How To Buy a Great Business

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Dennis Zink: Welcome to SCORE Business TV. In this series, experts share their opinions with business owners on a variety of topics. Today we’re beginning a new series about how to buy a business. Each step will be explored with our expert guests in a free-flowing dialogue, but before we begin I’m happy to introduce two of our guests. First, we have Peter Gruits. Peter has had a long and distinguished career as a banker, realtor and business owner, and he leads our exit strategy team. Peter is also a volunteer mentor for SCORE.

Dennis Zink: And we’re happy to welcome Michael Zuckerman. Michael recently retired after practicing law for 54 years in New York. He graduated with a BS in Economics from the Wharton School and a JD from Harvard Law School. His expertise is in estate planning, employment, shareholder and partnership agreements, succession planning, and the purchase and sale of businesses.

Dennis Zink: Both Peter and Michael are certified SCORE mentors on our Exit Strategy team. SCORE is a 55 year-old nationwide non-profit organization providing free mentoring services to business owners. Welcome gentlemen.

Dennis Zink: Buying a business is one of the most important steps in life taken by entrepreneurs. It can be a rewarding experience or it can be a minefield fraught with danger. Our experts are here to guide you safely through that minefield.

Peter, is it easier to start or buy a business?

Peter Gruits: Well, we receive a lot of requests from people at SCORE saying, “I want to start a business”, but really, buying a business is much easier than starting one because if you start a business you have to put all the parts together and you don’t have the cash flow that an existing business would have if you’re starting a business. So, the customer base, the cash flow, and the fact that you have all of this assembled is really better for you if you buy an existing business.

Dennis Zink: Michael, what would be three advantages to buying a business as opposed to starting one.

Mike Zuckerman:Let me just go back a second, Dennis, and tell you that there are certain businesses that you start, you have to start to do business. For example, I’ve dealt with a number of McDonalds franchises, and McDonalds will issue a new franchise for a new area. If you’re starting in a little place you have to form your own business. McDonalds trains you well enough. You have to go to, they call it Hamburger U, and you spend three weeks or four weeks learning how to run a hamburger place, and they sell you all the stuff and everything’s there. If you’re Bill Gates and want to start Microsoft you’ve really got to start your own business as Zuckerberg did with Facebook, but you could also buy a business that has a technical development situation. You could buy that part and then develop your own that way.

Dennis Zink: Peter, when you buy a business what are you actually buying?

Peter Gruits: When you buy a business the most important element you could buy is the customers. It’s the cash flow the customers produce. It’s the prospects and the people who look to that business for a particular service or product. When you buy a business you want to buy that cash flow. It’s very different than buying something for appreciation. If you were buying stock you would buy it for appreciation perhaps or a dividend. In buying a business you really want to buy it for the cash flow because that’s going to give you the flow of money necessary to support that business.

Dennis Zink: Michael, can you comment on goodwill and what that is, and what someone buying a business is getting in goodwill?

Mike Zuckerman: Goodwill is the ability to pass on customers, clients, suppliers, things like that so that a person … For example, I represented an accounting firm and the senior partner was retiring and he arranged to sell personal goodwill to the firm. His goodwill was his thousands of clients, all tax returns, all the records that he had for everybody, and they were able to pay for that. He was able to take it as a capital gain as goodwill, and they were able to write-it-off over a period of time, not as an immediate asset but as a longterm asset. Goodwill really gives you the ability to continue a business and grow it.

Dennis Zink: But when you’re a personal service company like an accountant or an attorney and when that person leaves what happens then, because the following was pretty much with the individual that sold the business, wasn’t it?

Mike Zuckerman: That’s very true. When I left the firm I spent three years in transitioning my clients to the remaining partners in my firm and never met with a client unless we introduced them. Particularly, I dealt with a lot of insurance brokers. The renewals come up and what you’re buying is renewals, and they find that, in most cases, unless people really want to change their agent they’re just going to keep on paying. The bill will come and they’ll continue with you, but there has to be a transition period and that’s really the personal goodwill. Very many of these businesses are sold on the basis of retained business. So that if they get a payout over three to five years, depending upon how the business comes in, they give them a percentage of the new business that comes in and that’s how they take care of that situation. Dennis Zink: Would that be considered an earn-out?

