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The purchase or sale of a small business is a complex transaction which requires skill and knowledge in law, tax, accounting, and negotiation. Generally these are not all found in one individual. Often the owner will be knowledgeable about the operations of the business, but lack the experience needed to buy or sell an enterprise. In fact, for many owners, buying or selling a business is a once in a lifetime transaction. For the seller, it can determine the size of his or her estate, have a material impact on retirement wealth, and provide funds for investing in new ventures. For the buyer, the purchase can mean the difference between success and failure and between wealth and financial ruin.
With so much on the line, it is important for both buyer and seller to approach the transaction in an informed manner and to assemble a team of experts to provide the knowledge and tools needed to achieve a successful transaction. The purpose of this article is to give the buyer and seller and members of their teams a transactional, "hands on," framework for identifying and analyzing the concerns which should be examined in both buying and selling a closely held business.
By combining into one article the considerations of both buyer and seller, each party may consider the concerns which the other party will be thinking about. This should also assist the acquisition and divestiture teams in considering the specifics of the proposed transaction.
We approach the sales process sequentially, i.e. analyzing the issues in the order in which they typically arise. We present the considerations of the buyer and seller during each step of the transaction, allowing both parties to understand the considerations of the other.
The Advantages of Buying a Business
Versus Starting One's Own BusinessThe spirit of entrepreneurship abounds in the United States. Business periodicals are full of statistics outlining the number of new business starts each year, raising a flag of honor for those brave entrepreneurs who venture into the unknown by starting a new business. What is seldom reported on are the number of businesses each year that are purchased by another group of entrepreneurs who are certainly no less brave than those who start their own business.
Much has been written about how to decide to start a new business. This article is devoted to another breed of entrepreneurs those who make the decision to buy or sell an existing business in today's environment of increasing regulation, difficult financial markets, and skeptical lenders and investors. Making the decision to buy or sell one's business is more than just a business or financial decision. More often than not, this decision is a very personal one that has long-term effects on the quality of life for both the buyer and seller.
Establishing goodwill in a business takes time and experience, something that an existing business has that a new start-up business does not. Although the actual value of this goodwill is dependent, of course, on how it is used by the acquiring business, starting with some goodwill is significantly better than starting with none.
However, the extent to which a prospective buyer is willing to pay for goodwill depends on many things, including the buyer's perception as to whether the goodwill can in fact be transferred as part of the sale. The issue of transferability is particularly important in the context of a closely held entity, especially if the seller has close personal ties with key customers.
Management Team Already in Place
An important advantage of buying a business is that usually a management team is already in place. This team has experience which can pay handsome dividends for the new owners, who may require some time to learn the business. Although some management personnel may not be the same personnel that the new owner would hire if a new business was started, existing management has a proven track record upon which it can be measured.
Existing Collateral and Critical Mass Available for Funding
One problem with start-up companies is the lack of available collateral to secure funding. An existing business may supply such collateral and the related critical mass necessary to interest a potential lender or investor. This may be particularly true in situations where the business is undervalued because of recent operating losses arising from circumstances unrelated to the value of the collateral itself. Furthermore, because business acquisitions often require a larger investment of capital than a newly formed business does, it may be easier to interest traditional lenders and investors who, generally, are more attracted to large loans than to smaller loans.
Reduced Start-Up Time and Cost
Buying an existing business eliminates many start-up costs (e.g. office supplies, travel and entertainment expenses, organizational costs, accounting and legal fees) because the business is a going concern and already has the majority of these items. Furthermore, because most acquisitions involve the retention of all or substantially all existing employees and systems, the new owner does not have to spend the time and resources to find the items needed to make the business efficient.
The Disadvantages of Buying An Existing Business
Notwithstanding the advantages of buying versus starting a business, there are some serious potential disadvantages to be considered, including:
Difficulty in Finding the Right Business
This is the most important disadvantage of buying versus starting a business. The number of qualified businesses for sale is very small compared to the number of potential buyers. Timing, it seems, is everything; the longer the search continues, the more disenchanted the potential buyer becomes. In fact, many potential entrepreneurs begin by looking for an existing business, only to find themselves quickly frustrated to the point where they give up and start their own business. This disadvantage may be overcome, as discussed below, but it represents a serious difficulty for many potential purchasers.
