When it comes to acquiring a business, many pitfalls present themselves along the way. Without the right guidance and expertise, it can be challenging to know how to buy a small business and not open yourself up to risk. This guide explores how you can buy a company in the knowledge that it is a viable and valuable investment.
Benefits of Buying an Existing Business
Some people prefer buying an existing business over starting from scratch because it offers more of a head start.
With established operations, customers, and workers, buying an existing business is often the fastest way to achieve your business goals over building your own from the bottom up.
Benefits of buying an existing business include:
- An established customer base, reputation, and brand identity
- Immediate income and cash flow
- A full workforce, including management teams and employees
- Established relationships with suppliers, vendors, and stakeholders
- Proven track record of success with a product or service
- Established business plan
The Importance of Evaluating a Business Before Buying
Before investing in an existing business, you need to understand the full picture and be informed about every aspect of the company.
If the person selling the business has left any information undisclosed or their asking price is higher than expected, you must establish the real value of the company by conducting an objective assessment of its worth.
Thorough assessments help you understand more about a business’s:
- Financial health
- Operational efficiency
- Assets
- Potential for growth
- Workforce dynamics
- Market position
Once you have this information, you can determine whether the asking price is fair, avoid overpaying, ensure the business aligns with your goals, and negotiate with confidence. Knowing all the key information from the get-go can also help you avoid future unexpected issues.
How to Evaluate a Business for Sale
Valuators use multiple approaches to value a small business. Depending on the type of business you are considering, it may be beneficial to combine the different methods to have a more comprehensive idea of its worth.
The three primary approaches are income-based, market-based, and assets-based.
Income-Based Approach
The income-based valuation method is a common, standardized approach. It focuses primarily on cash flow and risk detection to determine the overall income value of the business.
An income-based valuation can involve the following approaches:
- Using the business’s financial statements
- Assessing risk based on operations and market and industry conditions
- Using the seller’s discretionary earnings (SDE), such as the owner’s salary, additional benefits, and expenses. This method helps you understand the cash flow that would be available to a new owner, and is primarily done if the current owner actively operates the business.
- Calculating the earnings before interest, taxes, depreciation, and amortization (EBITDA), which is a standardized metric often used to determine the value of larger businesses and their operational profitability.
Market-Based Approach
Using the market-based approach is an effective way of comparing the asking price and value of the business you are looking at to the current state of the market.
When you adopt this approach, you generally investigate the recent sale prices of other businesses of similar size, in the same industry and region. You can then use this data as benchmarks for assessing the sale price of the company you are looking to buy.
Although it can offer useful insights, the market-based method is often a one-size-fits-all approach that must be tailored to integrate unique factors, such as the businesses’ assets, risk profiles, and growth potential.
Assets-Based
The assets-based approach focuses primarily on the fair market value of a business’s assets, once liabilities are deducted.
This approach is particularly useful if the company you are looking to buy is struggling with liquidity or if most of its value is in tangible or intangible assets.
How to Evaluate a Business
You must follow several steps when buying a business to ensure it is a viable investment, both personally and financially.
Assess the business’s financial health:
- Review financial statements: Investigate at least three years’ worth of income or profit and loss statements, cash flow statements, balance sheets, and statements of retained earnings.
- Analyze key financial ratios: Understand the business’s current financial efficacy by examining its return on assets (ROA), return on investment (ROI), and debt-to-equity ratios.
- Investigate debts: It is essential to have a key understanding of the business’s outstanding debts, liabilities, loans, unfinished contractual obligations, and any other loose ends.
Evaluate the business’s operational strength:
- Assess operational efficiency: Compares the current input of energy, finances, and resources with the current output. This process includes assessing the efficacy of systems, technology, and the seamlessness of communications. Key metrics to investigate include inventory turnover and fulfillment accuracy.
- Investigate scalability: When you invest in a new company, you want to know that you have the option to grow its offerings and profits without compromising the quality of products or services.
Review legal compliance and regulations:
- Ensure compliance: Before investing, make sure the company adheres to all necessary laws and has obtained all appropriate licenses and permits for city, state, and federal regulations.
- Investigate litigation: Research the company to ensure there are no outstanding lawsuits or unresolved legal issues.
- Review all contracts: Have a legal professional review the business’s contracts with suppliers, shareholders, and customers to determine whether they are transferable and legally compliant.
Assess market position:
- Assess market conditions: This step includes investigating the current demand for the business’s products or services and researching relevant economic trends.
- Identify competitors: You need to understand what you will be up against, should you buy the business. This step includes exploring competitor offerings, business models, services, market share, and marketing strategies.
Investigate the business’s workforce:
- Assess staff experience: Consider the experience, qualifications, training, and skills of the existing workforce to determine how well they suit your vision of the company.
- Determine owner dependence: Depending on the approach you would like to take as the new owner, you need to know how dependent the staff and employees are on the current owner. If you visualize having a hands-off approach, you will need an independent management team.
What to Look for When Purchasing a Business
When you are considering buying a business, keep an eye out for these positive signs:
- Consistent financial performance
- Loyal employees
- Diversified revenue streams
- Positive brand reputation
- Strong management team
- Clear standard operating procedures (SOPs)
- Strong relationships with vendors and suppliers
- Clear growth strategies
What to Avoid When Purchasing a Business
Just as there are positive things to look for, there are also certain things you should be wary of when buying a business:
- Inconsistent or declining financial performance
- High employee turnover
- Unstable market conditions
- Negative reputation
- Owner dependence
- Outdated infrastructure
- Unpaid debts
- Legal or regulatory issues
Make Informed Business Decisions With Crow Estate Planning & Probate
Buying a business is one of the most exciting things you can do as an entrepreneur, and with Crow Estate Planning & Probate, you can take that step with confidence.
With our business formation and planning services, you can have direct access to our business planning attorneys, who will be by your side and assist you in your ventures from formation to dissolution.
If you need help buying a business or more advice on how to value a small business, fill out a contact form or call us at 931 213 5543 to schedule your free consultation.