Mike Zuckerman: Absolutely an earn-out, yes.

Dennis Zink: Okay.

Peter Gruits: It’s pretty typical though that a buyer of a business expects, without additional negotiations, that the seller will stay on for 30 to 45 days to help them transition. That usually is not enough time and you need to be aware of that as you’re looking to buy a business. You want the participation of that seller.

Dennis Zink: What type of business does SCORE help clients look to buy? Is there any specific type?

Peter Gruits: Well, we get about 100 requests a month for mentoring services and they’re all over the place. Maybe half of that is from existing businesses who want to improve their business or are looking to sell their business. The other half are people who say, “I want to buy a business,” or, “I want to start a business,” and they range all over the place. We have people who want to start landscaping companies. We have other people who have an idea for a restaurant. They may have an idea for a service industry that doesn’t really exist, or a flower shop. So, we get all types of requests for help in reference to how can we help you make that decision.

Peter Gruits: The most important thing that our client base really needs is a sounding board for finding out what’s going to work for them, to help facilitate their activity in either buying or starting a business.

Dennis Zink: Peter, as a follow up, how important is it to have experience in the industry that they’re looking to get into?

Peter Gruits: Well, that’s why SCORE is so valuable, because our mentors are experienced and are confidential and are free, that’s very important, but it’s very important for the person who wants to start a business or buy a business to come in with some background. You have to have experience in the restaurant business if you’re going to buy a restaurant. Not just because you eat at a restaurant qualifies you to run a restaurant. There’s a lot of complexity.

Mike Zuckerman: Or know how to cook.

Peter Gruits: That’s right. You’ve got to have a lot more experience than that represents. So many people will want to buy a business they don’t have any experience in, and that’s really a recipe for failure.

Mike Zuckerman: If I could just interject on that a second, Dennis, it really depends on why the person wants to buy a business.

Peter Gruits: Yeah.

Mike Zuckerman: If he’s looking to earn a living then he’s got to have experience in that. If he’s a wealthy person who’s looking for an investment, all he cares about is putting his capital in and having it earn money. So, he really doesn’t have to have experience in that business. Our country club up north was bought by a guy who was in the waste management business. All he wanted to do is write off the taxes and do fracking if they were allowed to get gas in New York. So, he didn’t have to know anything about running a country club, and he didn’t, that’s why he went broke.

Peter Gruits: But if he’s going to have any operational success, he’s going to have to have people that are working for him that can manage that business successfully.

Mike Zuckerman: Exactly.

Peter Gruits: You can’t go in as a blank tablet and expect that you’re going to be competitive with the people across the street who’ve got 30 years-worth of experience.

Dennis Zink: Michael, in your experience, what are three areas of concern that a buyer should watch out for? One of those three I’d like you to address is leases.

Mike Zuckerman: The key here is to do your due diligence, and due diligence means that you hire a good accountant who’s familiar with the type of business, and hire a good attorney who’s familiar with buying and selling businesses and is familiar with that type of business, and a good consultant, and you make sure that you check all leases. Is the real estate being sold with the business or is it leased? And if it’s leased, how long does the lease have to go? Are there options to exercise, and is it assignable? Very many leases say it cannot be assigned to anybody else without the approval of the landlord. That is an invitation for the landlord to increase the rent and start all different kinds of things going. So those are extremely important.

Mike Zuckerman: The other thing you’ve got to do is a UCC search to make sure the assets are free from security interests. I bought this machine five years ago, I paid it off last year, but no one bothered to eliminate the UCC form. So, you have to do a search to make sure there are no things of record against you. And then you’ve got to check the employed people. Do they have employment contracts? Do they have covenants not to compete? You buy the business, are they likely to say, “Well, thank you we’ve got a better offer from your competitor down the road,” and suddenly not only don’t you have them but they take their clients with them. Those are three very important things that you’ve got to deal with.

