January 17, 2023
If you’re not sure whether to start a company or buy one, or even if you’re certain you want to buy but don’t know where to start, it’s time to weigh up some options. Startups come with their own challenges that can often be cut out of the process simply by buying an established business, but this doesn’t mean it’s an easy task, and buying a small business comes with a number of complicated steps.
In this article, we’re going to look at each of those steps and highlight some of the most critical for your attention. Before we get into that, let’s go over the initial considerations of buying small businesses.
Buying Small Businesses: The Pros and Cons
There are loads of good reasons to buy an existing business, but of course, there’s also plenty to consider that might dissuade you too. The simplest way to approach this is to weigh up the benefits and drawbacks and see how they apply to your specific goals.
Here are some of the major ways buying a small business might be a better option than starting one up:
- Easier access to capital - With an established business, you’ll have hard evidence of its success and its place in the market, making it a lot more convincing to a wider scope of financing options than you’d get from trying to start one.
- Assets - You’ll also have assets from the company that you can offer up as collateral, potentially reducing the cost or interest on a loan.
- An existing brand – These existing customers and this brand awareness contribute to significantly reduced marketing costs over a new startup. You’ll find it a lot easier to market to people familiar with your company than to lead them in from an unaware position.
- Immediate Cash Flow - This will not only be critical for repaying loans but will save a lot of the groundwork that would otherwise be needed to start generating income.
- Smoother Transition – Letting the owner and long-serving staff stay behind for a while will allow you to learn the ropes with expert guidance
Still, it’s necessary to consider the drawbacks too. The most common of these include:
- Higher investment costs – With a startup, you get to begin at the ground and work your way up. This means you can slowly increase your investment as the company grows. This isn’t the case when buying an established business.
- Upgrades – Depending on the company, you may need to put a lot of work and money into modifying processes and technologies, as well as getting rid of redundant staff and other resources.
- Reputation – While it’s true that you’ll get all the existing customers, you’ll also inherit all of the bad reviews and experiences of the company’s past. This can be a difficult thing to overcome.
If these challenges don’t seem too discouraging, you might be ready to start the buying process. But where to start?
Buying a Small Business: Where to Start
The first step to buying small businesses is knowing what you want. Whether you need to explore multiple options, or just sit and think about what you’re good at and what you can handle, this step is crucial to zero in on the type of business you want to take on.
Identify how much you want to be involved in the running of the company, what your strongest role would be, and where you want it to be in five years. Are you planning on sprucing things up and selling it on, or will you aim to make it your life’s work? Answering these questions will help you narrow your scope and find the industry and type of company you want to buy.
Next, you’ll need to start looking for available businesses that are worth purchasing. There’s a lot that can go into this, too, and you’ll have to look at the basics first to find a suitable one. As we’ll discuss soon, the finer details will be teased out in your due diligence later in the process, but for now, pay attention to:
- The industry – is it something you’re familiar with?
- Their cash flow – Are they profitable, or can they be made profitable with your skill set?
- Client diversity – How reliant are they on any one segment?
If you’re struggling to find where to look, consider brokers, attorneys, or franchisors; all of whom can be found online. If you can afford it, finding experienced help at this stage can save you a lot of time and money down the line.
Once you’ve got your eyes on a shortlist of businesses, you’ll need to get a valuation done. Again, this can be achieved by yourself, but if you’re not comfortable, it’s better to get advice or hire a professional. A valuation will give you a rough estimate of the price you’ll be expected to pay to acquire the company, and whether the asking price from the owner is realistic.
Depending on the type of business, the valuation will be calculated in different ways. Explore the best methods, and try to spare the expense for an objective valuation to be performed if you can. By the time this step is complete, and you’ve got a candidate in mind, it’s a good time to start looking for funding.
How to Buy a Small Business: Your Financing Options
There are several good ways to get money for buying a small business. The most common are grants, loans, or investments, but there are other options like crowdfunding, bootstrapping, or even asking your network for help.
