Purchasing an established company can improve the chances of success for a variety of reasons:
- Financial history – With historical financial data about the business, you can better assess its overall viability. Moreover, you can zero in on which products, services, and areas of the company are most profitable.
- Processes and systems already in place – Established workflows—even if they will eventually require some improvements—make it easier to manage inventory, serve customers, and handle other aspects of the business from Day 1.
- Brand recognition – Customers already know your brand, so you won’t have to start from square one to generate awareness and build goodwill.
- Established supplier and vendor relationships – Knowing you have reliable sources to depend on for materials, inventory, and services can alleviate a lot of headaches and unknowns.
- Existing customer base – With loyal customers supporting your business, you have revenue coming in from the very beginning to help you get a return on your investment. Also, existing customers can help you determine what the former owners did well and what you can do to improve the customer experience.
- Trained staff – Finding reliable employees can prove challenging, so having existing staff who know their jobs and have demonstrated responsibility and accountability is invaluable. Also, the experienced team members can give you helpful insights about daily operational challenges and opportunities.
- The benefit of the former owner’s expertise – Sometimes, sellers are willing to stay on for a period of time to help the buying party understand the ins and outs of the business.
Naturally, it takes some due diligence to determine if buying a business is a viable decision. Taking over an existing business comes with no guarantee of success, and you have to do your homework before you sign on the dotted line. To help you work through the process, we’ve created a list of important considerations and tasks to guide you.
1. Determine your Business and Personal Goals
Think about your personal and professional objectives:
- How much time do you want to spend working in your business?
- What income do you need to live comfortably?
- Do you wish to pass the business on to your heirs?
- Do you want a business that has significant growth potential?
- How much risk are you comfortable with?
These questions and others will help you assess if an opportunity will fit your vision of what you want from life as a business owner.
2. Consider the Industry and Niche
When buying an existing business, it’s essential to understand the outlook for the industry and the types of business activities the company is engaged in.
Some efforts that can help provide the insights needed to determine if a company is the right fit include:
- Market research to determine if a need exists for the business’s niche and whether that need will grow or decline,
- Competitive research to examine how many other businesses are selling similar products and services to your target market,
- Target audience research to understand customers’ needs, pain points, goals, and expectations, and
- SWOT (Strengths, Weaknesses, Opportunities, Threats) analysis to assess the company’s potential to thrive.
With insights into the potential market, customer needs and behaviors, and competitive landscape, you can assess whether there’s adequate demand for the business’s offerings and if you can realistically compete in the market and grow the company.
Your level of interest and expertise in the industry and niche are also important considerations. Even if a company looks strong on paper, it might not be an ideal fit for you if you have zero experience or interest in what it does. Sure, running a company on passion for the business alone is not a recipe for success. However, having an emotional investment inspires motivation to navigate challenges and reach your goals.
3. Review Entity Status and Compliance
You become responsible for the business entity the company was formed as—e.g., Limited Liability Company (LLC) or C Corporation. Different entity types have different compliance requirements, and it’s essential to determine whether the current business owner stayed on top of them. Failure to file reports, pay taxes, and complete other required tasks can lead to fines and other penalties, cause legal issues, and even place the company in bad standing with the state.
To ensure you understand how the company is structured, where it’s registered, and its compliance-related activities, request to see important entity documents such as:
- LLC and C Corporation formation filings (e.g., Articles of Organization or Articles of Incorporation)
- S Corporation status documentation
- Doing Business As (DBA) registrations for any fictitious business names the company has registered
- Governance documents (e.g., Partnership Agreement, LLC Operating Agreement, Bylaws)
- Meeting minutes which document the discussions and actions during LLC member, shareholder, and board of directors meetings
- Articles of Amendment which reflect significant changes made to the business entity
- Certificate of good standing from the entity’s state of formation
- Certificates of Authority for foreign qualification certificates identifying the states where the entity is registered to do business outside of its home state
- Annual Report filings submitted to the entity’s home state (and any states where it’s foreign qualified)
- List of states, territories, or countries where the company has employees or owns or leases property.
- Insurance certificates to verify the company has the policies required to operate the business and to protect its assets
According to the IRS, when a business is sold, generally, the new owner must obtain a new Employer Identification Number (EIN) for the entity. Discuss this with your accountant and attorney, as different business documents, bank accounts, tax accounts, etc., will need to reflect the new EIN.
4. Review and Validate Financial Statements
You need to determine if the business’s earnings will be adequate for your lifestyle and if you think you can improve (or at least maintain) the earnings. Do you see an upward trend in revenue, or is it plateauing or declining? Are sales primarily seasonal or evenly distributed throughout the year?
You’ll also want to review the business’s outstanding debts so you don’t encounter any unwelcome surprises after the sale is complete.
