The Art of Business Buying
By David Grossman
I had made a number of investments with other peoples’ money where I effectively limited my upside—and, importantly, my risk—before I first began seriously considering acquiring a small, private business. During my path to ownership, I started taking notes on what I was experiencing and what I was learning. They helped me improve the acquisition process, both in terms of streamlining the hunt and minimizing mistakes.
This multi-article series aims to serve a wide variety of situations. It is both for someone first considering buying a business and someone who has built a track record of acquiring companies. This first article provides an overview of the acquisition process, with the articles that follow diving into drafting a letter of intent, conducting due diligence, and general tips for a smoother overall buying process.
Buying a business is certainly more art than science. By this I mean, no matter what others may say, there is no generic, cookie-cutter recipe of steps to take in buying a small business. That said, I am attempting to provide some guidance as to what might help those in the process based on my experiences. This is by no means an attempt to be a definitive resource guide, but rather a handful of hopefully beneficial advice.
I will start from the assumption that an interesting business has been identified. Finding a target is a significant part of the challenge and requires a separate, lengthy discussion. (See sidebar for a quick guide to choosing a business to buy.) Also, for the purposes of example, throughout this series, I will refer to the seller as Jane and the buyer as John.
A good first step in the acquisition process is to review financial statements and any business plan or description. After that, it is appropriate to have a meeting—whether in person, via video chat, or by telephone. Even if schedules and geography permit an early face-to-face meeting, I typically like to first schedule at least a phone conference. I do this in the spirit of expedience and not wasting time since the business is still fairly unqualified at this point.[/one_half]
CHOOSING A BUSINESS TO ACQUIRE
Selecting which business you want to purchase is a large project outside the scope of this series, but here are a few tips for choosing a business.
Consider the following:
- What industry or industries are my interests and skills most suited for? Answering this question will help you find a company where you can have the greatest impact. It is fine to be general in your search if you think you can quickly learn a new industry.
- How much money am I willing to invest? Your pocketbook constraints will narrow the search.
- What type of role am I most interested in serving—sales, marketing, operations, administrative, or finance? Identifying your personal strengths and desires will weed out some sectors and eliminate specific companies where existing employees cannot handle the areas in which you are less proficient.
- What lifestyle do I want to live? The amount of time you are willing to put into running the business will will help you rule out some companies and sectors.
- What compensation package do I need? If current cash is important, then the business must be large enough to support a regular paycheck.
Finding businesses for sale:
- Look for businesses that are for sale online on sites like bizbuysell.com.
- Talk to CPAs, lawyers, small business owners, associations, and industry trade groups.
- Contact the primary trade publication for the specific industry.
- Like a number of things in business, the more proactive you are in approaching people—even if through a cold call—the more likely you are to hear of an opportunity.
One of the first questions I like to ask Jane is “Why are you selling the business?” Her response to this question can give early insight into the success you might have with the business and the selling process:
- If she is young and has had the company for less than five years—yet claims she is burned out or wants to pursue other interests—skepticism is warranted.
- If she offers no compelling reason, and you sense she is merely entertaining offers but has no real desire to sell (unless she receives a “can’t refuse” price), you may well never reach an agreeable price.
- On the other hand, if she is 70 years old, has run the company since she founded it at the beginning of her career, and has no children who can take the reins, then a rationale of retirement sounds legitimate.
It is important to understand and believe the seller’s position because:
- You do not want to go after a business that the seller wants out of because it is a perceived train wreck.
- You will have a better sense of deal terms she will find acceptable.
- An unmotivated seller frequently backs out of the deal even late in the game.
A few other questions to the seller might be helpful. Knowing the length of time the company has been on the market will provide a hint as to the difficulty in closing the transaction. If Jane has been trying to sell her business for over a year, it might mean her price is too high or the business has some problems. Since it is possible she simply has poorly advertised the availability of the business, you would benefit from asking her if she has received any previous offers.
In addition, you might want to investigate whether she has tried to sell the business to a competitor and ask: If not, why not? And if so, why did a sale not happen? It is possible that a strategic buyer does not view the company as valuable.
You should also determine Jane’s specific responsibilities and the extent of her involvement. Note that in virtually every small business, the owner—assuming she is active—is the chief or only salesperson. She also may be involved in most areas of the business including bookkeeping.
Whatever the situation may be, a replacement for her and her responsibilities should be found. In this piece we will assume that new owner John will be full-time active and handle the responsibilities Jane currently does (and then some). The same logic applies to the individual brought in to manage the company on John’s behalf, should he choose to play a less active role and hire someone to run the firm.
