This is the fifth post in a series about buying a small business and purchasing our first one. If you are catching this series mid-stream, I recommend you start at the beginning of the series with Buying a Small Business: Overview.
In the first post in this series, I covered the benefits and downsides of buying an existing small business. I also mentioned the fishing lure business that my wife was unenthusiastic about purchasing and that one week later, she found the perfect business to buy.
In the second post in this series, I talked about how you might go about finding a business for sale and establishing selection criteria. I also shared where we found our business and the selection criteria that we used.
In the third post in this series, I explained debt financing, and talked about how you might go about borrowing money to purchase a small business.
In the fourth post in this series, I explained equity financing, and talked about how you can tap into your retirement accounts penalty-free to get the equity you need.
In this post, I will be talking about doing your preliminary due diligence and making an offer.
Due diligence is a fancy term which simply means doing your homework. You should never do business with someone that you do not trust, and furthermore, you should never trust them blindly. Ronald Reagan’s famous phrase regarding the Soviets, “trust but verify,” is not only helpful for international relations, but it is also helpful for dealing with small business owners as well. This is where the due diligence comes into play.
Preliminary Due Diligence
Once you have found a business that meets your screening criteria and is within your price range, you should start digging into the details. At this point, you will likely sign a confidentiality agreement with the seller. This agreement assures the seller that you will not share their confidential business information with a competitor or anyone else for that matter.
After signing the agreement, the seller should give you access to all of the pertinent information that you will need in order to come up with an offer price and deal terms. In fact, most sellers will have a packet of information ready to share with interested buyers that they will give you right away. This is a good starting point.
Now, you should go through all of the provided information and start doing industry research on your own as well. You will want to come up with a list of questions that you can ask the seller along with potential red flags.
You may want to include a meeting with the seller at this point as well, in order to get a perspective on the business directly from the “horse’s mouth”, so to speak. The areas that you could delve into at this point are far ranging and varied depending on the industry and the circumstances, but would generally include:
- Seasonality of the business
- Customer churn rate
- History of steady cash flows and profitability
- Reliability of existing suppliers
- Tenure and status of key employees
- A list of key contracts
- Reason the seller is selling
- The list goes on…
You will also want to conduct an onsite visit if the business has a facility. This early in the process, your visit might be after hours, as the employees may not even know that the business is for sale. It’s unlikely you’ll be able to meet any of them personally this early in the process.
The whole point of this first step in the due diligence process is to formulate your questions and to get them answered. You will then use that information along with your own experience to put together a rough financial projection for how the business may perform in the future.
Don’t be intimidated by this step in the process, the projection can be as simple or as complex as you are comfortable with. For example, if the business has been growing at 3% per year for the past 5 years and nothing has come up during your preliminary due diligence that would put that growth rate into question, just assume 3% again next year. If you want to go more in depth, you certainly can.
The other objective in this preliminary phase is to identify red flags or deal killers – the sooner you find them the better. It’s always better to kill a deal quickly if it wasn’t going to work out anyway due to a red flag. That keeps you from wasting your time or your money once you bring in an attorney or accountant.
Once you have your questions answered, are comfortable that there aren’t any red flags, and have a financial projection for the upcoming years, it’s time to move on to the next step.
Making an Offer
Now that you have your financial projection and assuming that you still want to buy the business after your preliminary due diligence, you can make the seller an offer. Small businesses are usually sold for some multiple of their cash flow, technically it is a multiple of EBITDA (earnings before interest, tax, depreciation and amortization), but for our purposes, I’ll just call it cash flow. How do you figure out what multiple to use?
The best way to find the right multiple is to look at recent sales of similar businesses. You can usually find these through a service like BizBuySell for a small fee or you could hire a professional business appraiser as well. If your business is in a very clearly defined category, like a pizza shop, then the comparable sales will be very easy to find. If it is an unusual business, or a strange conglomeration of multiple businesses, then comparable sales may be more difficult to find.
Ultimately, you will end up with a range of multiples. Perhaps businesses like the one you are looking at generally sell for between 2x and 3x cash flow. How do you know where to offer? This is where the negotiation begins. In general, if there are negative aspects to the business prospects, that brings the multiple down and if there are positive aspects to future prospects, that brings the multiple up.
For example, if the business has been declining, use a lower multiple. If it has had 5 years of steady growth that you expect to continue into the future (based off your financial projection), then the multiple will be higher.
Furthermore, if the seller is giving you something of value, then the multiple will be higher as well. For example, if they are willing to stay on full time for three months to train you – higher multiple. If they are willing to provide 100% seller financing on favorable terms – higher multiple. You get the idea.
Typically, you will make your formal offer in a Letter of Intent (LOI), which outlines the general deal terms. This is where you would include the offer price in addition to the overall terms of the deal. For example, you might offer to pay a certain amount contingent upon the seller providing a certain amount of training and or financing and that you will need a certain amount of time for confirmatory due diligence.
What We Did
For the business that we bought, the due diligence was simple. It was a small company with no employees and only one supplier with no contracts. We interviewed the seller and she gave us access to the books. We then put together our own financials and looked at seasonality and customer churn rate.
We did not use a multiple to come up with an offer, because we had trouble finding comparable businesses for sale. Instead, we looked at a cash flow break-even period of one year. What does that mean? We wanted to get the cash from the purchase back within twelve months based off our financials. After that, the business would be net cash flow positive. We made an offer based upon that calculation which she accepted.
In the next post in this series, I’ll be wrapping things up. Did you think you were done with the due diligence? Well, you aren’t! In the final installment, I’ll talk about handling your confirmatory due diligence and getting to closing, and I’ll finally tell you about the business that we bought!
What do you think are some other areas to consider in doing your preliminary due diligence? What other approaches might you take to value a business besides using the multiple of cash flow or break-even methods?