We’ll look at the four most popular options to start with:
Get an SBA Loan
SBA loans are specifically designed for people looking to start or buy a small company. They are typically lent from banks, but the loans are somewhat insured against some of the. Risk by the SBA, so the rates and fees can be competitive, given the risk involved.
Still, you’ll have to jump through all the hoops to persuade the lender you’re reliable, and this makes it a time-consuming process. The major eligibility requirements from the SBA are:
- The business must operate for profit
- It must be engaged in, or propose to do business in, the U.S. or its territories
- There must be reasonable owner equity to invest
- You must use alternative financial resources, including personal assets, before seeking financial assistance
SBA-preferred lenders should be approached only if they have experience in your target industry, and they will likely have their own vetting process, too, but they can give you specific advice on what you need to do to apply.
Small business Grants
There is a variety of federal and state grants available for people looking to purchase a small business in the US. Eligibility requirements will vary depending on where you are and what you’re hoping to accomplish, and since you don’t need to return the finances, this can be a great place to begin looking.
Again, you’ll have to be very detailed in your application, so it’s worth making contact with the relevant sources to get advice on how to qualify. For Federal grants, check out Grants.gov; to find your state, search on USGrants.org.
Certain people spend their time (and money) investing in concepts they believe in. These are wealthy individuals who like to support a cause by facilitating the development of small businesses aiming to grow into something bigger.
Angel investors can contribute financial backing, and may even offer their expertise to help you along, and they’re a good place to start looking if you’re hoping to get investors onboard. As will all the funding sources listed here, your documents and business plan need to be well-curated and precise before you approach them, so that you give the right impression of someone who is about to do a good job.
If you want to get started looking for an Angel investor, there are numerous online sources, including the ACA, where you can search for people in your location to connect with. As with an investment opportunity, you’ll have to exchange some share of equity to make the deal, so consider that when making a decision.
VC generally comes from firms that also invest in persuasive projects in exchange for equity. The major differences between this source and an Angel investor are that these VC firms are usually looking for more rapid growth, can inject much higher amounts of capital, and will be looking to take your company public or sell it on down the line.
This isn’t a hard and fast rule, but keep this in mind when considering the pros and cons. As with Angels, you’ll be handing over some level of control to these entities, so you’ll need to be sure of your plans before going in.
With these options under your belt, it’s time to go over the general process of buying a company.
Search funds are a relatively unknown mechanism to finance a business acquisition. Search funds will allow you to pull together a group of investors to help fund your "search" process (finding the right business to buy). Then once you find the target business to acquire, the search fund investors along with debt from an SBA loan or other bank loan along with a seller's note can be used to ultimately finance the acquisition.
The Process of Buying a Small Business
If you’ve covered all the bases in the Where to Start section above, you’ll be ready to start on the next steps. If you’re certain you want to move forward with the acquisition, there are four key steps to doing so.
Step 1. Settle on the Price
From your valuation, you should have come up with an initial bid. You can use this as a non-binding offer for the company and assess the response from the seller. Ideally, this price will be similar to the asking price, but if it isn’t, it’s worth pointing out why that is.
They can either reject it, accept it, or come back with a negotiation. This process may go on for a while, with either of you negotiating based on what you have to offer and why it’s worth the price you’re offering. Remember, at this stage, nothing is binding, and it will all be predicated on the later due diligence steps that are there to confirm that the offer is what it seems.
At this stage, you’ll talk about the deal in terms of what you’ll be buying. Will you be making a stock purchase or buying the assets? This is a key part of the decision.
Asset sales allow the seller to hold onto ownership of the legal entity, while the buyer covers the cost of everything in it. These assets could be leases, licenses, inventory, equipment, etc., and this is beneficial in certain contexts for tax benefits, improving the cash flow of the company in the first years of purchase. This approach also dodges a lot of potential liability issues such as contract disputes or lawsuits.
This can get complicated when there are assets such as intellectual property or contracts. Obtaining consent for these can clog up the process and slow things down.
On the other hand, stock sales grant the buyer ownership of the shareholders’ stock and transfer ownership that way. Assets and liabilities that you don’t want can be offloaded before the transaction, as long as they’re obvious. Hidden issues may arise down the line with this kind of purchase, so it’s important to unearth them before taking this route.