Dennis Zink: And for clarification purposes, UCC is Uniform Commercial Code. Can you explain that?

Mike Zuckerman: Yes. The Uniform Commercial Code allows you to file with the state, a piece of paper that says that there’s a lien against this particular document. It’s like a mortgage on real estate, but it’s a lien on personal-type property, machinery. I go out and buy a new truck and I finance it, lease it back, and the finance company will file a UCC saying that they own the truck and I don’t really own it.

Peter Gruits: To Mike’s point about, and your point, about real estate. When buying a new business real estate can be an anchor, not a good anchor necessarily, and it can slow you down in being able to go out to the marketplace and find out what you’re doing. Forbes had an article recently about a hardware store in New England and it had been around for 200 years. That hardware store had six floors of inventory, and why couldn’t they sell it to anybody? Well, primarily because there was no parking. There was no way to park your car to get the inventory out, and there was no way to be competitive with other companies that were doing that kind of thing because of the real estate. So, we could encourage, at least I do and I’m in the real estate business, I would encourage most people to not include the real estate when they’re going to buy a business. You know, you have to have that flexibility.

Mike Zuckerman: What we very often do in that case is we’ll buy the business, lease the real estate with an option to buy so that we’ve paid off the business if I’ve borrowed the money from the bank or from the seller. I then have an option to continue similar payments and then I could own the real estate, and I get a right of first refusal so they can’t sell it to anybody else without offering it to me.

Peter Gruits: It’s important to have that option. It’s important to not be forced to buy that real estate.

Mike Zuckerman: Right.

Dennis Zink: Well, Michael, let me ask you. How do you make an offer? You’re interested in the business, what do you do?

Mike Zuckerman: Typically, I am a great believer in the team approach. I get the attorney, the CPA, the mentor from SCORE, anybody else if there’s a business broker involved, and we talk about what is this business really worth? How much can I afford to pay for it? And how can I pay for it? And what am I buying? Am I going to buy all the inventory if some of it is 10 years-old and been sitting on the shelf why should I buy that? Why should I do this? Why should I pay for that? Once you get your plan, I usually like to do it because it’s my profession, the attorney calls the seller’s attorney and says, “We’re thinking of this, this and that, and here’s what we have in mind. Where do we stand? Are we in the ballpark or not in the ballpark?” Then he comes back and says, “Well, we wanted this much. We wanted this,” and you negotiate that, and at that point you come up with a plan, and then I always encourage the buyer’s attorney to draw a letter of intent.

Peter Gruits: Absolutely.

Mike Zuckerman: And this letter of intent covers everything. It’s non-binding except for certain things. One of the things it says is while we’re doing our due diligence you cannot offer the business to sell to anybody else, you’ll not accept any other offers, you won’t increase the salaries of any of your employees so that you suddenly were paying them twice what they’re worth, and we’ll do that when we buy it. It sets forth the terms. And once you’ve agreed on the letter of intent, everybody signs it, and then you have your due diligence period where they open up their records and you can see just who they are. Some people will introduce you to some of their customers or clients. That’s very rare, but the suppliers it would be great to meet them, but most of the time the seller wants to keep this a secret. Doesn’t even want their employees to know that this is happening.

Peter Gruits: In the heat of the moment, many people will shortcut an extensive letter of intent, and that’s a mistake. You should not forget the importance of the letter of intent and the detail that has to be in the letter of intent. Well, my letter of intent is one page long. Well, if your letter of intent is one page long you may be buying an apple on the corner, you’re not buying a business. You have to have something extensively representing that deal and reduced to writing so that you can look at those components within that letter of intent and negotiate on each one of those elements.

Mike Zuckerman: Then once that letter is signed then you start drawing the primary documents, and when those are signed then the letter of intent automatically terminates. As I said, if I said I’m going to buy it for $1 million dollars or $100 that’s not binding. We can negotiate later on as we do our due diligence because we didn’t realize that you owed this many, or had this asset, or whatever.

Peter Gruits: It’s important to know, too, that when you issue a letter of intent you normally put up some good faith money, but unlike in a real estate deal where you put up good faith money and if you can’t deliver you then lose it, a letter of intent typically is refundable.

