The right business acquisition can provide you with immediate cash flow, business assets, and other benefits. However, if the business fails to meet your expectations, you could face consequences for years.

The stakes are high with a business acquisition, so you have to get all of your ducks in a row before making a decision.

Here’s what you need to know before buying an existing business:

How Much You Should Pay for a Small Business

Before you buy a small business, you need to determine its value . Buying an existing business, you may find something that is well run and has an established customer base, but if you pay 50% above the market value, you will be facing an uphill battle.

There are several ways to get an accurate business valuation. The easiest may be to use a valuation calculator, but you’ll want to ensure  you understand how it is evaluating the business before you simply accept the results. Another common way to value a business is to use a cash flow or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) analysis. To do this, simply take the free cash flow or EBITDA average of the last two years and multiply it by three, adding in the net book value of any assets the business owns.

Let’s look at an example:

• The company has an average free cash flow of $200,000 per year, and the market is paying 3 times the free cash flow. Then, you also have $500,000 in netbook value for existing assets. Based on this, the company is worth $1.1 million.

Now, there are other valid ways to value a company, and this method doesn’t take everything into account. For example, the company may have intangible assets like a strong brand that isn’t captured in the books, but that makes it worth more.

Keep in mind that any valuation is just a starting point. The goal is to keep you from overpaying when you’re buying an existing business.

What to Consider When Buying an Existing Business:

Buying a local business is more than just looking at numbers. To make an informed decision, you also need to look at these additional factors:

• The Industry: Whether you’re a budding entrepreneur and this is your first business or a small business veteran looking to expand your portfolio, you need to understand the industry of the business you’re trying to buy. The lawn care industry is different than the roofing industry or the restaurant industry. If you don’t know the ins and outs of the kind of business you’re considering, make sure you educate yourself before buying a company. This includes understanding seasonality, the supply chain, the existing customer base in your area, and the competition.
• The Culture: It’s the people that make a successful business. And it’s essential that you understand the culture of the company you’re buying. If your leadership style is rigid and you’re buying a company with a laid-back culture, you might see a high staff turnover rate. On the other hand, if company culture is a good match with your management style, it will help ease the transition to new ownership.
•  The Financials: Just because a business owner says their business is doing well doesn’t mean  it’s true. Some small business owners don’t understand their financials , while others might be trying to hide something in order to get a better price for their company. It’s vital that you do a proper analysis of their financial statements  on your own in order to validate the company’s good standing. Be sure to review the company’s balance sheet, taking the business assets and subtracting the liabilities. There are some things, like real estate, receivables, and payables, that won’t be hard to value. But you might have intangible assets, such as patents, copyrights, and other types of intellectual property that have harder-to-estimate values – you should use your best judgment for these categories.

What Information Do You Need to Gather Before Acquiring a Small Business?

As a small business investor, you need to make sure everything is in order with the company you’re buying before you finalize the purchase.

You need to get the following information from the previous owner:

Business Licenses and Permits

In certain industries, you need a long list of licenses and permits to operate a business – restaurants are one of those types of businesses. You may need licenses and permits on the local, state, and federal levels. You should do your own research or consult with a lawyer to make sure that the business isn’t breaking any laws.

Contracts

Does the new business have a long-term lease agreement? Or agreements with vendors? As the new owner, you are going to take on any existing agreements.

Say you want to move to a new office, but the previous owner still has five more years on their lease agreement. You should either be comfortable with staying in that space for five more years or see if the landlord is open to terminating the agreement.

Letter of Intent

A letter of intent (LOI) is a document that spells out the terms of a prospective deal between the two parties. With an LOI in hand, you can proceed with the more time-consuming aspects of your due diligence, as there is a high chance of a finalized deal if everything checks out.

Financial Statements

You may have already reviewed some financial statements when settling on a purchase price, but you should look at all of them before signing on the dotted line. You should carefully evaluate the cash flow statement, tax returns, balance sheet, and debt disclosures.

