An entrepreneur considering starting his or her own business from the ground up is presented with a number of significant obstacles. Barriers to entry can include insurmountable start-up expenses, marketing an unproven brand of product or service, retaining experienced and trusted employees, building a loyal customer base and establishing consistent cash flows. Each of these challenges must be overcome contemporaneously with the payment of the entrepreneur’s professional and personal bills out of savings prior to depletion. Another route an entrepreneur might consider is the purchase of an existing business venture which has already established itself and possesses a track record for generating sustainable profits.
While there are benefits to acquiring an ongoing concern, you, must complete a due diligence investigation to ensure a proper understanding of what exactly is being purchased. It is quite possible that the acquisition of an up-and-running venture presents less risk than starting a new endeavor from scratch. However, the diligence process provides an opportunity for an educated determination of whether the particular enterprise is a good fit for your professional and personal needs. If you are not conscientious you may end up with strong competition, useless inventory, a dissatisfied customer base, disgruntled employees and outdated methods of operation.
Before You Get Started
If you don’t already know exactly what type of business you want to purchase, know that there are a wide variety out there. Consider the following factors to focus on the type of enterprise that is best suited for you.
If you can’t initially identify the particular business you want to operate, eliminate those areas of industry in which you have little or no interest.
Discard those enterprises which don’t realistically match up with your talents and experiences.
Consider those conditions that may exist regarding a business which are unappealing to you such as various barriers to entry, time commitment, location, availability and quality customer base and regulatory controls.
Assess the size of the venture you are considering in terms of sales, employees, square footage and number of locations.
Identify the locality where you wish to operate.
Evaluate the costs of doing business in your selected geographic location such as purchase price, rent, taxes and wages.
Locating a profitable enterprise available at a reasonable price can be a Herculean endeavor. You need to ask yourself, “Why is this operation on the market if it is bringing in the bucks for the current owner?” There may be a good reason, but you need to be smart and ask the right questions.
Hiring a Business Broker
Many metropolitan areas have brokers promoting businesses for sale. Brokers are regularly retained by owners wishing to sell their companies to find potential buyers and assist in negotiating sales transactions. Depending on industry and geographic location, a business broker typically charges a commission equal to five to ten percent (5-10%) of the purchase price. Brokers can be an invaluable tool, especially in the case of a first time buyer. These professionals prescreen businesses for you eliminating ventures that refuse to provide satisfactory disclosures or that are substantially overpriced. If you decide to engage a broker, forge a good working relationship with him or her, so he or she can gain insight into your skills, experience and interests. In this way, the broker will be well equipped to search for a business that is well suited for you. Once an appropriate business is selected, your broker plays a significant role in negotiating the deal and guiding the parties to a smooth problem-free closing. Finally, good brokers are very knowledgeable about business transfers and are apprised of the laws and regulations regarding licensing, permitting, financing and escrow. Employing a broker goes a long way toward reducing the likelihood that you will skip some crucial step, fail to complete an important filing or pay a necessary fee.
Advantages versus Disadvantages of Buying an Existing Venture
There are potentially numerous advantages to buying an ongoing concern such as reduced start-up costs and decreased lag time between making an investment decision and commencing income producing activities. You may also be in a position to acquire an already recognizable and well received brand, established customer base and employees who are more familiar with day-to-day operations than you will initially be.
A number of disadvantages to purchasing an existing enterprise may also exist. The acquisition cost may be greater than starting a venture from scratch because of the popularity of the brand, quality of the customer base and other “sweat equity” that the seller has created. In addition, there may also be issues which go undiscovered during the due diligence process such as hidden debt, unknown liabilities and aging equipment.
Prior to entering into any purchase arrangement, you must consider Federal, state and municipal obstacles that must be navigated prior to commencement of the new ownership’s operations. Almost every business requires licenses and permits of one kind or another to operate. The state, municipality and industry in which the venture is situated will determine the type of licenses and permits you require. Further, the locality where you intend to operate may impose zoning restrictions on the type of business you plan to operate, and there may be particular environmental concerns and regulations with which you must comply prior to engaging in your new endeavor.