Mike Zuckerman: That’s negotiated, yeah.

Peter Gruits: Yeah.

Mike Zuckerman: I’ve had sellers who say, “All right, I’ll do this but if it’s going to cost me so much for my attorney, my accountant, I want to keep that down payment unless it’s my fault. If I break the deal then you get it back. If you break the deal then you don’t get it back.”

Dennis Zink: Michael, let me ask you about the difference between an asset purchase and a stock purchase? What are some of the differences and which one do most people do and why?

Mike Zuckerman: It’s spelled T-A-X-E-S and liabilities. The two of those. Incidentally, buying assets in New York, I don’t know what it is in Florida, but it does not eliminate all liabilities. Sales tax is a huge thing in New York.

Peter Gruits: Oh, yeah.

Mike Zuckerman: And if you sell a business and you are collecting sales tax, and you owe five years back sales taxes, and you don’t get a letter from the Department of Taxation saying all taxes are paid, the buyer is responsible. It follows the assets. So the buyer could be responsible. I’ve seen guys really get burned where their attorneys didn’t know enough to go to the Department of Taxation and say, “I want a letter,” and the letter will come in that said, “No, you own $42,000 in taxes and we won’t give the letter until that’s paid plus the interest and penalties.” Then, you negotiate that part of it. Okay, that will come out of the closing money. Of course, if I could afford it I would have paid it. That’s why I’m selling the business.

Dennis Zink: My understanding is about 90%+ of deals today are asset purchases. Do you think that’s about right?

Mike Zuckerman: No.

Dennis Zink: What percentage would you think that is? Mike Zuckerman: I would think more 50-50.

Dennis Zink: Really?

Mike Zuckerman: Yeah.

Dennis Zink: Wow.

Mike Zuckerman: Yes.

Peter Gruits: I think that’s primarily, Dennis, because there are some intellectual property elements involved, and the customer base is the most important thing you’re buying. So, if you throw away the customer base when doing, if you haven’t been careful about how you do that, that could be problematic in reference to cash flow.

Mike Zuckerman: So what you do is you negotiate the taxes by employment agreements, by noncompete agreements, by different things where you shift the income taxes, but they want to … keeping the business intact where it’s been in business for a long time. I represent a grandfathered engineering company in New York. You can’t own an engineering company unless you’re a licensed engineer unless it was formed before 1923. So, I’ve got a 1922 company. That license to be able to sell it to someone who’s a non-engineer is worth over $1 million. I can’t do anything but sell the stock of that company.

Mike Zuckerman: The other thing is a lot of people, there’s probably not a lot of the SCORE people, but a lot of people will buy a business for tax losses. They have a huge tax loss, I’ve got a very, very wealthy business

Peter Gruits: That’s a great point.

Mike Zuckerman: … I would like to buy that business just to take the tax loss against my income. If you buy the assets you lose that whole thing.

Dennis Zink: And that’s for the NOL, the net operating loss?

Mike Zuckerman: Yes.

Dennis Zink: Okay.

Peter Gruits: Businesses and people who want to be in business need to have those things sounded out. They need to think about this stuff. They need to have input to it, and sometimes you have to make a decision back and forth. You have to really do a balance sheet on this to make sure that you’re making the right decision. It’s not just something that you pick A or B. You have to think about A or B.

Dennis Zink: Michael, how do you negotiate the deal? And I’d like you to touch on cash and terms, seller note, and maybe an SBA loan.

Mike Zuckerman: This depends upon the ability of the buyer to either get a bank loan, an SBA loan, or the willingness of the seller to take money over a period of time. As I had said earlier, if a type of a sale is of a service business and you have to retain the business, and it’s a payout over a period of time, then of course that fixes itself. Of course, if I represented a seller I’d say, “Let’s get all cash.” Because I don’t have to worry about it. I had a very dear relative who had a business that was an extremely valuable business worth tens of millions of dollars, negotiated a sale with a publicly held company to exchange stock for stock in a tax-free deal. He said, “Boy, what could be better. I’m going to get stock in this New York Stock Exchange company. I don’t have to pay tax on it. It’s terrific.” And two years later guess who’s in bankruptcy. The purchaser. The guy suddenly had nothing left. So, you really have to be very, very careful. It’s a function of what it is and very often you can reduce the purchase price by saying I’ll pay cash or change the interest rate. If the person owns the real estate … I’ve many times upped the rent far beyond the fair market value and said, “Why don’t you do this and we’ll take less here, and I can write that off every year.”

