How To Buy An Existing Small Business Without Buying Its Problems
Acquiring a running business can be faster than starting one. The diligence questions below separate a solid company from a seller's well-presented exit.
Buying an established small business has an obvious appeal. It comes with customers, staff, suppliers and cash flow on day one, which can take years to build from scratch. It also comes with every problem the seller knows about and has not mentioned.
The difference between a good acquisition and a painful one is usually decided in diligence, the period between agreeing on a rough price and signing the purchase agreement. That is when a buyer verifies what the seller has claimed.
Understand what the earnings number means
Small businesses for sale are often marketed on seller's discretionary earnings, a measure that starts with profit and adds back the owner's salary, personal expenses run through the company, interest, depreciation and one-off costs.
Each add-back is a claim that needs evidence. A personal vehicle may be a genuine add-back. A one-time legal bill may have happened every year. And if the owner works sixty hours a week, you will need to pay a manager or do that work yourself, so the owner's salary is not free cash.
Ask for tax returns, bank statements and the general ledger for at least three years and reconcile them against each other. If the reported earnings do not appear in the bank account, find out why before going further. For larger deals, buyers often hire an accountant to run a quality of earnings review.
Look at the trend as well as the level. Three years of steady earnings tell a different story from a sharp rise in the final year, which can reflect cuts to marketing, deferred maintenance or delayed hiring that make the business look more profitable just before a sale. Ask what spending was reduced recently and what it would cost to restore.
Look for concentration, including in the owner
Ask what share of revenue comes from the largest customers, the largest supplier and the largest referral source. A business that depends on a single client or a single channel is riskier than its earnings suggest.
Ask how those relationships are documented. Are there contracts, and do they survive a change of ownership? Many customers buy from a small business because of a personal relationship with the owner. When the owner leaves, some of them may too.
Map what the owner actually does each week. Who handles sales, pricing, key accounts, supplier negotiations and hiring? If the answer to most of these is the owner, the business you are buying is partly the owner's personal effort.
A transition period, during which the seller stays on to introduce you to customers and train staff, reduces that risk. Put its length, the seller's duties and the seller's compensation in the purchase agreement.
Contracts, leases and liabilities
Read every significant contract, including the property lease. Check whether the lease can be assigned to you, at what rent, and for how long. A business whose lease expires soon after closing may not be able to stay in its location.
Deal structure matters for liabilities. In an asset purchase, the buyer acquires specific assets and generally takes on only the liabilities it agrees to. In a stock purchase, the buyer acquires the company itself, including its history. The choice has legal and tax consequences for both sides, so it should be decided with an attorney and an accountant, not by default.
Check the people side too. Review employment arrangements, which staff are essential to keep, whether workers are correctly classified as employees or contractors, and any pending claims or disputes. Confirm that the licenses and permits the business relies on can be transferred, or that new ones can be obtained in time for closing.
How deals are financed
Small business acquisitions are often funded with a combination of buyer equity, a bank loan and a seller note, where the seller agrees to be paid part of the price over time. The SBA's 7(a) loan program lists changes of ownership among its eligible uses, and its page sets out the current terms and requirements.
A seller note is also a signal. A seller willing to be paid over time is betting that the business will keep performing after they leave. A seller who insists on all cash at closing deserves an extra round of questions.
What to do before you make an offer
Request three years of tax returns, financial statements and bank statements. Get a customer list with revenue by customer. Write down every add-back and the evidence for it. Map the owner's role week by week. Read the lease. Then bring in an accountant and an attorney who have done small business deals before signing anything binding, and budget for their fees as part of the price.
This is general information, not financial advice. Nothing here is a recommendation to buy or sell anything; speak to a licensed adviser about your own position.