Due Diligence Investigation
Once an enterprise has been identified for purchase, it is imperative that you conduct a comprehensive due diligence investigation of the ongoing concern. Completion of this examination will permit you possess a better understanding of what exactly is for sale and what you will be undertaking to operate.
You, as the potential buyer, and the seller should prepare and negotiate a non-binding term sheet spelling out, the proposed price, transactional timeline and other terms and conditions of the purchase. In addition to the term sheet, the seller may reasonably require you to enter into a confidentiality agreement committing not to use information obtained during your investigation for any purpose other than making an investment decision. Whether you elect to engage a broker or not, you will require at minimum a small team of at least a business lawyer and certified public accountant (CPA) to assist in due diligence and completion of the acquisition process.
You must examine all furniture, fixtures, equipment, inventory and buildings and prepare itemized lists of each. Quantity, quality, condition and market value must be determined. It is prudent to have each of these items inspected and appraised by professionals familiar with the industry.
Every business enters into contracts with its customers and with other businesses. Your investigation must include a review of all documents evidencing the company’s existing contractual arrangements. If permitted by the seller, you should speak with existing customers and venders about their interactions with the venture to gauge the health of business relationships. It is also a good idea to contact the Better Business Bureau, licensing boards, industry associations and credit reporting agencies. You should also conduct a Yelp and similar reviews to become knowledgeable regarding any complaints about the company.
Often terms in business contracts prevent the seller from transferring rights and obligations without the consent of the other party. For example, if the venture is operated at a leased property, you may need to negotiate with the landlord to permit you to assume the existing lease or enter into a new leasing arrangement in order to take ownership of the business.
In addition to the above discusses arrangements, further information requires examination, including corporate records, state filings, equipment and customer lists, sales records, marketing materials, lists of employees, salaries, business liabilities and accounts receivable, employee handbooks, advertising materials and registered and licensed trademarks, copyrights and patents. You must also determine if the business is in compliance with OSHA (Occupational Safety and Health Administration) and whether the business is properly insured.
Your team must assess the asking price for the business as against its past and potential returns. Your valuation of the enterprise should take into account market competition, financial health, historical earnings, growth potential and intangible assets such as brand and good will. If the due diligence valuation yields a number that is significantly below the tentatively agreed-to purchase price, it’s time to renegotiate or back out of the deal.
You and your CPA should conduct a professional review of the business’ financial statements for at least the most recent three (3) year period. It is prudent to demand an audit letter from the seller’s CPA rather than accepting unaudited financial statements rendered by the seller’s internal staff. In conjunction with your financial review, you should also request any financial projections the seller has prepared and copies of the business’ Federal and state tax returns for the most recent five (5) year period.
A review of the financial history and prospects of the business will better position you to determine the company’s fair market value. While the seller has his or her own concept of the worth of the enterprise, you, with a view from a different perspective, may arrive at another number. The importance of the due diligence review is paramount as the most well prepared party to the transaction typically has the upper hand in negotiating a final purchase price.
Factors unrelated to the finances of the enterprise can also affect the purchase price such as the seller’s personal motivations to deal the business and the then present state of the national, state and local economies. Beyond these factors, various methods exist from which to choose in establishing the fair market value of an existing business and determining an appropriate purchase price. Several approaches are presented below.
The Capitalization of Earnings method refers to a determination of value by calculating the net present value of future profits or cash flows. The capitalization of earnings estimate is completed by taking future earnings and dividing them by an established capitalization rate. The capitalization of earnings method is particularly useful when future earnings can easily and accurately be predicted.
