Buying a business instead of starting one

In short

A friend of mine spent two years drawing up plans for a bakery that never opened, and I think of him whenever someone tells me starting from scratch is the only honest way to build something. If you have been picking between a blank page and a business already running, you are in good company. Buying one means you pay money now for customers, staff, and a track record that already exist. The price usually rests on what the business earns, so ask to see the books before you ask anything else. Most buyers borrow part of the price, and the lender will want to know the business can cover the payments. Plan on hiring an accountant and a lawyer who have done this before. Take your time.

The whole of it

What it is

I once watched an old hardware store change hands, and what struck me was how little changed on the shelves and how much changed in the owner's chair. That is the whole idea. You are buying a going concern, which is a business that is already open and already bringing in money. The buyer gets the customers, the equipment, the name, and often the lease and the employees. The seller gets paid and walks away, or stays on for a while to teach the new owner the ropes.

There are two common ways to do it. In an asset sale, the buyer picks the pieces he wants, like the equipment and the customer list, and leaves the old debts behind. In a stock sale, or an equity sale, the buyer takes the whole company, past troubles and all. The two paths carry different tax results and different risks, so a good lawyer earns every dollar here.

Buying will not save you from work. You will still have to run the place. What you skip is the part where nobody has heard of you yet.

How it works

If you are holding a little savings and a big idea, the process may look like a long staircase, but it is mostly a few steps taken in order. First comes the search. Owners sell through brokers, through listing sites, and sometimes just by word of mouth at the local diner. Once you find a business that fits, you sign a short letter of intent, which says roughly what you will pay and how the deal will go. It is usually not binding on the price, though a few parts, like keeping the talks private, often are.

Next comes due diligence, a fancy name for checking everything the seller told you. The buyer should look at tax returns, bank statements, the lease, contracts, and any lawsuits. Do not skip this part. Sellers are mostly honest, but even honest people forget things, and a forgotten debt becomes your debt.

Then comes the money. Many buyers pay some cash, borrow some from a bank, and sometimes ask the seller to carry a note, which means the seller lets the buyer pay part of the price over time. The U.S. Small Business Administration backs certain loans made by banks, and its website explains the 7(a) loan program, including what the agency requires of a borrower. The lender, not the agency, decides whether to say yes.

Last comes closing. The papers get signed, the money moves, and the keys change hands. A fair deal usually includes a transition period, where the seller helps the buyer meet the customers and learn the quirks.

The numbers, and where to find yours

A seller will quote a price, and you will want to know whether it is fair. Many small business sales are priced as a multiple of the owner's yearly earnings, and brokers often use a figure called seller's discretionary earnings. That is the profit left over once you add back the owner's own pay and one time costs. The multiple you will hear depends on the industry, the size, and the risk, so treat any rule of thumb as a starting point, not a promise.

Your own numbers live in a few places. The business's tax returns, which the seller must hand over, show what the business reported to the IRS. The profit and loss statements show the month by month story. Your own side of the ledger comes from your bank balance, your credit report, and your lender's quote for the interest rate. If the purchase uses an SBA backed loan, the program's limits and fees are set by the agency, so look at the current figure, which the official source publishes each year and the current figure, which the official source publishes each year on the SBA's official page for the current figures. For the tax side, the IRS publishes instructions for Form 8594, the Asset Acquisition Statement, which covers how the price of an asset sale is divided among the assets, and a tax professional can say which other forms apply to a given deal.

A worked example

Let me tell you about a woman named Marisol, who runs a small route of coin laundromats in her town. She was thinking about buying a shop that sells and repairs bicycles. The owner, a man named Walt, wanted to retire.

Walt's books showed that the shop earned $90,000 a year after paying all costs but before paying himself. He also paid himself $45,000 a year for working there. To see what the shop really earned for an owner, Marisol added the two together. $90,000 plus $45,000 is $135,000. Walt called that figure his owner earnings.

Walt asked for a price of 2 times those earnings. 2 times $135,000 is $270,000. Marisol thought that was fair, but she wanted to know if she could carry it.

She planned to put down 20 percent. 20 percent of $270,000 is $54,000. That left $216,000 to borrow, because $270,000 minus $54,000 is $216,000. Say the loan ran ten years at a payment of about $2,450 a month. Over a year, 12 payments of $2,450 come to $29,400.

Now she checked the shop could cover it. The shop earned $135,000 before an owner's pay. If she paid herself a modest $50,000, that left $85,000. From the $85,000 she set aside the $29,400 for the loan, and $85,000 minus $29,400 is $55,600. That cushion was what she had to cover surprises, like a broken furnace or a slow winter.

She also noticed Walt's lease ran out in eight months. That worried her more than any number, so she asked the landlord for a new lease before she signed anything. Good thing she did.

Where it goes wrong

I have seen smart people stumble on this, and it is almost never about the math. The most common trouble is paying for earnings that are not real. Sellers sometimes count personal costs as business costs, or leave out work they did for free. Ask who does what, and then price that work.

Another snag is the owner who is the business. If every customer comes because of one person, the customers may leave when that person does. A transition period helps, but it does not fix everything.

Hidden debts, unpaid taxes, and lawsuits can ride along in a stock sale. The buyer should have a lawyer check for liens and claims. A lease that cannot be renewed, as in Marisol's story, can sink the whole deal.

Then there is the pull of the heart. A man falls in love with a shop and stops asking hard questions. Hold on to your curiosity. Walk away if the answers do not sit right.

Last, buyers often forget they need working cash after closing. Slow months happen. A buyer who puts every dollar into the price may have nothing left for payroll.

Questions to answer before you leave this page

Do you know what the business earns once you subtract a fair wage for yourself, and have you seen the tax returns that prove it? Could the business keep its customers if the seller left tomorrow? Is the lease long enough, and does the landlord agree in writing to let a new owner take it over? Have a lawyer and an accountant who handle small business sales read the papers, and have you asked them what could go wrong? After you pay the down payment and the closing costs, will you still hold enough cash to run the place for a few lean months? And finally, do you want to run this particular business day after day, even when it is cold, slow, and hard?