July 8, 2019
I will guide you safely through that minefield. By the end of this article, you should have a good idea about How to buy a business.
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. You are buying the customer base, the cash flow, and the fact that you have all of this already assembled so it’s easier if you buy an existing business.
However, there are some businesses that you have to start. For example, a McDonalds franchise. McDonalds will issue a new franchise for a new area. If you’re starting a small business you have to form your own business whereas McDonalds trains you well at Hamburger U. You may spend three or four weeks learning how to run a hamburger restaurant. McDonalds sells you everything that you will need. If you’re Bill Gates and want to start Microsoft you’ve really got to start your own business from scratch.
The most important element you buy is the customers. It’s the cash flow the customer’s produce. It’s the prospects and the people who look to that business for a particular product or service. This is very different than buying something for appreciation. If you were buying stock you buy it for appreciation and perhaps for the dividend. When buying a business, you want to buy it for the cash flow to give you the flow of money necessary to support that business.
Goodwill is the ability to pass on customers/clients, suppliers, processes, essentially everything non-tangible. There was a senior partner in an accounting firm who 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, and they were able to pay him 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 long-term asset. Goodwill provides the ability to continue a business and grow it.
One of the benefits and an asset of buying a business is buying the renewals. In most cases, unless people really want to change their provider they’re just going to keep paying. The bill will come and they’ll continue with you. There has to be a transition period and that’s really the personal goodwill conveyed to the buyer. Many personal service businesses, such as accounting and legal firms, are sold on the basis of retained business. They may receive a payout over three to five years, depending upon how the business comes in; a percentage of the new business will be paid to the seller. This is also considered an earn-out.
It’s typical 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. Often, that’s not enough time and the buyer should be aware of that when looking to buy a business. The participation of the seller may be needed longer and the buyer needs to negotiate for a reasonably longer time frame if he believes it is necessary.
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, that’s different. It’s different in every circumstance. If the seller needs to be around for a period of time, you’re typically going to have to enter into an employment agreement, or a consulting agreement. The seller can be accessible to answer questions. It is typical for the seller to think, “I’ll be around long enough to show you how the keys work and how to turn on the air conditioner.”
A typical deal will include an employment and/or a consulting agreement from the seller for two reasons. One is, it’s the way to get the tax benefits. If as buyer, I can make a deductible expense by paying the seller a salary or a consulting fee, I can write that off each year instead of, if I bought an asset, I have to treat it as capital gains and I might never get it back. The second reason is to have the seller available. Employment agreements are effective if the seller is going to come-in, be in the business and actually work at it.
Associations like SCORE with their Exit Strategy initiative act as a sounding board for finding out what’s going to work in a buy-sell transaction. Their certified Exit Strategist mentors help facilitate the activity of either buying, starting, or selling a business. This is a complicated process and buyers and sellers should not go it alone.
As a buyer, you’ve got to have experience in the business or become a quick study under the seller’s wings. Many people want to buy a business that they don’t have any experience in and that’s really a recipe for failure. However, if the business purchase is for a wealthy person who’s looking for an investment, all they may care about is putting capital in and having it earn money. In that case, they do not have to have experience in the business. If the buyer hopes to have any operational success, then he’s going to need to have people that are working for him that can manage that business successfully.
It is critical to conduct comprehensive due diligence. 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. You also want a good consultant.
Some areas to look at include, reviewing all leases. Is the real estate being sold with the business or is the location leased? If it’s leased, how long does the lease have remaining. Are there options to exercise, and the lease assignable? Many leases cannot be assigned without the approval of the landlord. That is an invitation for the landlord to increase the rent and create roadblocks. So this step is extremely important.
Another important item to check is conducting a thorough UCC (Uniform Commercial Code) search to make sure the assets are free from security interests. You have to do a search to make sure there are no things of record against you.
It is very important to check on the employees. 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 these employees but they take your clients with them. Those are three very important things that you’ve got to deal with.
When buying a new business real estate can be an anchor, not a good anchor necessarily, and it can slow you down. You need to look to the marketplace and find out what comparable rents would be. Regardless, you may not want to change locations to save a few hundred or a few thousand dollars, especially if the location is critical to the success of this business. Nevertheless, it will give you a better handle on valuing the current lease that you may be about to assume.
There was an interesting article in Forbes magazine about a hardware store in New England and it had been around for 200 years. That hardware store had six floors of inventory, and they couldn’t they sell it. The primary reason was that 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. I would encourage most people to not include the real estate when they’re going to buy a business. At the very least, look at it as a separate transaction.
What often happens is someone buys the business, leases the real estate with an option to buy so that when they have paid off the business, and if they have borrowed the money from the bank or from the seller, they then have an option to continue similar payments. Then you can own the real estate, and get a right of first refusal so they can’t sell it to anybody else without offering it to you first.