You should have a second set of eyes – ideally, a Certified Public Accountant (CPA) – look over the financial statements to identify any irregularities and give an opinion on the long-term viability of the business model.

Other

Here are other things to put on your due-diligence to-do list:

• Is the business in compliance with zoning laws?
• Are there any environmental regulations that are relevant to the new business?
• Ask for a certificate of good standing – this is necessary to operate in the state.
• Request the articles of organization if it is an LLC and the articles of incorporation if you are buying a corporation.

This is by no means an exhaustive list. You should have a lawyer help you through the due diligence process to ensure that you request everything you need and properly evaluate all of the documentation. The process varies depending on the type of business you are buying, so you should try to find a lawyer who has experience in your industry.

How Do You Finance a Small Business Acquisition?

You should consider using a term loan,  U.S. Small Business Administration (SBA) 7(a) loan, or seller financing to finance a small business acquisition.

Let’s look at these options one by one.

Term Loan

A term loan gives the borrower a lump sum of cash that is to be repaid at predefined intervals at a fixed or variable interest rate. A term loan often has a relatively low interest rate compared to other types of financing.

SBA 7(a) Loan

The SBA 7(a) loan, like the term loan, typically has a relatively low interest rate. Since it is backed by the Small Business Administration, lenders view it as lower risk than non-SBA loans, and they are willing to grant more favorable terms. That being said, SBA loans take longer to approve, as they have a more rigorous application process. So if you need fast funding to take advantage of an opportunity, SBA loans may not be the right fit.

Seller Financing

With seller financing, you make payments directly to the small business owner you are buying the company from. Seller financing can be attractive to the seller if they prefer receiving monthly payments for their business rather than the full sale amount upfront. Plus, they get more for the sale, since a typical seller financing arrangement means that you’re paying interest to the seller, just like you would to the bank. Of course, the risk increases for the seller—if you default on your payments, or the business goes under, it means they miss out on the remainder of the sale price.

As the buyer, you can sometimes negotiate a lower interest rate with the seller than you would pay with a bank, since any interest will be more than they would have received during a traditional sale. But you may also have to agree to return the business back to the seller if you miss too many payments, so seller financing can also increase the risk for you.

A Case Study For Buying a Business With Fast Financing

Ram Ajjarapu, President of consulting firm Global Information Technology, wanted to acquire another company. He knew that a traditional lender would take too long to get him funds so he turned to Biz2Credit.

Biz2Credit was able to quickly provide $3 million in financing. Ajjarapu said, “I was quite impressed with Biz2Credit’s expediency” and gave Senior Funding Specialist Kamal an “11 out of 10 when it comes to customer service.”

Learn more about how Biz2Credit can help you acquire a small business.

FAQs About Buying an Existing Business

What are the key steps to take before buying an existing business?

Before buying an existing company, you need to conduct due diligence, assess the company’s valuation, educate yourself about industry trends, the customer base, and the competition, review existing contracts and the company’s business plan, and ideally, get to know key employees.

How to determine if the asking price for buying an existing business is fair?

To determine if your business investment is fair, you can use a valuation calculator, or use an analysis like a cash flow multiplier. A common way to do this is to take the free cash flow average of the last two years and multiply it by three, then add in the value of any assets on the books.

What financing options are available for buying an existing business?

When buying an established business, you can use SBA loans, seller financing, bank loans, capital from private investors, or your personal savings to fund the purchase.

When buying an existing business, what should I know about existing employees and contracts?

You’ll want to know how much employees are being paid, but just as important, make sure you understand the value of individual contributors. It’s essential for new business owners to understand what would happen if a few key employees decided to leave.

How do I ensure a smooth transition after buying an existing business?

It’s often ideal to get the current business owner to stay on for a few months to help with the transition. Regardless, to protect your small business investment it’s vital to spend time understanding company culture, as staff are more likely to leave if you disrupt an existing culture.

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