Here’s where you’ll benefit from an accountant’s help in requesting and analyzing financial documents, such as:
- The company’s audited year-end financial statements (e.g., profit and loss, cash flow, balance sheet) for at least the last three years to see if revenues are rising or declining
- At least three years’ worth of tax returns
- Key financial ratios from the sellers—such as gross profit to net sales, net income to net worth, and net income to total assets
- Debt schedule to view the company’s outstanding debt balances and related payments
- Fixed assets schedule
- Accounts receivable and accounts payable lists
- A description of the company’s accounting methods and an explanation of any changes in those methods
- General ledger report
You also want to familiarize yourself with how the company handles its receivables. Are customers used to paying COD or net 90? What percentage of customer accounts are past due? Is the company writing off any uncollected debt? Your accountant can help you review the company’s financial statements and help you answer critical questions like these and more.
5. Perform a Credit Check on the Seller
Checking the business’s and its owner’s credit score can help you assess whether the company has handled its financial obligations responsibly. A simple way to do that is to order credit reports (fees vary) from one or more of the major credit reporting agencies—e.g., Experian, Equifax, TransUnion, and Dun & Bradstreet.
Credit checks can help you assess if:
- The company has maintained favorable relationships with vendors and suppliers.
- The business has outstanding debts that are not captured in its accounting records.
- You might be limited in how much financing you can receive from banks and other sources.
- You may be eligible for favorable interest rates when taking out business loans.
- You may be eligible for preferred rates on business insurance premiums.
If the seller has frozen any of their personal credit reports, you will need to request that they temporarily unfreeze them if you wish to view their ratings.
6. Review Outstanding Contracts
Make sure you understand the terms and conditions of any contractual arrangements the business has in place, so I recommend having an attorney review agreements and advise on any red flags that put you at legal or financial risk.
Examples of contracts the business might have entered into:
- Customer sales and service agreements
- Vendor and supplier contracts
- Work-for-hire agreements (e.g., with freelancers and other independent contractors)
- Subsidiary, partnership, or joint venture agreements
- Nondisclosure agreements
- Confidentiality agreements
- Non-compete agreements
- Contracts between the business and shareholders, officers, directors, and affiliates
- Real estate leases and rental agreements
- Equipment leases
- Vehicle leases
7. Review Intellectual Property
Intellectual property can hold immense value; typically, those assets will be included in the purchase agreement. An attorney can help you review IP to determine its validity, assess the scope of protection it provides, and examine any encumbrances (such as patent licensing agreements or security interests) on the IP. It’s critical to ascertain if the IP belongs to the company you’re buying, not an individual or other party. An attorney can also identify any pending IP claims against the business you want to buy.
Examples of Intellectual Property:
- Patents (e.g., inventions, innovations, trade secrets, know-how, software)
- Trademarks (e.g., brands, logos, business names, domain names)
- Designs (distinctive look of things like products, patterns, configurations, and ornamentation)
- Copyrights (artistic works, literary works, music, sound recordings, films, broadcasts)
Additionally, an accountant’s assistance can be helpful for determining the value of any intellectual property you’re purchasing, which can affect the value of the business overall.
8. Review Customer Lists and Related Information
Request to see the company’s customer lists with purchase history. The information will help you understand where revenues come from and determine the estimated value per customer. It will also give you insights about repeat business and upsells, which can indicate customer satisfaction with the business’s products and services and the degree of customer loyalty the company has built.
Some specific details that can prove immensely useful:
- A schedule of the company’s largest customers in sales revenue
- Sales reports to identify recurring customers and determine where most of the business’s revenue comes from and whether there’s a good balance of customers or if the company is heavily reliant on one or two big clients
- List of significant customers lost over the past two years, along with an explanation of why they left
- Customer survey results
- Description of the company’s marketing plan and advertising strategy—along with samples of sales and marketing collateral (e.g., email copy, print materials, digital assets)
9. Evaluate Employees and Benefits
If the business has employees, learn as much as you can about them, the company culture, compensation, and benefits. Try to get a sense of whether key employees will stay with the business after it changes hands and what incentives you might need to offer to keep them on. Have your attorney review any employment contracts to ensure the company is following applicable employment laws.
Examples of key documents and information to request:
- Employee list with names, positions, job descriptions, years of service, wages, salaries, commissions, bonuses
- Key employees’ resumes
- All employment and work-for-hire agreements which include data on non-compete agreements, independent contractor agreements, non-disclosure agreements
- Description of retirement plans
- Employee handbook with descriptions of employee benefits, time off policies, etc.
- Workers’ compensation and unemployment claims history
- Collective bargaining agreements and records of any labor disputes or grievances
- Stock options and stock purchase plan information
- Employee dispute records with alleged discrimination, wrongful termination, harassment, etc.
Depending on the business, there may be other details you should review, so talk with your attorney and accountant for guidance.
10. Examine Online Reviews and Social Media Accounts
Digital word of mouth—whether favorable or unfavorable—wields power. So, it’s vital to assess what customers, prospective customers, and the public at large are saying about the company online. Do some digging to better understand how well the business has managed the customer experience and how satisfied customers are with the company’s products and services.