Peter Gruits: All-in bets don’t always work. Sometimes you should, in effect, balance that bet. You should, in effect, know hey some is cash and some is not, and you don’t want to just do one thing. You’ve got to find ways to indemnify the risk that you’re running when you buy a business.

Mike Zuckerman: I consulted with a client last week who, we made a deal two years ago for an employee to buy out the business out of profits that he would get from bonuses. The business wasn’t quite able to do that, he was able to go to a bank and get two-thirds of what the price would have been, came to us and said, “Would you take that in full satisfaction?”, and I said to the guy, “Run so fast that you don’t know what you’re doing.” I said, just take it. You don’t need it to live on you have other wealth. He owned the building and was leasing it to him. So he wasn’t concerned, but these things are really … You have to know the ability, the financial status, of all the parties and try to negotiate that.

Dennis Zink: Michael, can you comment on the advantages of having an earn-out in the equation of a transaction?

Mike Zuckerman: If you’re the buyer it’s all to your advantage. If you’re the seller you want to take your money and run. You don’t want to have to rely on who they now hire to take your position selling what you were selling or keeping and maintaining the customers or the clients. I think that you hate an earn-out if you’re the seller although you might understand that that’s the only way you’re going to sell the business. That’s the practicality of it.

Dennis Zink: The buyer could, if they did a great job, get more money if they negotiate it properly.

Mike Zuckerman: Yeah, but the other thing about it is how is the buy out? If suddenly I put my wife and three kids on the payroll, and it’s based upon a net profit, I’m not going to hurt anything. If it’s based upon the gross sales then it could be dealt with otherwise. So you’ve got to really … that’s a very tough formula and you really need an expert to prepare that formula.

Dennis Zink: Peter, would you want to weigh in on that?

Peter Gruits: Yeah, if it’s a unique business I would never buy a business without an earn-out. I wouldn’t want … There’s so many indemnification issues that you have when you go to buy a business that if you don’t have an earn-out you have no way of recapturing that. The problem that you have when the seller takes the cash and runs, now where are you going to go, and there are representations that occur in selling a business. You don’t know what you don’t know, and you have to have some way to indemnify that purchase.

Mike Zuckerman: But in light of that, I’ve practically never, representing a seller or buyer, ever done an indemnification without an escrow agreement.

Peter Gruits: All right, there it is.

Mike Zuckerman: It’s held by a bank or by self for a period of whatever the indemnity lasts so you know that the tax problems are gone, you know that any lawsuits are gone, and all that type of thing, and make sure it’s sufficient. That’s usually one of the big negotiations, how much are we going to hold back in a safe place so we can pay you back if you get in trouble. Dennis Zink: Right, and that would be for some misrepresentations for example.

Mike Zuckerman: Right. I paid all my taxes and the IRS shows up the next day and says, “Hi, I’m your best friend. Guess what?”

Dennis Zink: Let’s talk about a seller staying on after the transaction. I mean, most sellers probably want to take the money and say bye I’m going to Hawaii, but assuming they stay on, what is typical in terms of length of time?

Peter Gruits: Well, the assumption is by most sellers, I’ve got to hang around for 30 days and then I can escape. It’s important for a buyer to negotiate that period of time very carefully. Now, it depends on how experienced the buyer is. If the buyer knows this business and the seller is just going to be a pain to have around, then that’s different. So it’s different in every circumstance. Everybody needs to be aware of that. Now, if they need to be around for a period of time, you’re typically going to have to enter into an employment agreement, or a consulting agreement, with the seller to be around to answer those kind of problems, but it is typically that you think, “Well, I’ll be around long enough to show you how the keys work and how to turn on the air conditioner.”

