Should You Buy an Existing Business?

Summary: New entrepreneurs are often torn between buying an existing business versus launching a new company from scratch. Buying an existing business typically has a lower risk than starting a new company. However, this outcome depends on buying the right company and operating it successfully.

The article discusses the advantages and disadvantages of buying a business. It also provides proven strategies to decrease your risk. It covers the following:

  1. Advantages of busing a business
  2. Disadvantages of buying a company
  3. Strategies to reduce risk

1. Advantages of buying an established business

Buying an existing business is typically safer than starting a new one. Furthermore, operating an established business is easier than running a new venture.

However, there are a number of other reasons why buying a company can be more attractive than starting one.

a) The business has a valuation

Starting a new business from scratch is always a gamble. You never know how much it will cost you until you do it. Furthermore, new projects are notorious for going over budget.

On the other hand, buying an established business is different. The company has a valuation you can check against industry standards or comparables. You also have the option to get an appraisal that provides a professional opinion on the value of the business.

b) The company has a track record

Established companies have track records that you can review. You can determine how that company performed in the past under different conditions. Forecasting the company's future performance is also easier and more accurate. Having this information lowers your risk dramatically.

c) You can take a salary

Entrepreneurs who launch a new business must live off their savings for some time. This scenario creates uncertainty and puts substantial pressure on the founder. They must wait until the business generates enough income to pay themselves a salary.

On the other hand, most acquisitions allow you to take some form of compensation immediately. Owners are usually employees of the business and get a regular salary. Additionally, you may also receive profits/distributions from the company.

d) Getting financing for an acquisition is easier

Getting financing to buy a business is much easier than getting a new venture funded. Acquisitions under five million dollars are usually financed with help from the Small Business Administration (SBA).

Getting an SBA-backed acquisition loan is easier than getting conventional financing. SBA-backed loans have flexible qualifications requirements and provide competitive rates/terms.

e) You can use leverage to your advantage

Buyers usually don't have enough resources to buy the whole business. Instead, they finance most of the purchase. Transactions that use a large portion of financing are considered leveraged buyouts. Most small business leveraged buyouts are financed using SBA-backed financing.

In some cases, buyers can finance up to 90% of the project cost. The remaining 10% must come directly from the buyers as an equity injection.

Leverage has advantages and disadvantages and should be considered a double-edged sword. It amplifies your outcome - good or bad. Using leverage can increase your returns if things go well. However, leverage can also wipe out your equity quickly if things don't go as planned.

Resource: How much money do you need to buy a business?

f) The business has customers

The company already has an established market, customers, and reputation. Having customers in place is important because building a customer base is difficult and time consuming. Buying a company allows you to leverage the previous owner's efforts and experience.

g) The business has supplier relationships

Having established suppliers can be just as crucial as having customers. The previous owner has already gone through the effort of qualifying suppliers and negotiating contract rates. Many new business owners underestimate the time it takes to find reliable suppliers.

h) The business has an infrastructure

Another advantage of an acquisition is that the business should have the entire infrastructure to operate. Infrastructure includes items like real estate, machinery, and equipment. Buyers can also use the current infrastructure to forecast maintenance and expansion costs accurately.

Keep in mind that buyers often take the acquisition as an opportunity to make infrastructure improvements. The specifics of the business determine the size of these improvements. However, the financing is usually bundled with the acquisition loan.

i) The business has systems and processes in place

A big part of an acquisition is the "know-how" built into the business. A well-run business should have systems and processes in place. These are invaluable, especially to business buyers who don't have sufficient industry experience.

The company should have systems and processes to handle activities such as:

  • Accounting
  • Payroll
  • Supplier management
  • Customer acquisition and management
  • Operations, and so on

j) The business has employees

Most small business acquisitions include the option to keep the company's existing employees. Along with the customers and the company's systems, the employees are one of the most valuable assets of a company.

On the other hand, launching a new venture requires finding talented employees. This process is difficult and time-consuming. Unfortunately, many new entrepreneurs underestimate how hard this task is.

k) You can retain existing management

An acquisition allows you to retain existing management. These individuals are key employees because they help you run the business. Current managers can also provide stability and knowledge during the company's transition to the new owners.

l) Sellers can train you

Lastly, most purchases include a period of training by the seller. Training can take a few weeks or a few months. Buyers can use this training to learn important information from the seller's experience. This training provides you with valuable know-how.

Entrepreneurs who start a company from scratch don't get this important benefit. Consequently, they learn from experience and by making their own mistakes.

