offered to “forget” about the 20% loan he had made to my friend.) Owner financing helps keep the seller’s skin in the game — don’t forget that.

FIND THE HIDDEN COSTS

The business plan is only a small part of the ownership equation. If you’ve never been in business, you need to educate yourself about the things that can and do go wrong. If brick and mortar businesses were really as simple as most people think, more people would be doing it. Keep your eyes wide open.

The most common hidden costs are dependent on the type of business, but here are some examples:

  • Golf courses are heavily dependent on weather. Get a few consecutive rainy days, common in the Northeast, and you’ve got a cash flow problem.
  • Car washes need some pricey maintenance every few years. If the previous owner “can’t find” the maintenance records, you should run away screaming.
  • Laundromats suffer from vandalism more often than you would think. The previous owner should have invested in a video surveillance system or, alternatively, should provide you with a list of equipment that had to be repaired/replaced in the last 12 months.
  • Lawn care businesses need fertilizers and other chemicals that are oil-based — you’re at the mercy of oil prices. Good luck to you.

From my own experience, I’ll tell you that the most stressful times you’ll face are going to be related to hidden costs. Spend the time up-front to discover the hidden costs of any business you’re looking to get into — you’ll never be prepared for 100% of them, but it’s your responsibility to discover anything that the previous owner might be hiding.

PUSH THOSE ADD-ONS

Most first time buyers buy a bar or some other business because they got caught up in the romance of it and forgot to pay attention to the fundamentals. Never forget that, as a private business, your business’ goal is to make money.

In addition to the heavy lifting that comes with managing any business — agonizing over profit-and-loss statements, meeting a payroll, and deciding how much to spend on improvements — understand that running a brick & mortar business is more than just about your primary product or service. I’d say that 99% of businesses out there have a secondary product or service that can contribute a huge amount of revenue to the top line — if you own a golf course, you should be pushing food and beverages. (After all, what kind of golfer says “Oh, I’ll just grab a beer at home once I finish off these 9 holes.”)

Most first time buyers don’t have a problem identifying the business’ secondary products and services — but they do underestimate the time and hassle involved with getting the liquor licenses or negotiating contracts with distributors.

DO YOUR RESEARCH. AND THEN SOME.

If you remember nothing else from this post, understand that you’ll never finish doing your research. The absolute best way to make a better deal is to know what you’re getting yourself into. Here’s how I do it:

  1. Go to BizBuySell and do a search for the type of business you’re interested in.
  2. Contact 10 of the brokers and sign their non-disclosures.
  3. Read the sales documents and compare the business’ financials.
  4. Pat yourself on the back — you just learned more than most people and you spent nothing.

Be patient, do this 3 times (yeah, you need to look at ~30 deals) and you’ll be in a great place to pick up a business of your own. Once you’ve looked at the financials of a few businesses, you’ll start to see some patterns emerge and you’ll avoid getting suckered into some shady deals.

Update: Here’s my next post on how to actually run a small business.

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7 Responses to “How to buy a small business”

  • well in buying small business you have to be very careful.

    — 12/08/08 at 2:22 pm

  • This is a GREAT post. Very detailed and full of useful information. Thanks !

    — 12/08/08 at 6:16 pm

  • You really have to do your due diligence in times like these.

    — 12/08/08 at 6:40 pm

  • Buying a business can be a very frustrating experience. The writer is correct in staing that patience is very important when looking to buy a business or sell one for that matter.

    — 12/08/08 at 8:01 pm

  • Thank you for that article. I have thought about purchasing a business before and may still be interested but this insight will definitely be something that I consider going forward. I have heard from people that it is a lot of hassle and a lot of work but it can also be very rewarding.

    Jeremy
    http://refocusing.wordpress.com

    — 12/11/08 at 8:21 pm

  • Great insight article. I have messed up by not looking at “hidden costs” before and I know how it feels.

    — 12/19/08 at 9:57 pm

  • Wow, I had no idea something like that existed.

    I’ve never been a bit business person myself (only 22) but lately I’ve been really digging into questions to my father about running a business – he owns a large business out of the Tampa area.

    I didn’t know there were places like this that sold businesses, although I don’t have the income (right now) I think I’ll go through my local area and see what’s for sale :)

    — 04/18/10 at 9:06 pm

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