Online Reviews
Read through what customers have posted about the company on online review sites. People may have left reviews on several or all of the review platforms listed below:
- Google Business Profile
- Trustpilot
- Better Business Bureau
- Angi
- Foursquare
- Yelp
- Tripadvisor
- G2
Also, look for reviews by employees on job and career websites, such as:
- Glassdoor
- Indeed
As you check online reviews, consider what they indicate regarding the company’s strengths and weaknesses in their customer care efforts, human resources management, work environment, and product and service quality.
Social Media Accounts
Check the business’s social media accounts (e.g., Facebook, Twitter, Instagram, TikTok, etc.) to see what current and past customers say about the company, its employees, and its products and services. You can learn a lot about the company’s reputation and relationship with its customers by viewing people’s comments on the company’s posts.
Also, search each platform for posts people have left on their personal social media accounts that mention the company. Sometimes, customers shout out accolades (or grievances) about businesses they’ve visited or bought products or services from.
11. Confirm Business Licenses and Ongoing Compliance Needs
Most companies must obtain some type of license(s) or permit(s) to conduct business at their location(s) in compliance with industry regulations and zoning rules. Depending on the business, the requirements might be at the federal, state, or local level. Before buying a company, verifying the current owners have maintained their required licenses is essential. Moreover, you will need to know how to renew licenses and permits.
The following are examples of the licenses and permits companies may need regardless of their industry:
- Zoning Permit
- General Business License (Operating License)
- Building Permit
- Sign Permit
- Elevator Permit
- Holiday Sales License
Here are some examples of industry-related licenses:
- Food Establishment Permit
- Food and Beverage License
- Entertainment License
- Health License
- Day Care License
- Contractor’s License
- Transportation License
- Insurance Business License
- Cosmetology License
These are just a sampling of the many licenses and permits businesses may need.
12. Determine Business Valuation
Naturally, you’ll want to pay a justifiable price for the business. The seller will typically conduct a business valuation to ensure they’re getting a fair and realistic price for their company.
Business valuation is a process for evaluating all aspects of a business to determine its worth and value on the market. Professionals, such as valuation specialists, CPAs, business appraisers, business advisors, real estate agents, business brokers, and mergers and acquisitions firms, use object metrics like financial data and industry data to conduct business valuations.
Keep in mind that the value of a business can extend beyond its fair market value—other considerations, such as strategic value may also come into play. Strategic value, also known as investment value, relates to the company’s value specific to the buyer. For example, there’s strategic value if a buyer has other companies and the one they wish to purchase brings synergies that will expand the other businesses’ market and increase their revenues.
It’s helpful to have your own financial and legal professionals examine the seller’s business valuation to ensure it’s a reasonable and accurate assessment of the company’s worth.
13. Prepare and Negotiate an Offer
After you’ve done your due diligence to determine the business is a viable opportunity, it’s time to make an offer and strike a deal!
Negotiate
Ideally, you’ll have communicated with the seller and their agents throughout the process of evaluating the company so that the negotiation phase goes smoothly without any unexpected surprises that can cause delays and increase legal and accounting fees. During negotiations, you’ll discuss the fine details, such as purchase price, agreement terms and conditions, and any contingencies. A productive and thorough negotiation process helps ensure the written agreement by your attorney reflects both yours and the seller’s expectations.
Letter of Intent
Depending on the size of the purchase, you may decide to (or be required to) have your attorney draw up a letter of intent (LOI) to establish earnest commitment (by both parties) to pursuing the transaction before a full purchase agreement is presented. An LOI starts the buying process—addressing key elements that will later go into a binding contract without getting tangled up in the minutia in the early stages. It typically occurs before performing due diligence research.
Purchase Agreement
Review the final purchase agreement carefully. It’s ultra-critical as it details the terms and conditions of the transaction. Address any questions you may have with your attorney before the contract goes to the seller.
Common Elements of a Business Purchase Agreement:
- Parties with legal names of the seller and buyer and their contact information
- Business description
- Type of sale
- Purchase price
- Payment terms
- Assets included in the sale
- Covenants with provisions the seller is responsible for before or after closing the deal (e.g., paying outstanding tax liabilities) and protective clauses (such as confidentiality, non-compete, and indemnification)
- Assumed liabilities the buyer agrees to take from the seller
- Contingencies
- Timeline and details for closing the transaction
- Appendices and related documents such as letter of intent, financial statements, valuations, vendor agreements, etc.
The More You Know
You’ll probably have more questions to ask the business owner depending on your industry knowledge, your needs, and your plans for the business. Ask your attorney, accountant, or other business advisors for guidance to ensure you get all the information you need as you work through the process.
References:
https://www.bls.gov/bdm/us_age_naics_00_table7.txt
https://www.irs.gov/businesses/small-businesses-self-employed/do-you-need-a-new-ein