Negative Goodwill
Where some existing businesses have developed positive goodwill, others may have developed negative goodwill. Negative goodwill relates to the negative value assigned to the image and reputation that an existing business has developed over the years because of its business practices, the actions of its owners or employees, or other factors which are adverse in nature. Accountants treat negative goodwill as the amount by which the fair value of the net assets exceeds the purchase price for the business. Accountants look skeptically at such negative goodwill transactions and attempt to find out why a seller will accept an amount less than the fair value of the net assets since it often spells trouble for the potential buyer.
Business Assets May Be Underutilized, Poorly Maintained, or Technologically Antiquated
When the assets of a business are acquired, there is the possibility that the motive for the sale was the inability or unwillingness of the current owners to invest in the type of equipment or new technology necessary to remain competitive in the market. Although business valuations and appraisals may substantially reduce the risks in this area, they do not eliminate the risks completely.
NOTE: As technology continues to increase rapidly, this disadvantage can result in a costly mistake for the new owners if they do not properly research the industry and prepare a business plan that analyzes these risks.
The Purchaser May Be Buying Someone Else's Problems
The seller's motives are important to the potential buyer in a business acquisition. One motivation that may represent a disadvantage is that the new owner may be simply buying the current owner's problems. Disgruntled employees, recent loss of key personnel, declining product life cycle, and pending regulatory or legal problems affecting the business are just a few examples of the kinds of issues that may be facing the company. Even the most carefully planned and executed scheme for buying the business will not discover all potential contingencies. Many factors will be invisible, even to an astute buyer, often until it is too late.
It is important to understand that when an existing business is purchased, the new business owner inherits all or part of the problems inherent in the existing business. A properly planned approach and sound legal advice may protect the buyer from the majority of these contingencies, but there will always be some invisible ghosts in the closet.
NOTE: The buyer and seller have competing interests regarding the assumption of risk in a purchase or sale transaction. In most cases, the seller wants to eliminate or minimize his or her liability or risk for post-sale events. For example, sellers often hesitate to assume the risks of financing the deal by allowing the buyers to fund part of the purchase price with cash from ongoing business operations. Instead, the typical seller prefers to shift all financing risks to a bank or other financial institution. Conversely, buyers typically wish to maximize sellers' liability or risk for post-transaction events and minimize the amount of the purchase financing that comes from their personal funds. In any event, the parties should devote special efforts to identifying contingencies and putting their agreements in writing.
The Purchaser Will Be Assuming Someone Else's Business Culture
One of the most important reasons why many people want to own and operate their own business is to establish their own style and culture. Buying a business means buying the existing culture of that business. Changing that culture may be relatively easy or extremely difficult
The Buyer's Perspective
Potential buyers, it seems, are continually present in large numbers. Qualified potential buyers are less plentiful but, nonetheless, significantly outnumber the businesses available for sale. The problems, then, for a qualified potential buyer are:
A) Selecting the "right" business,
B) Matching his or her strengths and resources to the target companies, and
C) Finding potential acquisition candidates.
(A) Selecting the "Right" Business
This can be the easiest or the most difficult part of the entire acquisition process depending on the motives, background, and experience of the potential buyer. Although there is a wide variety of individuals who look for businesses to purchase, there are really two basic types: (i) those who are not sure what kind of business they want, but cannot find it, and (ii) those who know what they want, and still cannot find it. The individual who knows, or thinks he knows, what he wants tends to be more successful than one who simply knows he wants change.
The "right" business is a business that, for the most part, fits the economic and quality of life goals that the buyer has set for himself as an owner. Because business acquisitions deal with money and finance, many believe that finding the right business is a financial decision, not a personal one. Experience, however, shows that most people buy businesses because of some personal desire to own, for increased personal stature or out of frustration with a previous employment situation. Most buyers are astute enough to recognize that the odds of the new business being an immediate answer to their financial problems are small. Rather, they seek to find the right business to satisfy most of their personal and financial goals.
