Purchasing an existing business can offer several advantages over starting a new company. The operation may already have customers, employees, equipment, cash flow and a recognizable name in the marketplace. However, those benefits can come with hidden risks.
A buyer should never rely solely on the seller’s asking price or representations. Every important part of the company should be independently examined before the transaction is completed.
Here are five essential steps to take when considering the purchase of a business.
1. Examine the Financial Performance
Begin by determining how the company actually makes money. Request at least three years of tax returns, profit-and-loss statements and balance sheets, along with current financial information.
The review should extend beyond annual revenue. A company can generate strong sales while producing little dependable profit.
Pay close attention to:
- Gross and net profit margins
- Changes in revenue from year to year
- Owner salaries and discretionary expenses
- Accounts receivable and collection history
- Outstanding debt
- Inventory levels
- Payroll obligations
- Recurring capital expenditures
- Customer concentration
The seller may present an adjusted earnings figure that adds certain expenses back to the company’s reported profit. Some adjustments may be reasonable, while others may overstate what a new owner can expect to earn.
A CPA with business acquisition experience can help normalize the earnings and identify inconsistencies between the company’s internal records, bank statements and tax returns.
2. Determine What the Machinery and Equipment Are Worth
When purchasing a construction company, manufacturer, medical practice, restaurant or other equipment-intensive operation, the physical assets may represent a substantial portion of the transaction.
Do not assume that the equipment values appearing on the seller’s balance sheet reflect the current market. Book value is an accounting figure and is not necessarily an indication of what an asset could sell for.
An independent machinery and equipment appraisal can establish credible values for the assets included in the sale. Depending on the purpose of the transaction, the appraisal may include Fair Market Value, Orderly Liquidation Value or another appropriate value premise.
The appraiser should consider factors such as:
- Manufacturer and model
- Age and operating hours
- Maintenance and repair history
- Overall condition
- Current market demand
- Technological or functional obsolescence
- Installation and removal requirements
- Availability of replacement parts and manufacturer support
An appraisal may reveal that the equipment provides meaningful collateral for financing. It may also show that the assets are older, less marketable or more expensive to replace than the buyer initially believed.
The results can help the buyer evaluate the purchase price, negotiate the transaction and prepare for future capital expenditures.
3. Discuss Financing With a Lender
Buyers should involve a lender before finalizing the deal structure. Even when a buyer plans to contribute substantial cash, financing may preserve working capital and provide flexibility during the ownership transition.
Provide the lender with information about the business, including its financial statements, tax returns, equipment list, real estate, proposed purchase price and the buyer’s background.
Ask the lender about:
- Down-payment requirements
- Interest rates and repayment terms
- SBA loan eligibility
- Collateral requirements
- Personal guarantees
- Debt-service coverage expectations
- Required business and equipment appraisals
- Minimum working-capital requirements
A lender may view the company differently than the buyer or seller. Weak cash flow, limited collateral or heavy dependence on a few customers may affect the amount the lender is willing to finance.
Beginning this conversation early allows enough time to modify the purchase structure, negotiate seller financing or raise additional equity if necessary.
4. Confirm What Is Included in the Transaction
A buyer needs a precise understanding of what is—and is not—being purchased.
The transaction may include machinery, vehicles, inventory, accounts receivable, intellectual property, customer lists, real estate, lease rights, contracts, telephone numbers, websites and trade names. These items should be clearly identified in the purchase agreement.
The buyer should also verify ownership of the assets. Search for liens and other security interests that could prevent the seller from transferring clear title. Leased equipment should be separated from seller-owned property, and serial numbers should be confirmed whenever practical.
Legal counsel should review the company’s:
- Customer and supplier agreements
- Property and equipment leases
- Licenses and permits
- Employment agreements
- Pending claims or litigation
- Tax obligations
- Intellectual property
- Environmental responsibilities
- UCC filings and recorded liens
The attorney can also help the buyer decide whether an asset purchase or stock purchase is the more appropriate transaction structure. That decision may significantly affect taxes, liabilities and the obligations assumed by the buyer.
5. Evaluate the Business Without the Current Owner
One of the most important questions is whether the company can continue operating successfully after the seller leaves.
Some businesses are highly dependent on their owners. The seller may personally manage the largest customer relationships, prepare every estimate, supervise employees, approve purchases and resolve operational problems. If that knowledge has never been transferred or documented, the business may be less valuable than it appears.
Before closing, determine:
- Which responsibilities are handled exclusively by the owner
- Whether key customers are loyal to the company or the seller
- Which employees are essential to continued operations
- Whether those employees intend to remain
- How long the seller will assist with the transition
- Whether operating procedures are documented
- Whether the company has effective management below the ownership level
A formal transition agreement may require the seller to provide training, introduce the buyer to important customers and vendors, and remain available for consultation after closing.
The buyer should also consider appropriate confidentiality, nonsolicitation and noncompete provisions with the assistance of legal counsel.
Due Diligence Protects the Buyer
A business acquisition can look very different once its finances, assets, contracts and daily operations are examined closely. That does not mean every issue should end the transaction. It means the buyer should understand the risks and account for them in the price and deal structure.
Before purchasing a company, analyze its financial performance, order a machinery and equipment appraisal, discuss financing with a lender, verify exactly what the transaction includes and determine whether the operation can succeed without its current owner.
The objective is not simply to complete the purchase. It is to acquire a company with a supportable price, dependable earnings and a realistic path forward under new ownership.