An effective way is to use the team approach. Get the attorney, the CPA, a mentor from SCORE, and anybody else (if there’s a business broker involved), and discuss what this business is really worth. How much can the buyer afford to pay. How can the business be purchased. What is being bought. Is the buyer going to buy all the inventory if some of it is ten years-old and has been sitting on the shelf? Why buy that. Once the buyer gets the plan, the buyer’s attorney calls the seller’s attorney and asks, “We’re thinking of this, that and the other, and here’s what we have in mind, where do we stand? Are we in the ballpark or not?” Then the seller comes back and says, “Well, we wanted this much and then the buyer and seller negotiate. If there is a basic agreement, the buyer comes up with a plan, and then the buyer’s attorney should draw up a letter of intent based on the plan.
The letter of intent is non-binding except for certain things. One of the important areas needs to state that while conducting due diligence the seller cannot offer the business to sell to anybody else, and that the seller will not accept other offers. Furthermore, the seller won’t increase the salaries of any of their employees so that the buyer suddenly will be paying them twice what they’re worth. The buyer we’ll make those determinations when they buy the company. It sets forth the terms. And once there is agreement on the letter of intent, both buyer and seller sign it. Then comes the due diligence period where the seller opens up their records and the buyer can see exactly what they will be buying. While some sellers may introduce the buyer to some of their customers or clients, that rarely happens. It would be great to meet some key suppliers but most of the time the seller wants to keep this confidential. The seller doesn’t want their employees to know that a transaction is happening for fear of a mass exit.
Once the letter of intent is signed, the primary documents are created. When those documents are signed then the letter of intent automatically terminates. Whether your offer for the company is $100 or $1 million, it is not binding at this stage and you can negotiate later on as you go through the due diligence process. If you have to put up money, it is generally refundable and should be so stated. A seller may want to keep the down payment unless the deal breaks up because it’s his fault. “If I break the deal then you get it back. If you break the deal then you don’t get it back.”
There are differences between an asset purchase and a stock purchase. Most buyers today opt to buy the assets for fear of buying skeletons in a stock transaction. The determining issues are taxes and liabilities. In some states such as New York, buying assets does not eliminate all liabilities. 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. Buyers have been burned when 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 says, “No, you own $49,000 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 with the seller. That will come out of the closing money. Of course, if the seller could afford it he would have paid it. That may be why he is selling the business.
Some people will buy a business for tax losses. They may have a huge tax loss, a Net Operating Loss (NOL). A wealthy buyer may buy a business just to take the tax loss against his income. If he bought the assets he would lose that write-off.
Structuring payment to buy the business may depend upon the ability of the buyer to either get a bank loan, an SBA loan, or the willingness of the seller to hold paper (receive money) over a period of time. If the type of a sale is of a service business and the seller has the right to retain the business, and it’s a payout over a period of time, then of course that fixes itself. From the sellers perspective, he would want to receive all cash. A buyer of 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. What could be better. The seller received stock in a New York Stock Exchange company and didn’t have to pay tax. Two years later the company was in bankruptcy. The purchaser suddenly had nothing left. You really have to be 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 many times they will increase the rent far beyond the fair market value and say “Why don’t you do this and we’ll take less here, and I can write that off every year.”
If you’re the buyer it’s all to your advantage to have an earnout. 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.
The buyer could, if they did a great job, receive more money if they negotiate the earn-out properly. You should consult an expert to prepare an earn-out formula.
Indemnifications will have an escrow agreement. It may be 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 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.
A typical deal will include an employment and/or a consulting agreement from the seller for two reasons. One is, it’s the way to get the tax benefits. If as buyer, I can make a deductible expense by paying him a salary or a consulting fee, I can write that off each year instead of, if I bought an asset, I have treat it as capital gains and I might never get it back. The second reason is to have them available. I find employment agreements are effective if you’re going to come and be in the business and actually work at it.
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.
A covenant-not-to-compete is 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.” These are all important.
Employment agreements typically run from one to three years. The seller should be careful because they may not be happy working for someone else after working for them self for many years. The buyer is going to change the way things are done. They’re going to fire some of the people that the seller loves. They’re going to hire people that the buyer doesn’t want. The seller must learn to bite the bullet and accept that this is part of the deal.
Buying a business can affect the rest of the buyer’s life and their family. Do it properly. Have the proper experience and have the proper help. Don’t go to a divorce lawyer to buy a business. Get someone who knows exactly what they’re doing and then follow their advice. I may be reached at dennis@Time4Exit.com
Watch the TV show on this topic: https://manasota.score.org/resource/buying-business-score-business-tv