Dennis Zink: Michael, do you have any comments?

Mike Zuckerman: Yes, I do. I rarely negotiate any deal without either an employment and/or a consulting agreement from the seller. It’s for two reasons. One is, it’s the way to get the tax benefits. If I can make a deductible expense by paying him a salary or a consulting fee. So I can write that off each year instead of, if I bought an asset, I have to capital gains it and I might never get it back. The second thing is to have them available. I find employment agreement is effective if you’re going to come and be in the business and actually work at it.

A recently sold business, the guy who had owned it was the shop manager. He was terrific. He knew how to bid jobs, he could do everything like that. So they kept him on for three years. At the end of the three years they kept him on for another five years. And he loved it. He was getting a hell of a salary. They have him now in charge of all their plants all over the place, and it was great.

Consulting agreements are, “I’ll be available by phone. If you have any questions, call me. Or if I’m in town I’ll stop in if you want me to. We’ll pay you X number of dollars just to be on call.” Again, that’s very helpful.

Mike Zuckerman: A covenant not to compete is a third way that you do this and it’s definitely important because the worst thing you want is to have somebody walk out, sell you their business, call their customers the next day and say, “Oh, by the way, guess who’s not in business. But I’m forming my new one, would you come over with me. We’ve had a wonderful relationship.” So these are all important things.

Mike Zuckerman: I’ve had employment agreements from one to three years. When I’m representing the seller I say, “Be very careful to do this because you’re not going to be happy working for someone else after you’ve worked for yourself for how many years you’ve owned the business. They’re going to change the way things are done. They’re going to fire some of the people that you love. They’re going to hire people that you don’t want to see, but bite the bullet and this is part of the deal.”

Dennis Zink: Peter, in summary, how can SCORE help a buyer with a business?

Peter Gruits: It’s important that you don’t do this alone. We’ve said that before. This is not something that you can do isolated in a cabin in the woods. You have got to have people around you who have expertise, who understand and are knowledgeable about this, and allow you to sound it out over a period of time. You can’t do it in five minutes. SCORE representatives have the experience. They represent confidentiality, and it represents freedom because you don’t have to pay for it. Then, it allows you the opportunity to profile your business questions and the decisions you’re going to make with the professionals such as legal, accounting, and the broker. Without that it’s going to be very tough for you to be successful.

Peter Gruits: We at SCORE are happy to do that. We have over 90 mentors. We get requests every day for people who want to buy or start a new business. So give us a call. We’re there. We’re ready to help you.

Dennis Zink: Michael, do you have any final thoughts?

Mike Zuckerman: I certainly do. I think that the one point we tried to get across is that this is really big business. This can effect the rest of the buyer’s life and their family and the rest of their lives. You’ve got to do it properly. You’ve got to have the proper experience behind you. You’ve got to have the proper help with you. You don’t go to a divorce lawyer to buy a business. I’m not saying anything bad about divorce lawyers, but you’ve got to have someone who knows exactly what they’re doing and follow their advice.

I also would say that if you’re buying a part of a business, and very often this happens, you’re buying into an existing business, that’s a whole different subject that we should cover at some later time.

Dennis Zink: Peter?

Peter Gruits: If you’re going to start or buy a business you have to have a sanity check with someone other than your mother-in-law. You have got to make sure that you’re thinking this through correctly, and once again, SCORE is a great place to do that.

Dennis Zink: Okay. Peter, how can our viewers reach you and Michael?

Peter Gruits: To reach a mentor like Michael and myself, all you have to do is go to www.score.org and request a mentor to help you in your quest for starting a business or buying a business or selling a business.

Dennis Zink: I’d like to thank our guests for appearing on this episode of SCORE Business TV. I’d also like to thank our viewers and our sponsor, Wells Fargo. Please tune in next episode when we continue our series on how to buy a franchise business. Until then, this is Dennis Zink for SCORE Business TV. I may be contacted at dennis@Time4Exit.com

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