The Capitalized Excess Earnings approach determines a valuation by summing the net tangible value of the assets with the capitalized value of its excess earnings. A typical procedure to establish a business’ value employing this method is: (a) begin with the numeric value of the venture’s net tangible assets; (b) estimate the business earnings attributable to net tangible assets by multiplying that number by a reasonable rate of return; (c) determine the excess earnings as the difference between the total business earnings and those attributable to net tangible assets (these excess earnings reflect the enterprises’ good will); (d) capitalize the excess earnings by dividing their value by an appropriate capitalization rate; and (e) add the capitalized excess earnings value with the value of the venture’s net tangible assets to establish its overall business value.
The Discounted Cash Flow method is often employed to determine the value of the venture based on three fundamentals (a) business cash flow stream, (b) discounted rate which captures business risk, and (c) long term business value. The strength in this valuation approach lies in business estimation based on the precise match between earnings power and risk.
The Book Value approach measures the value of the venture by determining the difference between the company’s assets and its liabilities to arrive at its net worth. If you have access to the company’s financial statements, the work has already been done in the venture’s balance sheet. Your CPA will remind you that assets are normally listed by depreciated value rather than replacement value. If the assets have been fully depreciated, there won’t be anything on which to base a book value. You must also keep in mind that certain assets such as brand and good will are not taken into account in a book value valuation.
A common method by which entrepreneurs determine the value of a business is Return on Investment (ROI), the amount of money you will realize from the company’s income after debt service and taxes. As a rule, a smaller business venture should return somewhere between fifteen and thirty percent (30%) on your capital investment. This determination is made in regard to after tax dollars. If the business’ revenues pay for its operations and generate a return on your investment of at least fifteen percent (15%), you are likely buying into a good investment opportunity.
A larger business can earn ten percent on its investment and be extremely healthy; supermarket chains net two or three percent (2-3%) on sales. However, that small percentage represents great volume. Smaller enterprises are much different animals. These businesses must generate a greater return because of the degree of risk involved in the venture is almost always much higher.
An entrepreneur should not complete this detailed an analysis of the business’ records without the assistance of an experienced business lawyer and qualified CPA. These professionals are not emotionally invested in the opportunity and can complete an unbiased examination of the venture you want to buy.
Structuring the Deal
Assuming that the purchase transaction does not involve a merger, you have two (2) options in deciding how to structure the deal. The first is an asset acquisition; a situation in which you buy only those assets you want to use in continuing the business. An asset acquisition shields you from the company’s existing legal liabilities. Rather than purchasing the equity of the existing entity inclusive of its legal risks, you are purchasing only its assets and leaving the existing corporation or LLC in the hands of the seller.
The second option is a stock or equity acquisition; a scenario in which you purchase the seller’s equity interests in the existing business entity. Here, you are not only buying all the assets of the enterprise; you are assuming all of its liabilities. Typically, buyers prefer asset purchases and sellers prefer stock sales. While there are many considerations when negotiating the structure of a transaction of this type, tax implications and potential liabilities are primary concerns. This said, an equity acquisition may be favorable to you where there are numerous valuable vendor and customer contracts at stake which are difficult to transfer from one entity to another without individual consents and a great deal of man hours.
In the event of a sale of the business’ assets, the seller remains the owner of the existing legal entity, whether it is a corporation or LLC, and you buy the assets of the company including equipment, fixtures, leasehold rights, goodwill, trade secrets, trade names, telephone numbers, domain names, inventory and so on. The terms of an asset purchase normally do not include cash and the seller usually retains long term debt obligations. This is commonly referred to as a “Cash Free, Debt Free” transaction. Normalized net working capital such as accounts receivable, inventory, prepaid expenses, accounts payable and accrued expenses are generally included in an asset purchase.