2. Acquisitions also have some disadvantages

Keep in mind that acquisitions are far from perfect and are not risk-free. The wrong acquisition can have serious problems and end up losing money or failing. Keep in mind the following disadvantages of buying a business:

a) You could buy a bad business

One significant risk of buying a company is that you could end up buying a bad company. The last thing you want to buy is a troubled company that someone wants to unload.

You can do careful due diligence and still miss indicators of problems. Ultimately, an acquisition is a calculated risk.

b) The business could be overvalued

Another disadvantage is that you could buy an overvalued business. There are ways to minimize this risk, but buyers can never eliminate it.

Invest in the services of a reputable business appraiser. If you are uncertain of the company's value, consider getting a second appraisal. Having two valuations gives you a better idea of the company's actual value.

c) Due diligence is never perfect

If done well, the due diligence process should uncover any significant problems. However, the process is far from perfect, and buyers can miss problems.

This situation exposes buyers to the risk of buying a company that looks good on paper but fails to perform in real life.

d) Accounting can be notoriously spotty

Small companies are notorious for having unreliable accounting reports. This is a serious problem for buyers because they need these reports to determine past performance. Buyers also use these reports to forecast future results.

Unscrupulous sellers can manipulate the numbers to make the business appear more attractive. These manipulations can be as blatant as using false information. However, they can be as subtle as using deceptive accounting.

At a minimum, buyers should retain a CPA or similar advisor to help them evaluate the company.

e) The current owner's motives for selling aren't always clear

The current owner's reason for selling the company will never be clear to you. The seller and the broker will use common explanations and tell you that the seller is "pursuing new opportunities," "retiring," or "reducing their workload." These explanations should be viewed with caution. The seller could be hiding their true intent.

You have no way of knowing if the seller is selling for other reasons. For example, the seller may believe that demand for services will drop and want to cash out while the market is still hot. Do as much research as you can about this possibility. The seller's real motivation is extremely important.

f) Existing customers may not be loyal to you

It's common for small business owners to form friendship bonds with their customers. These relationships are good for businesses but can make acquisitions harder.

Customers may not want to stay on and work with the new owner. They may also start demanding concessions (e.g., price discounts) as a condition of staying with your company. Lastly, buyers may face a situation in which clients compare them against the previous owner.

g) Staff may not be loyal to you

Many small business owners develop a strong bond with their employees. Loyalty from the owner to their employees (and vice-versa) is a hallmark of many small companies.

Unless they are under contract, employees are not obligated to continue with the new business. There is always the risk that they will take the acquisition as an opportunity to look for a new job elsewhere.

h) The business could have a bad reputation

Gauging a company's reputation during due diligence can be notoriously difficult. Buyers cannot call all the customers before the acquisition to ask for their opinion. Consequently, you could buy a business that looks good on paper but has a bad reputation.

3. Strategies to reduce risk

There is no way to eliminate all the risks of an acquisition. However, the following four strategies can greatly reduce the risk in your transaction.

a) Get professional advice

Many first-time business buyers make the mistake of trying to save money by doing everything themselves. This is a recipe for certain failure.

Buying a company is the most complex and expensive transaction that you will be involved in. You should have a team of seasoned experts advising you along the way.

Assemble a team before submitting a Letter of Intent (LOI) to the buyer. This will give you the most chance of success and help you avoid problems.

At a minimum, your team should have an attorney, a CPA, and a quality of earnings professional. Work only with firms with experience in small business acquisitions.

b) Start your due diligence early

Acquisitions typically have a period that allows the buyer to perform their due diligence. This is the buyer's chance to find out as much as possible about the target business before moving forward.

It is in the buyer's best interest to start the due diligence process as early as possible. Go into as much detail as necessary to ensure the acquisition is a good investment.

c) Get a Quality of Earnings report

We strongly recommend that buyers engage the services of a competent Quality of Earnings (QOE) professional. These professionals are due diligence experts with experience examining the quality of companies.

They can develop realistic financial forecasts, validate assumptions, examine company details, and identify key risks. More importantly, they help you avoid buying a bad business.

d) Walk away from bad transactions

Consider walking away from a transaction or modifying its terms if your due diligence team finds serious issues. There are times when the best investment is the one you avoid.

Always consult your legal team before taking this course of action. The LOI and other legal documents you sign determine your ability to terminate or alter the transaction. Consequently, you should always have a seasoned attorney review all documents before signing them.

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Editor's note:

This information should not be considered legal or financial advice. Given the complexity of business acquisitions, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide you with the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.


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