When a meeting between the buyer and seller does occur during the acquisition process, it can be very beneficial to meet with the employees in as informal a setting as possible. In doing so, you can learn a significant amount about the company, the employees’ collective morale, and their individual capabilities.
However, since most small business owners are very nervous about causing apprehension in their team, they often do not even inform staff that the company is for sale until very late in the process. In many cases, buying a business where you have had few, if any, interactions with the employees is a risk you may simply have to take. You may not know if you want them to stay, and, conversely, they may not know if they want to stay with you. One potential mitigating factor is to have a price adjustment included in the agreement with the seller in the event a key employee leaves during the first three months.
Making an offer
Once some preliminary financial information has been reviewed and a company has been visited, it may be time to make an offer. This involves drafting a “letter of intent,” which is also known as a “term sheet.”
While this step may sound intimidating, it is recommended that a lawyer be engaged to create this document—particularly if this is your first time through the process. If done properly, the offer is wholly reversible as the offer should be completely contingent on satisfactory due diligence, a discussion of which is found later in this article.
It is important to note that any required down payment should only be made if it is deposited into a dedicated escrow account and considered fully refundable immediately should the transaction not occur for whatever reason. There are few worse situations than a deal that falls apart and then requires the buyer to take legal action to obtain his deposit.
Trying to reach an agreement early in the acquisition process can save you a lot of time, energy, and money because often the seller’s expectations for her business are way out of line with the buyer’s valuation. Specifically, making an offer is done through submitting a letter of intent with fairly detailed information that outlines the following:
- The total purchase price
- The portion of the purchase price that is in the form of a cash down payment
- The terms of the purchase price’s balance (referred to as a “seller’s note,” which is money paid over the next several years) such as the interest rate and the payback schedule
- The work and specific action requirements of the seller during the transition
- Some key accounting issues, such as specification of a stock sale versus an asset sale—and in this case, if there are any assets such as cash or accounts receivable not included (See sidebar for a note on sale types.)
- Any other important
As a general rule, the letter of intent should be comprehensive enough so that all major terms envisioned at the time are addressed but not so detailed that it takes a team of lawyers and weeks to execute it. Two or three pages is sufficient. Bear in mind that likely little is known about the target company (and possibly the industry) at this time, so expect changes and additions to be made to the deal terms when the transaction is consummated.
You may benefit from requiring a reasonably short timeframe, say one week, for the seller to execute the term sheet in order to decrease the risk that she uses your offer to shop the deal with other potential buyers. Furthermore, I recommend obtaining an exclusive look at the business (a “no-shop provision”) once the letter of intent is accepted. That way, the seller cannot entertain other offers while you are conducting your investigation. In exchange, a timeframe for due diligence can be added so as to not bind the seller for an unreasonably long period of time to do a deal only with you (should you choose).
WORKING WITH A BUSINESS BROKER
A seller is sometimes represented by an intermediary known as a “business broker,” who will primarily control the acquisition process and, at least initially, insist on being the interface for communication with his client. I have seen a number of deals go south because of excessive interference and biased involvement by the broker.
An experienced business broker increases the chances of a deal closing and can expedite the timeframe in which it happens. You also likely know the company is for sale because of him.
Four points to know about a broker:
- Do not be surprised if a broker is not particularly knowledgeable. He may be less proficient in handling deals than he projects himself to be, which casts a false sense of security on the even more inexperienced
- The broker may have set the price expectations of the seller unrealistically
- The broker is paid by the seller 6-12% of the sale proceeds (and sometimes a small monthly retainer for 3-6 months), thereby increasing the seller’s asking price by that amount.
- Although, in theory, the broker should be keenly focused on closing the deal since he is paid almost entirely only when a transaction closes—he typically is partial towards the seller throughout the
If a business broker is involved, there is little that can be done, so you might as well attempt to win him over as much as possible. Working through him directly and providing frequent updates on your progress and concerns can accomplish these objectives.
A NOTE ON SALE TYPES AND FINANCING
The discussion of an asset versus a stock sale is a detailed one and is beyond the scope of this article, but, briefly, unlike in a stock transaction in which all of the company’s assets and liabilities are purchased, an asset sale allows the buyer to purchase some or all of the company’s assets and none of its liabilities. Thus, an asset sale shields the buyer from any financial and existing or future legal or tax liabilities the seller might have incurred.
