So, you want to buy a small business. What are some of the considerations? Who do you go to for advice?
These days when big companies have been laying off people by the thousands, most of the job growth has been in small businesses. Many of the people buying those small businesses are coming from the ranks of the unemployed, said Ed Pendarvis, chairman and founder of Sunbelt Business Advisors (www.sunbeltnetwork.com), which has offices in Biloxi, Hattiesburg, Jackson and about 350 other locations across the U.S. and in 11 foreign countries.
“What you need is the same thing from a job working for someone else or owning a small business: income to pay the bills to support yourself and your family,” Pendarvis said. “With the insecurity of the job market, virtually no job is secure. There are three things causing job insecurity: offshoring of jobs, downsizing and technology improvements which are eliminating jobs. Maybe for the first time in your adult life, you don’t have a job. So you have to replace that income. You might get another job, and be laid off from that in a few years through no fault of your own. Oftentimes, going into business yourself may provide the best job security.”
Investing in a business is investing in yourself. Pendarvis calls it “a sure thing.” And he believes the risk is significantly lower when buying a business or franchise with a proven record of success.
“Startup businesses 65% to 90% of time are not still in business after five years,” Pendarvis said. “If you buy an existing business or a franchise that has a true proven track record of success, 90% to 95% of the time, it is still in business after five years. If you think about that, it makes sense. The business has already proven itself in the marketplace.”
People who purchase a car usually shop a number of dealerships and test drive quite a few different models before making a decision. The route to buying a home, also, often means looking at a large selection. Pendarvis said it makes sense to do the same thing when buying a business. He recommends shopping with a business broker who has a large selection of different types of businesses available in different locations.
Using a broker is necessary because business sales are very confidential, he said. Most times a business owner doesn’t want employees, competitors or customers to know the business is being sold.
“Brokers have hundreds of businesses listed,” said Pendarvis, who travels around the country training business brokers on how to handle sales and get people interested in different business opportunities. “Sunbelt has more than 10,000 businesses listed.”
When determining what type of business to buy, he recommends finding something that you like. He doesn’t mean, necessarily, that if you like fishing you buy a fishing business. But if you hate to get up and go to work every day, you have a problem. By contrast, if you love what you are doing, the business almost always does much better.
“How we feel is radiated to others,” Pendarvis said.
Asking the seller why the business is being sold is a valid question. People sell businesses for a lot of human reasons: poor health, divorce, relocation or retirement. And, sometimes an unsuspecting buyer can be taken in by someone wanting to unload a white elephant.
Looking at long-term profitability, not just the last few months or year, is also important. For example, a business owner on the Coast purchased a hotel that was having high occupancy rates. But, unknown to the purchaser, the high occupancy rates were due to a large construction project that was completed soon after the purchase. When the hotel went back to lower occupancy rates, the new owner was unable to turn a profit and went bankrupt.
Pendarvis said one way to avoid those kinds of pitfalls is to finance the purchase through the owner.
“If there is a major problem with the business, the seller won’t finance,” he said. “If the seller finances, that gives me reason to believe that his representations of the business are true. Unlike buying a house where there is no continuing relationship between the buyer and seller, in our business, relationships are everything. If you put your life savings into a down payment, and finance half of the purchase price over five years, the relationship with the seller begins at the sale, not ends. The seller is going to train you how to run the business. They have a strong financial investment in the continued success of the business.”
Most times banks won’t finance the acquisition of small businesses because of the lack of security. Another problem is that the financial records of a small business are usually done to minimize taxes and maximize the lifestyle of the owner.
“Oftentimes, the financials will not reflect the true value and cash flow of the business,” Pendarvis said. “Not being able to properly scrutinize the financials to determine the real true value of the business can be very frustrating and could kill the deal. Typically, the problem begins when a small business owner, in order to end up with the lowest possible tax liability, prepares homemade-type financial statements with under-reported income and over-reported expenses. This small business financial reporting methodology works well for the owner until it is time to put the business up for sale. Then there is no documentation of its true worth.”
Generally in the case of owner financing, a downpayment of 30% to 50% is required, with the remainder financed for between five to seven years.
Looking at cash flow is a critical way to determine whether the business is profitable.
“Cash flow is generally 10% to 20% of sales,” Pendarvis said. “The buyer should work with the owner to determine how much cash flow there is. Chances are the sales amounts shown on cash register tapes, a daily journal or a box full of sales slips is greater than those on the financial statements or tax returns. Going through these receipts is one method of determining the cash flow cycle of the business.”
Next, he recommends reviewing all the expenses with the owner to gain an understanding of the actual cost of running the business. Be aware that there is no way to determine if all the expenses are being presented. The owner can easily not show some repair bills or other negative items.
Gary K. Reed, economic development specialist with the U.S. Small Business Administration Gulfport branch office, agrees it is vital for a potential buyer to carefully study the company’s history and operation.
“It is also important to learn how the nature of the business may have changed since its inception,” Reed said. “A buyer should understand the company’s methods of acquiring and serving its customers and how the functions of sales, marketing, finance and operations work and interrelate. General information about the industry can be obtained from trade associations, consultants and other resources.”
Reed said the company’s financial statements, operating practices and other documents should be reviewed. Many items must be looked into prior to making an offer. However, others can be reviewed or verified only after a bona fide offer to purchase the company has been made and accepted — contingent on satisfactory verification of any unreviewed items.
“Check the balance sheet, accounts receivable, inventory, marketable securities, real estate, machinery and equipment, accounts payable, accrued liabilities, notes payable and mortgages payable,” Reed said. “Review the income statement. The potential earning power of the company should be analyzed by reviewing profit and loss statements for the past three to five years. It is important to substantiate financial information by reviewing the company’s federal and/or state tax returns.”
The company’s earning power is a function of more than bottom-line profits or losses. The owner’s salary and fringe benefits, non-cash expenses and nonrecurring expenses should also be calculated.
After obtaining all the information needed to make a decision, Reed recommends seeking professional advice if necessary to interpret the significance of the information.
Other recommendations from the SBA include:
• Review the sales journal. Any and all sales records, such as sales journals and sales reports, should be used to verify sales information on the income statement. Furthermore, sales journals can help determine the level of sales concentration among key customers.
• Determine its financial ratios. While analyzing the balance sheet and income statement, sales and operating ratios should be calculated. Some of the most important ratios are the current ratio, quick ratio, accounts receivable turnover, inventory turnover and sales/accounts receivable. The significance of these ratios, the methods for calculating them and industry averages are available through Dunn & Bradstreet and Robert Morris Associates. Look for trends in the ratios over the past three to five years.
• Are there any patents? Make a list of trade names, trademarks, logos, copyrights and patents noting the time remaining before each expires.
• Are FICA, unemployment and sales tax payments current?
• Legal issues. Are there any suits now or soon to commence? Are all state registration and local zoning requirements and regulations being met?
“Evaluating a company must be carefully scrutinized and weighed,” Reed said. “Some factors will have a positive influence on the decision to buy and others a negative influence. Seek professional assistance if necessary to interpret the significance of the information. The important thing is to obtain all the information needed to make a decision.”
For more information, visit http://www.sba.gov/ms/sbdc.html. There is a link on that page to the Small Business Development Center (SBDC) network of business counselors who provide business assistance.
Also, for a free copy of a SBA Success Series document titled “How to Buy or Sell A Business”, contact the SBA District Office at (601) 965-4378 or the Gulfport branch office at (228) 863-4449
Contact MBJ contributing writer Becky Gillette at firstname.lastname@example.org.