Buying an existing business

In short

I once heard a buyer say that paper tells the truth when people cannot, and I have never forgotten it. If you are thinking about buying an existing business, you are already doing something wise, because you are studying before you sign. Before you talk price, ask what the seller is willing to show you, since a good seller will open the books and a nervous one will not. Then work out what the business earns after the owner is paid a fair wage, because that is the real number. Compare the asking price to that figure, and never to the seller's hopes. Plan for a loan, a down payment, and a cushion of cash for the first months. Take your time, and bring an accountant and a lawyer to the table.

The whole of it

What it is

I once watched a neighbor buy a hardware store from a man who had run it for thirty years. She did not buy a building or a stack of shelves alone. She bought the customers who walked in every Saturday, the supplier deals, the name on the sign, and the little habits that made the place work. That is what you get when you purchase an existing business. It is a running machine with its history attached.

The appeal is plain enough. You skip the shaky first years of a startup, when nobody knows your name. You start with sales, and you can look at the past to guess at the future. But you also inherit the mistakes, the debts, and the quirks. You are stepping into someone else's boots, and they may not fit right away.

There are two common ways to buy. In an asset sale, you pick the pieces you want, such as equipment, inventory, and the customer list, and you leave the rest behind. In a stock sale, you buy the company itself, including its debts and legal troubles, whether you know about them or not. Some buyers prefer the asset route because it limits what they take on. Your lawyer can tell you which one fits your case.

How it works

You have probably heard that a business is worth some multiple of its earnings. The idea is simple. The price is set by taking a measure of yearly profit and multiplying it by a number that reflects risk and growth. A steady shop with loyal customers earns a higher multiple. A shaky one earns less.

Small business buyers often use a profit measure called seller's discretionary earnings. It starts with the profit on the tax return. Then it adds back the owner's pay and any personal costs that ran through the business. So if the owner drove a car on the company dime, that cost gets added back. The result shows what one working owner could take home. It is a fair way to compare small shops. Still, you must check every add back yourself.

Many buyers do not pay all cash. You may combine a bank loan, your own savings, and sometimes a note from the seller, where the seller lets you pay part of the price over time. A seller note can help because the seller stays interested in your success. Some buyers also use loans backed by the U.S. Small Business Administration. Its 7(a) program is one route, and the agency explains the rules on its own website at sba.gov.

Lenders will want to see that the business earns enough to cover the loan payments. Many of them look at a ratio called the debt service coverage ratio. That is a plain test. Does the yearly cash left over cover the yearly loan payments, with room to spare? Ask your lender what ratio they require. It varies from lender to lender.

The numbers, and where to find yours

You know how it feels to want a number handed to you. Here is where each one lives. The seller's profit and loss should match their tax returns, and you can ask for the last three years of both. The seller can also sign a form that lets you get a copy of the returns straight from the IRS. That is a good way to be sure they are real. Sales tax filings, bank statements, and payroll reports give you a second and third look at the same story.

For the price, ask what multiple similar businesses have sold for in your field. A business broker or an accountant who works with small firms may be able to tell you. Do not treat any one multiple as a promise. Two shops in the same trade can be worth very different amounts.

For loan terms, the SBA lists the rules for the 7(a) program on its site. The maximum 7(a) loan amount is the current figure, which the official source publishes each year. The required equity injection, which is the cash you put in yourself, is the current figure, which the official source publishes each year of the project cost for certain deals. Check the SBA page for the exact rules that apply to you, and for the date they were last updated.

Your own cushion matters too. Add up your savings, what family might lend, and what you can borrow. Then hold back cash for the first few months. Early weeks can cost more than the spreadsheet said.

A worked example

Picture a woman named Denise who wants to buy a small print shop in her town. The owner, Walt, is ready to retire. These figures are invented to show the steps, and no real shop is meant. His tax return shows a profit of 60,000 dollars for the year. He paid himself a wage of 45,000 dollars. He also ran a truck through the business that cost 5,000 dollars a year and was partly personal.

Denise builds the earnings figure step by step. She starts with the 60,000 dollars of profit. She adds back Walt's pay of 45,000 dollars, which brings the total to 105,000 dollars. She then adds the 5,000 dollars of truck cost, for 110,000 dollars. This is the money one working owner could take from the shop before paying anyone to run it.

Next she asks what her own time is worth. If she hired a manager instead, she would pay about 50,000 dollars. So she subtracts that from 110,000 dollars and finds 60,000 dollars left for the business itself. That is the number she trusts.

Walt asks for 220,000 dollars. Denise divides the price by the 110,000 dollar earnings figure and gets a multiple of 2. That is 220,000 divided by 110,000. She takes the number to her accountant, and she still checks it against the bank statements and the tax returns.

For financing, she plans to put down 44,000 dollars, which is 20 percent of the price. That is 220,000 times 0.20. It leaves 176,000 dollars to borrow. She asks Walt to carry a note for 22,000 dollars, or 10 percent of the price. That leaves 154,000 dollars for the bank, since 176,000 minus 22,000 is 154,000. Every piece is written down so her lawyer can check it.

Where it goes wrong

I have heard a good many stories from buyers, and the sad ones share a pattern. They fell in love with the shop and stopped asking questions. That is a very human thing to do. But love is a poor accountant.

The first trap is trusting numbers you have not checked. If the profit and loss does not match the tax return, stop and ask why. The second is paying for goodwill that walks out the door. If every customer loves the old owner and no one else, that value may leave with him. Ask how long the seller will stay to train you and introduce you around.

Another trap is hidden debt, unpaid taxes, or a lease that ends soon. Read the lease. Know who owns the building and what happens to the rent. A great shop with a bad lease can turn sour fast.

Last, do not run out of cash. A new owner can spend everything on the price and have nothing left for the slow first season. Keep a reserve. It buys you peace, and peace helps you make good choices.

Questions to answer before you leave this page

What would I earn from this business after paying myself a fair wage, and do I trust the figures behind that answer? Have I seen three years of tax returns, and do they match the seller's own books? Am I buying assets or the whole company, and what debts or legal troubles could come with each choice? How much cash can I put down, and how much cushion will I hold back for the first months? Will the seller stay long enough to teach me the work and introduce me to the customers? What does the lease say, and how long does it last? Have I talked to an accountant and a lawyer who know small business deals? And if the numbers turn out weaker than I hoped, am I still willing to go forward?