Some potential owners believe that they know exactly which business they want in order to satisfy their goals. Usually this type of buyer has worked or is currently working within the industry or in the target company. Finding the right business for this type of buyer is easy and the purchase transaction itself tends to be less complicated as well. Management Buy Outs (MBOs), where current management buys the company, are common because they tend to be less complex and more satisfying for the buyer and the seller. Likewise, buyouts by individuals who have worked in the same industry and who have some knowledge of the operations of a particular business therein tend to be better fits and, generally, are more successful.
The more common type of buyer is one who simply knows that he wants to buy a business and has set only general guidelines for determining the type and size of business to buy. Looking for the right business for this type of buyer is often a difficult and slow process. Furthermore, many of these buyers put more emphasis on simply owning a company rather than on owning the right business, that is, one that meets their long-term objectives.
Selecting the right business is hard work, requiring the potential buyer to go through a number of steps necessary to ensure that the business purchased meets the buyer's basic goals and objectives.
Key steps for the buyer to follow in selecting the right business include:
- Establish reasonable, measurable, and attainable goals that reflect personal, business, and financial needs.
- Identify and evaluate personal strengths and resources.
- Research economic trends in the market.
- Identify sources for potential acquisition candidates.
(B) Matching Buyer's Strengths and Resources to Those of Target Company
Identifying one's own strengths and weaknesses is a difficult process. Such an evaluation requires honesty, openness, and a healthy dose of self-confidence. As difficult as it may be, this step is important to a successful search for a viable acquisition candidate.
Some find the self-evaluation process is extremely difficult and generally ineffective for a variety of reasons. One may often find it helpful to seek the advice of a person he trusts to be honest and who has at least a general knowledge of business and the qualities and characteristics necessary to be a successful owner. These advisors can offer invaluable insight into the buyer and his ability to own and manage.
The following list is a compilation of key characteristics a potential business owner may want to consider before making the decision about which business to purchase. Although not all-inclusive, the list highlights strengths and weaknesses that should considered when matching the buyer's strengths and weaknesses with the requirements of the business or businesses considered for acquisition. It may be helpful for the potential buyer to rate himself on a scale of 1 to 5 where 1 is a strength and 5 is a weakness. After going through this exercise, the buyer should review the ratings and evaluate the seriousness of his weaknesses and the importance of his strengths in the context of the requirements of the business he may wish to acquire.
Passion and the Desire to Succeed
This characteristic is the one that many consider to be the most important. Without a passion for ownership and all of the positive and negative factors that go along with it, the business has a good chance of failure. Being an owner means having no supervisor except yourself and no one to be accountable to except yourself. As the old adage goes, it can be ²lonely at the top,² and the primary cure for that kind of loneliness is a passion for ownership and the desire to succeed.
Patience and Persistence
The processes of buying and owning a business require a great deal of patience and persistence. Those individuals who have the ability to stick with things and not give up in the face of difficulties have a much greater chance of success in the long run.Work Ethic
There are few, if any, businesses that allow for the owner to have an average or less than average work ethic. Hard work is part of the package. This is especially true when buying a business because so much effort must be put into changing the culture and operating style of the business to suit the owner's needs and the requirements of the business.Self-Confidence
Being an owner requires a high degree of self-confidence. An honest belief that one can fulfill all of the basic requirements of ownership is mandatory in order to succeed. Self-confidence is built on self-image and the strength of one's convictions about one's own ability to make things happen.Personal Stability
A potential owner who is going through difficult times in his personal life often has difficulty dealing with the added pressure of acquiring and managing a new venture. This is generally a threshold factor that should be of concern only if there are serious problems in one's personal life that could potentially impair one's ability to function rationally.Decisiveness
One of the most striking characteristics of most successful owners is their ability to make good decisions quickly and consistently. Those who have difficulty making decisions may find that ownership is not in the best interest of the potential owner or of the business.Leadership Skills
Extensive literature has been written on the subject of leadership in business. Leadership is difficult to define but everyone knows it when he sees it. Leadership requires, among other things, vision, compassion, understanding and action. A lack of effective leadership is a deficiency in a business that seldom, if ever, can be overcome.Management Skills
Management skills differ from leadership skills and usually are less important to the ultimate success of the business. The basic difference between leadership and management skills is that an owner can often supplement a lack of management skills with other resources whereas leadership skills are unique to the owner. Nonetheless, a potential owner who considers himself deficient in management skills should consider this carefully when selecting the kind of business that fits his needs.Technical Knowledge/Professional Skills
