How to buy an Existing Business

If one feels that starting up a business is not for them, there is the option of purchasing an existing business or a franchise. We discuss in depth the process of purchasing a business.

There is some security in buying a company that is established and already secured a customer base. If you are interested in purchasing a business, you can locate possible opportunities from newspapers, Internet, brokers, attorneys, accountants, bankers, and magazines.

There are several advantages and disadvantages of purchasing a business.
Some of the benefits of purchasing a business include:
1. There is only a single transaction involved to acquire the business rather than multiple filings with the city, state, and federal governments.
2. An existing customer base and market share.
3. One competitor is automatically eliminated.

Some of the possible downsides of purchasing a business include:
1. The company may be a collection of problems rather than an opportunity.
2. Transition from one owner to another is highly stressful on the employees, the vast majority of whom are resistant to change.
3. Employees may leave as a result of the change to new ownership.
4. A purchase is predicated on past performance and is not indicative of future profits.

Step-by-Step Procedure
The key to making a smart purchase is making sure the buyer knows what he is buying which is not quite as simple as it sounds. Below is a step-by-step procedure that can be used as a guideline for those looking into purchasing a business.

Step 1: Assemble the Team
At the very least, the buyer must have access to legal and accounting assistance. Depending on the buyer's familiarity with the business itself, he may need a specialist to comment on the operations of the company.

Step 2: Analyze the Market Step
The analysis of a business starts outside of the business itself. It is vitally important that the industry the business is in is healthy. The best businessman in the world will have a rough time succeeding if the industry as a whole is suffering. Some of the questions you must ask are: What are the trends in the industry? Who is the competition? What about international competition? State of technology? Who are the company?s suppliers and customers?

To get an idea of how the industry is doing as a whole, the best places to look are:

1. U.S. Census Bureau:
The U.S. Census Bureau organizes businesses based on the North American Industrial Code System (NAICS). Once the NAICS code for the business is identified, the buyer can look up the relative size of the market in a given geographic area. The smaller markets may not be represented due to lack of data, but for the most part, the information is complete.

2. Robert Morris and Associates: Annual Statement Studies
Robert Morris and Associates (RMA), like the US census organizes business types by NAICS codes. RMA provides aggregate financial statements for businesses. They get base their information on data provided to them by banking institutions. When examining the financial statements, pay special attention to the "Net Profit before Tax." If that figure is negative or barely positive, it should send up a red flag. Generally speaking, it is unwise to go into a business where the average business takes a loss or returns less than a savings account.

3. Trade Associations
Depending on the industry, there may be trade associations that conduct their own marketing demographic research. They may contain very good statistics, however there may be cases where the trade association is merely trying to promote the industry and are only providing rosy financial figures.

Step 3: Analyze the Business
Once the buyer feels comfortable with the industry he must then turn his attention to the business itself. It is at this time that buyer can request to see the business' tax returns. The potential buyer needs to ask qualitative and quantitative questions. For example: Why is the owner selling the business and how long has he/she owned the business? What does the owner plan on doing after they sell the business? Has the business been in bankruptcy or had any lawsuits filed against it? What outstanding leases does the company have? It is suggested that the potential buyer examine the company?s financial statements (if they do not have a sensitivity analysis, breakeven analysis, or financial ratios it is recommended that you develop these):

1. Income Statement
2. Balance Sheet
3. Cash Flow Statement
4. Sensitivity Analysis
5. Breakeven Analysis
6. Financial Ratios

The buyer can perform simple ratio analysis. If the buyer is uncomfortable with computing and interpreting financial ratios, an accountant can help. The financial ratios can be compared with the industry profiles in RMA to see if the business is performing better or worse than the market. Bizstats.com has information on industry average ratios as well.

Step 4: Business Valuation Models
The next step would be to determine the value of the company. There are many different ways to value a business: fair-market valuation, liquidation value, book value, cash-flow based valuation (e.g., multiple method, discounted cash flow method). It is recommended that the buyer contact a good accountant to determine the value of the business.

Two of the most common valuations to determine if the purchase will be a good move are:
Net Present Value (NPV)
Internal Rate of Return (IRR)

Both methods are closely tied together and consider only the business' cash flow over a set number of years. A business calculator or a spreadsheet program can be used to determine these values. Doing them by hand is not recommended. Again, an accountant can help if the buyer is unfamiliar with this type of analysis.

NPV is based on the thinking that money today is worth more than money tomorrow. Money that is due to arrive years from now suffers a penalty in terms of opportunity cost, inflation, and overall risk. To compensate for that, accountants introduce what is called a discount rate (15) at which the future profit figures are time-corrected downward. The amount of the discount rate depends in large part on the expectation of the individual performing the calculation. If the business is extremely risky, one might use a higher discount rate to compensate. Likewise, if the business is relatively safe, a lower discount rate may be appropriate. The calculation of NPV takes into account the initial investment (large negative number), and the projected profits for the next few years (3-5 years is common). Once the future profits are discounted back to today's dollars, they are summed and the initial investment is taken out. The result is the Net Present Value of the cash flows. If the NPV is positive, the project is profitable. If the NPV is negative, the project will lose money.

For example, let's say a business will cost $50,000 to purchase, and will make $10,000 in the first year, $20,000 in the second year, $30,000 in the third year, and $40,000 in the fourth year. The business is moderately speculative, so a discount rate of 25% will be used. The Net Present Value would be $2035.20.

It is clear that the NPV is highly dependent on the chosen discount rate. A higher discount rate would reduce the value of the future cash flows and make it more likely that the NPV would be negative.

The next valuation, the Internal Rate of Return (IRR) looks at what discount rate the NPV will be zero. In our example, the IRR was 27% meaning if we chose to run an NPV calculation at 27% rather than 25%, the NPV would equal 0.

The IRR gauges the risk in many respects. If the IRR is low, it shows that the project in question is high risk. There wasn't much buffering capacity and a slump in sales could mean the difference between a modest profit and a net loss on the deal.

Step 5: Finalizing the Sale
Once the purchaser is satisfied with the prospects of the company going forward, it is time to make a purchase decision. Once the decision to buy is made, it is recommended that an attorney draft a letter of intent to purchase the business. Make certain that the letter is clear and unambiguous before signing. Once signed, you are officially the new owner of the business.