Asset Purchases from the Buyer’s Perspective
The Internal Revenue Service (IRS) permits buyers in asset sales to “step-up” a business’ depreciable basis in its assets. By allocating a higher value for assets that depreciate quickly (like equipment, which typically has a 3-7 year life) and by allocating lower values on assets that amortize slowly (like goodwill, which has a 15 year life), you may gain additional tax benefits. This reduces taxes in the near term and improves the company’s cash flow during the vital initial years of ownership. In addition, buyers prefer asset sales because they more easily avoid inheriting potential liabilities, especially contingent liabilities such as product liability, contract disputes, product warranty issues and employee lawsuits.
Asset sales can also present obstacles. Certain assets are more difficult to transfer due to issues of assignability, legal ownership and third-party consents. Examples of assets which are more diffcult to transfer include certain intellectual property, contracts, leases and permits. Obtaining consents and re-filing permit applications can slow down the transaction process a great deal.
Asset Purchases from the Seller’s Perspective
Asset sales generate higher taxes for sellers because while intangible assets, such as goodwill, are taxed at capital gains rates, tangible assets can be subject to higher ordinary income tax rates. Federal capital gains rates are currently twenty percent (20%) while ordinary income tax rates depend on the seller’s individual tax bracket. Additionally, if the selling entity is a corporation taxed under Subchapter C of the Internal Revenue Code, the seller faces double taxation. First, the corporate entity is taxed upon the sale of the assets. Second, the corporation’s stockholders are taxed again when the proceeds of the sale are distributed to them from the corporate entity.
In an equity purchase transaction, you purchase the seller’s equity in the existing business entity and become the owner of said entity. While the assets acquired in a sale of equity interests can be substantially similar to those acquired in an assets sale, you also acquire the company’s liabilities in an equity purchase. Unwanted assets and liabilities can be distributed to or paid off by the seller prior to the sale. Unlike an asset sale, equity purchases do not require numerous separate conveyances of each individual asset because title to individual assets lies within the purchased business entity.
Equity Purchases from the Buyer’s Perspective
You, as a buyer in an equity acquisition, lose the opportunity for a “step up” basis in the business’ assets and therefore cannot re-depreciate certain assets. The basis of the assets at the time of sale (book value) sets your depreciation basis. This reduced depreciation expense can result in higher future taxes compared to an asset sale. Additionally, you likely accept more risk by purchasing the company’s equity, including all contingent risk that may be unknown or undisclosed. Future lawsuits, environmental concerns, OSHA violations, employee issues, and other liabilities become your responsibility. Your business lawyer can mitigate these potential liabilities in the purchase agreement via seller representations and warranties and indemnifications.
In the case of a business possessing a great number of copyrights or patents or significant government or corporate contracts that are difficult to assign, a sale of equity may be the better solution because the business entity, not the stockholders, retains ownership of those rights. In addition, if a venture is dependent on a small number of large vendors or customers, an equity purchase reduces the risk of loss of these contracts.
Equity Purchases from the Seller’s Perspective
A seller will often prefer a sale of equity because all business proceeds will be taxed at the lower rates afforded to capital gains and, in the context of a C corporation, the corporate level tax is avoided. In addition, the seller may avoid some responsibility for future liabilities such as products liability, claims under contracts, employee suits, etc. As noted above, the purchase agreement can be used as a tool to shift responsibilities for these types of things back to the seller.
The structure of the transaction can greatly impact your future and that of the seller. Factors such as the business’ structure and industry can also influence the decision making process. Consultation with your business lawyer and CPA early in the life cycle of the transaction is crucial to fully understand the important issues at hand and structuring a deal that produces the intended results for the parties.
Financing the Purchase
If you don’t have cash on hand to fully fund the purchase of the business enterprise, you can seek out a traditional lender, ask the seller “hold a note” on the business or sell a percentage of the equity in the venture to one or more investors such as friends and family. The seller may be agreeable to accepting a promissory note as a portion of purchase price. This is similar to a bank loan in that you promise to pay the lender, here, the seller, the principal amount of the loan with interest over the course of a pre-determined period of time. The downside to debt financing the purchase whether through a traditional lender or the seller is you must make fixed payments on the loan regardless of the condition of the company’s cash flow at the time of any particular due date.