Either way, with an often-lengthy negotiation process out of the way, both you and the seller will have settled on a fair price.
Step 2. Get your Letter of Intent
To submit an LOI, you’ll need to outline and compile everything you’ve gone through in the negotiation process and state your intention to buy. This is not a legally binding agreement of sale, but it is necessary for the next step in the process.
This letter is supposed to grant you exclusivity in the purchase of your target business so that nobody can step in and take it from you while you do your due diligence. Further, it’s a prerequisite for getting access to the company's inner workings to find out if they are doing things the way they told you they are.
Step 3. Due Diligence
This step is arguably the single most important part to do right. For it to work, you will be investigating all the key areas of the business and its product, from profitability to financial risks, pending legal complications, and forming realistic, evidence-based projections.
This process can take a long time and be very complex, so it’s a very good idea to get others involved where possible. At the very least, an accountant and attorney should be present, both of whom should have specific experience in this field. Bringing them in will give you the most powerful tools to spot any red flags.
The process will start by signing an NDA. This entitles the seller to confidentiality around what you’ll discover in their company. Then, you’ll go over the following elements of the business in fine detail:
Finances – you’ll need to check the financial health of the company as it stands. This will include the accounts, assets, and liabilities, as well as trends and projections.
Balance sheets, income statements, cash flow statements, inventory value, the accuracy of past projections, and countless other data points should be exposed and assessed. But financial diligence isn’t the only part of the process.
Legal - legal contracts need to be evaluated, and leases, purchase agreements, the Articles of Association, sales contracts, and everything related to trademarks and secrets will come under this check, among others.
Operational – The business model and the market/competitor analysis will fit under this type of diligence. Identify trends such as peak purchasing times, the most popular products, and price points, evaluate the success of previous marketing strategies, and compare everything to industry trends.
This stage will give you data that you can compare to benchmarks you found in your own industry assessments and will be a useful leverage if you find out you’ll need to make expensive adjustments to continue making good cash flow after the purchase.
Product – Here, you’ll get a detailed look at all the products or services being sold, including the cost of purchase, the price of sale, manufacturing costs, profitability, and how the products have changed over time.
Human Resources – Identifying the value and cost of the human element in the company is another important step in the due diligence process. How does payroll compare with what you’ve discovered in your industry assessments? What are the benefits packages and holiday plans? Get to know the organizational structure, and gather valuable information relating to how things are run.
A good due diligence process with illuminate all the areas for improvement and give you a better idea of what the fair selling price will be. It’ll also give you a chance to evaluate the honesty and reliability of the seller; if lots of figures don’t match what they’re reporting, it might be a good idea to reconsider the deal, in case they’re hiding something that will come back to haunt you down the line.
Step 4. Get the money
If you’ve done your research into financing, and your diligence checks are all complete, you’ll have a financing plan by now. Here is where you will approach the source of capital to get the money.
Be sure your documents are in order and go in with all the necessary information. Financial papers need to be airtight, so consider using our projection template built specifically for creating projections for an acquisition. These spreadsheets are specially designed to be customized with your data, providing professional-looking projections for five years and providing you with a persuasive projection to take to lenders or investors.
Step 5. Close the deal
Hopefully, everything you unearthed in the previous step was as expected, and you’re ready to move forward with the purchase. This begins with the draft of the purchase agreement. Bring in expert help for this stage, too, as it’s critical that everything is done compliantly.
After the draft is signed, you can agree on a closing date and release the funds from your lender or investor. Usually, this will involve an escrow service, in which a third party will hold onto the money until all the documentation is recorded and processed.
When everything is ready, you and the seller agree to the handover, and the transition will be complete.
You should now have a rough idea of how to buy a small business, but the process will depend on a lot of details specific to your case. Ultimately, the purchase process will depend on why you want to buy, the industry you’re looking at, and the location you’re in.
The rest is a matter of doing your research and finding the right capital sources to get you moving.