A lack of technical knowledge or professional skills may not be important in some businesses but may be a very important factor in others. Rating knowledge and skills in this area is vital in selecting an appropriate business.Business Savvy
This may be one of the most difficult of all categories to define and evaluate. Business savvy encompasses a variety of subtle skills that relate to an individual's ability to operate a business successfully.Understanding of Basic Financial Information
Although this is another area, like management, that an owner can supplement with other resources, a basic understanding of financial information is a necessity in today's environment. This is especially true when buying a business because so much of the acquisition process deals with financial information.Organizational Skills
Organizational skills, unlike some of the other skills discusaed `bgde, c`n be obtained through training and effort and are less dependent on the personal characteristics of the owner. However they are obtained, good organizational skills are important throughout the acquisition process and in operating the business.Identify Critical Operating Characteristics of Target Company
After identifying the relative strengths and weaknesses, the next step for the buyer is to attempt to match those characteristics with those of the company targeted for acquisition. Much of the matching process is done intuitively, but there are some important steps to go through to ensure that the match is appropriate.
Each target company has unique operating characteristics that are critical to its success. In some businesses it may be sales and marketing, in others it may be technical expertise, and in others it may simply be effective management. In order to make certain that the strengths and resources of the buyer match the key operating characteristics of the target company, it is necessary to identify and prioritize those key operating characteristics.
The potential buyer should consider these qualities only after the business has been investigated and after a self-evaluation of relative skill level has been performed. For each major element, the potential buyer should rate the importance to the success of the business first and then rate his own relative strengths in each particular element. In situations where the ratings of needs and skills are relatively close, there is a good match. Where the business needs are not rated as ³important² but the potential owner's skill level is considered to be high, there may only be a minor problem since, by definition, the business needs in this area are not relatively important. However, where the business needs are rated as important or very important and the potential owner's skill level is considered to be low, there is a serious problem that must be evaluated and remedied before continuing with the acquisition.
A brief explanation of the nature and potential importance of each key element for consideration follows.
Sales and Marketing
Most businesses rely heavily on their ability to sell products or services consistently and at a profit. In only rare instances ( e.g., public utilities) is this area considered to be relatively unimportant to success. However, not all potential owners consider selling and marketing to be one of their strengths and, therefore, the potential buyer should carefully consider the nature and availability of other resources necessary to overcome any such deficiencies.Technical Expertise\Professional Qualifications
Some businesses depend heavily on technical expertise or professional qualifications. For example, a person who does not hold an insurance license would probably not consider buying an insurance agency. Likewise, a person with no engineering background would want to use caution when considering buying a business that relied heavily on advances in engineering technology.Businesses that require a special technical expertise or professional qualification can be excellent targets for those who do possess those skills or who can safely secure those skills though personal training or from hiring others with the appropriate qualifications. Next to sales and marketing, technical expertise or professional qualifications tend to be the most prevalent driving force in the success of many businesses.
Sound Business Management
Although most believe that sound business management is an important need in every business, some businesses rely on this skill more than others. Generally, labor intensive businesses tend to be more reliant on sound management skills than do businesses which are more capital intensive. Furthermore, as a general rule, the more reliant the business is on the work habits and effectiveness of lower paid employees, the more management skill is necessary.Creativity and Innovation
In addition to certain technical expertise, some businesses also rely heavily on the creativity and innovation of its owner. This is particularly true in businesses which are dynamic and reliant on rapidly changing consumer needs. For example, most businesses in retail and related industries such as advertising must be guided by an individual who is not only creative, but who can also put the creations into practice.Knowledge of Product or Service
This area may appear to be indigenous to all businesses, but some businesses are more dependent on having intimate knowledge of the product or service offered than others. For example, a highly niched manufacturing business may survive principally on its technical skill and product knowledge. Sales and marketing skills, in this scenario, may play a relatively minor role.The need for product knowledge is a business need that can often be satisfied by personal training and experience or by hiring from the outside. In many business acquisitions, the knowledge is already in place.