Also, early in the documentation process, the buyer should address any third-party financing such as debt. It might not be a viable option since most businesses without significant cash flow or fixed assets, such as accounts receivables, property, and equipment, will have difficulty obtaining traditional bank or U.S. government-sponsored Small Business Administration financing. However, if the likelihood of debt financing is high, then I encourage a discussion of the seller’s note being paid only after bank or SBA debt is repaid.
Doing due diligence
While it is difficult to estimate the length of the due diligence period, 3-6 weeks for a small business is the norm. This assumes Jane is available to respond to John’s information requests in a timely manner. If the industry is foreign to the buyer, the business is complex, or outside financing from investors or a bank is needed, then a longer period of time may be warranted. From a practical standpoint, a buyer should not be concerned about having inadequate time for due diligence because, if the process is moving along, he will most likely be able to obtain a short extension from the seller.
Now it is time for our buyer John to roll up his sleeves and begin the real due diligence process. Here we assume that what John learns about the business and the industry—as he continues to peel the onion—confirms what the owner (and/or the broker) has previously disclosed. That does not mean he should not probe and probe deeply. The buyer should remain very skeptical when digging into the company’s operations, finances, employees, partners, customers, competitors, and industry.
John must be prepared to pay the price offered under the terms specified if the business truly is in the condition advertised, but it is important to note that the offer is contingent on the buyer’s satisfaction of due diligence efforts. I have never seen a transaction go through that is exactly the same in the end as specified in the initial letter of intent because results of the due diligence process necessitate making some adjustments. Common changes include:
- Lowering the price because the actual or projected profitability is not what was divulged
- Lengthening the timeframe of the seller’s note payback because the capital expenditure needs are greater than anticipated, resulting in less cash generated from the business to pay the seller
- Increasing the owner’s transition period because getting up to speed will take longer than
I am not advocating a bait and switch strategy; rather, if the buyer is professional about documenting findings and conveying concerns, he is justified in requesting needed changes. At the end of the day, once the letter of intent has been accepted, the leverage switches from the seller to the buyer. If changes are warranted, to show goodwill (or out of necessity), the buyer might consider sweetening for the seller some of the terms that are less important to him, such as the interest rate on the seller’s note.
Drafting the purchase agreement
After completing the due diligence period, if John is still comfortable moving forward, it is time to draft the purchase agreement and any other closing documents. At this point, if a lawyer has not been involved in the acquisition process, the buyer most certainly will want one. Unlike the letter of intent, in which the buyer typically writes the document, it is less clear as to which party writes the first draft of the closing documents. Factors into that decision include:
- Speed: Which side’s lawyer is more available?
- Cost: The buyer might end up with a higher bill if he drafts the documents and the deal falls apart.
- Leverage: The party who drafts the agreement generally has the leverage.
- Thoroughness of the letter of intent: If there are a number of previously unaddressed terms, controlling the process will benefit the buyer, as he can initially propose those
Finally, John will need to decide which corporate structure is most appropriate for the situation. This is a lengthy topic best handled via the input of legal counsel. Either an LLC or an S corporation, where there are no corporate taxes but the owner is shielded from personal liability, is generally recommended.
Expect the documentation process to take several weeks and possibly longer. If time is critical, legal papers can be drafted concurrently with the due diligence process. However, they likely will need to be amended if the deal terms change, thereby increasing legal fees. More importantly, the buyer could be stuck with a large bill if the transaction does not close.
Facing potential problems
As you find yourself moving along through this acquisition process, you should listen to your instincts and stay on guard against issues that could arise. While nervousness and anxiety are normal emotions experienced as the process unfolds, if at any time you gain the sense that you should not move forward with the purchase, seriously consider calling off the process—or at the very least altering the terms.
One area I pay a considerable amount of attention to is the financial performance of the business from when I first started looking at the company. If the business’ sales or profitability is deteriorating or is not performing relative to the seller’s plans, you should be concerned. It is common for the owner to claim that she has not been able to adequately focus on running the business during the due diligence and documentation processes, but you should be very careful here.
Some of the best deals are the ones not done, so there is no shame in calling off a deal at any point even if considerable time and money have been put into it. That will be a small amount lost relative to buying a bad business or buying a business on unfavorable terms.
Look for three follow-up articles in this series in future issues of Cleanfax. Find a more detailed explanation of the letter of intent’s key elements in part two, and for more on the due diligence process, see the third installment. Lastly, the fourth article will offer a list of buying tips to help save time, energy, and money during the acquisition process.
David Grossman is President of Renue Systems Inc., a global franchisor and operator of specialized deep-cleaning services businesses to the hospitality industry. He can be reached at [email protected] with more information available at www.renuesystems.com.