If you have a close knit group of friends and supportive family members with readily available cash, they may be interested in investing in your business opportunity. If this is the case, you may consider offering to sell these folks equity interests in your venture. One upside to an equity financing of this kind is distributions of monies to your investors will ordinarily not be fixed and depend in large part on the health of the business’ finances at any particular time.
However, you finance the acquisition of your business, it is important to involve your business lawyer and CPA in financial structuring and other legal and liability arrangements.
Barring accomplishing the acquisition through a merger, the purchase agreement may take the form of a equity purchase agreement or asset purchase agreement. This contract is the key document in planning for and finalizing the purchase of the business. The document will identify everything you intend to buy, including tangible and intangible assets such as equipment, vender contracts, customer lists, leasehold rights, intellectual property and good will. Your CPA should work closely with your business lawyer to determine the most suitable structure for the business acquisition and draft the proper documentation to accomplish the goals of the principal parties. The purchase contract should reflect in minute detail your understandings regarding the legal, financial and tax aspects and implications of the transaction. It should also provide you with the option to opt out of the deal if you (a) discover that the seller misrepresented or omitted information essential to making a fully informed investment decision or (b) are unable to obtain the required financing.
Closing the Deal
Once the sale agreement is executed, it replaces the term sheet as the operative document and guide to closing on your business acquisition. At the closing the following items must be attended to:
Purchase price adjustments will be made to account for such prorated items as rent, utilities and inventory up to the time of closing.
Each of the buyer and seller must present the documents required by the purchase agreement for review and approval by the other party’s legal counsel. These documents often include, corporate resolutions approving the terms of the purchase and sale, certificates of good standing from state offices such as the Secretary of State and the Department of Revenue and, if applicable, UCC releases of existing liens on the business’ assets.
In the event you, as the buyer, are financing your purchase through a financing arrangement with the seller or other lender, a promissory note evidencing the loan must be executed. In addition, a security agreement is often entered into describing the assets which are to serve as security for your loan repayment obligations. A UCC financing statement is typically filed with the Secretary of State to provide public record of the existence of the lender’s security interest in the assets.
If the business involves the lease of property, you must be sure that the landlord has approved the assignment of the lease with the appropriate documentation or, if you are entering into a new lease, the new document has been properly executed by the parties. Of course, if the acquisition of the business involves a purchase of real estate, there may be an entirely separate real estate transaction running in parallel with the business acquisition.
Should the purchase involve motor vehicles of one kind or another, appropriate transfer documents must be completed whether the vehicles are owned or leased. You should contact the local registry of motor vehicles to determine the proper action to be taken as a pre-closing action item. Intellectual property rights may be transferred as part of the sale of the business. As such, transfer and assignment documents may be required in regard to patents, trademarks and copyrights. If the business being acquired is a franchise there will be additional contractual arrangements that must be considered.
In the case of an asset sale, once all other formalities have been satisfied, the seller will deliver you a bill of sale proving the sale of the business and explicitly transferring ownership of the business assets not otherwise transferred in their own right. A settlement statement will also be executed and exchanged between the parties itemizing each financial aspect of the purchase and sale.
In the event of a transfer of equity from the seller, rather than a bill of sale, there will be an assignment and assumption agreement executed by the principal parties, the seller will surrender certificates and you will be issued new certificates to represent your new equity ownership. A settlement statement should still be employed in closing a sale of equity, and your business lawyer must ensure Federal and state security laws and regulations are adhered to.
You should also request, negotiate and receive a covenant not to compete agreement from the seller to prevent interference with the newly acquired business from the previous owner. In addition, if you deem it beneficial and the seller is agreeable, it is often a good idea to request that the seller provide consulting services to the business for a short period of time to ensure a smoother transition in ownership and operations.
Now it’s time to wish you all the best as you embark on your newly acquired business endeavor.