Relevant Industry Experience
This area differs from product or service knowledge in that it focuses on the entire industry rather than on the products or services one business may offer to the industry as a whole. Relevant experience in, and an understanding of, the needs of the industry in which the business operates can be very important. The construction industry is one example where relevant industry experience is critical to the success of the business. Having strengths in this area, like one or two others, is one of the reasons why so many insider acquisitions are so successful.Financial Expertise
In almost every business, having some degree of expertise in financial matters is a must. Although in more cases than not this expertise is supplied by employees or outside experts, all owners should have some degree of expertise and, in some industries, should be very experienced in financial matters. Industries that usually require a higher level of expertise in financial matters include, for example, insurance, banking, trading companies, and other organizations that use money as an integral part of the product or service offered.Location
Location can be very important to some businesses, e.g. proximity to customers or suppliers. Location may be critical to the success of the business but may not be acceptable to a potential owner because it is too far away, difficult to get to, or for some other reason. In some acquisitions, the location needs and preferences of the owners have an important bearing on the outcome.The Impact of Buyer Weaknesses
After identifying the weaknesses of the buyer relative to the needs of the target business, the buyer should consider the impact of these weaknesses on the proposed transaction. If, for example, the weaknesses appear to be of such magnitude that a proper match does not exist, the buyer will probably want to identify another target that has a better chance for success. If, on the other hand, the weaknesses do not seem to be significant in terms of the needs of the business, the buyer may be ready to move forward with the acquisition process.
This step is a difficult one for many potential buyers who find themselves infatuated or enamored with a particular business. The key to ensuring that this step is properly performed is to be honest and to check with an outside party to get an impartial opinion. Many acquisition failures can be traced to a lack of performance of this step in the process.
Identify Supplemental Resources Required by the Buyer
The chances that all important business needs will be satisfied by the strengths of the buyer are very small. Typically, one or more of the critical business needs identified by the buyer cannot be effectively met by the buyer alone and, therefore, the potential buyer will need to acquire supplemental resources.
In an acquisition, the primary source for this additional help will usually come from the business itself. Most existing businesses have identified some or all of the same requirements as the buyer and have developed ways internally to deal with these needs. The manner in which the existing business is dealing with these needs may not, however, be to the satisfaction of the potential buyer. In those situations, the buyer is faced with identifying outside resources for filling these needs. Those resources may include individuals from competing companies, customers, vendors or from friends or acquaintances.
An important factor in this step is to identify resources that will fill the critical needs. Potential lenders and investors will be interested not only in the experience and expertise of the owner but also in the owner's selection of key personnel and other resources necessary to meet the demands of the business.
Closing The Deal: Finding a Business to Purchase or Finding a Buyer
When you have decided to pursue either a small business to operate or a purchaser for your own business, one of the best places to go is a local CPA firm. A CPA firm with multiple professionals has its hand on the pulse of the community. They often know well ahead of a public announcement which businesses are available.
As discussed earlier, the number of acquisition candidates available at any one time is usually significantly less than the number of potential buyers. However, experience has shown that many more acquisition candidates are available than may be apparent because many do not want to advertise the fact that they may want to sell, fearing customer backlash. Still others may be strong acquisition candidates but the current owners aren't even aware that their businesses are marketable. Thus, finding the right potential candidates depends on the extent to which the potential buyer can be efficient in locating viable candidates.
A sizable CPA firm is in the unique position of having a complete overview of the financial health and well-being of the community, and of knowing about individual businesses within the community. The firm can guide you through the process of selecting a seller or buyer, and often knows about particular strengths and weaknesses of various types of business. Furthermore, once a decision has been made, the CPA can assist you in selecting a bank, obtaining financing, and choosing an attorney, for CPAs are familiar with the local professional community and can steer you towards the most amenable resources.