Why not take a common sense approach to entrepreneurship, and consider the option of buying an already established business?
March 22, 2004 7 min read
Opinions expressed by Entrepreneur contributors are their own.
If you’re getting serious about joining the entrepreneurial ranks, you’re probably considering launching your own venture or maybe buying a franchise or business opportunity. But have you thought about buying an existing business? According to some business experts, it’s the safest and most effective way to go into business for yourself.
But why should you consider buying a business as opposed to starting your own company, or even buying a franchise? The most important reason is the startup failure rate for all newly launched businesses: It’s high, and if you’re not a risk-taker, this could be a deterrent. The same is true of franchises, especially if you consider that the “turnovers” many franchisors refer to are actually business failures.
So instead of starting from scratch, look for a seasoned small business with three to five years of verifiable financial records and tax returns that coincide with the data on the financial statements. Businesses like these, with a record of growth, trained employees, a good customer base, proper equipment, and an established inventory, are excellent business opportunities. In fact, the failure rates of businesses that have been around for at least five years is quite low.
So what are your chances of finding such a business? Of the five to six million businesses in the United States with 19 or fewer employees, at least 1 million of these are for sale at any given time. According to the 2003 Business Reference Guide(Business Brokerage Press), the average annual revenues of these businesses is $ 412,611-a nice-sized company within reach of many budding entrepreneurs.
If you’re ready to begin your search, here are five ways to find businesses for sale:
1. Checking the “Business Opportunities” or “Businesses for Sale” classified section of your newspaper. Local and national papers all have one of these sections in their classified ad area where you can peruse listings of businesses for sale.
2. Searching the business opportunity classified Web site of The Wall Street Journal. Individuals and business brokers alike can access this site to find businesses for sale all over the nation. Known as BizBuySell.com, it’s probably the biggest online marketplace for business acquisitions of all sizes.
3. Finding an experienced business broker in your area who’s a member of the International Business Brokers Association (IBBA). Your chances of finding a broker you can trust are better if they’re a member of the IBBA because this organization has a strong code of ethics that members must adhere to.
4. Calling local CPAs to see if they have any clients interested in selling their business. Understand, however, that this is long shot territory and not very time effective.
5. Finding businesses you’re interested in and calling on the owners yourself to determine if he or she wishes to sell. Be warned, however: This method exposes you to the eager seller who wants to unload his problem business and has few compunctions against misrepresentation.
If you think that buying a business is an option you want to pursue, your first step is to find an experienced business CPA and an attorney to help in the due diligence process. Hiring these qualified professionals is essential because you’re going to need help evaluating the ongoing viability of an existing business.
When it comes to actually valuing a small business, however, accountants, attorneys and sellers are fundamentally clueless. That’s right, I said “clueless.” Based on my more than 16 years of experience as a business broker, here, instead, is a method of valuation that will get you in the ballpark of valuing a business about 85 percent of the time-if you don’t deviate too far from this system, it should keep you out of trouble.
First, you’ll need to determine the actual pretax discretionary cash flow of the business. When it comes to small businesses, the net profit doesn’t mean beans because the seller is doing everything possible to keep this number low to avoid taxes. Pull out the owner’s salary, perks, depreciation, interest, amortization, excessive and over market expenses, nonbusiness expenses, nonbusiness use vehicles and insurance, the cost for “employees” who aren’t there (like the son who’s in college), one-time nonrecurring expenses (like a lawsuit), and add all this up.
Next, add this number to the businesses net profit (if any). If there’s a net loss, subtract the net loss from the above amount. The result is what business brokers call the seller’s pre-tax discretionary cash flow. This number usually corresponds to about 10 – 20 percent of the business’s gross sales, and is better than determining the owner’s pre-tax salary at the same rate because the seller has most likely successfully tax-sheltered a good portion of his income.
Once you’ve determined the business’s true cash flow, you can use the following method to get your price in the ballpark. Take the seller’s discretionary cash flow that you figured above. Let’s say you’re buying a business with $400,000 in sales and a discretionary cash flow of $75,000. Divide that $75,000 by three. Dividing by three means the maximum amount you should be spending for debt service is no more than 33 percent of your pre-tax cash flow. In this case, that would be $25,000. Then divide that number by 12. In our example, that amount would be $2,083.33. Dividing by 12 breaks your annual debt service into a monthly figure, which represents your monthly principle and interest payment. You’ll then use this number to determine how much debt you can handle using the amortization tables.
Let me spell it out:
75,000 divided by three = the maximum amount for financing you should be paying for a year ($25,000)
$25,000 divided by 12 = your monthly payment of principal and interest ($2083.33)
You can then consult an amortization table to determine how much debt a payment of $2083.33 per month can support. Currently, small businesses are being seller financed at 7 to 10 percent at 3 to 10 years depending on the type of business. A payment of $2083.33 per month will finance approximately $100,000 at 9% for five years. This represents the financed portion of the sale price. Now we have to determine the down payment. (Generally, at least 75 percent of all business sales contain some component of seller financing. Consequently, we’ll probably have a cash down payment by the buyer and some seller financing in order to sell the business.)
As a buyer, you should get your down payment back to you in the form of pretax discretionary income in 12 to 24 months. So if $25,000 of the $75,000 is for debt service, then the balance of $50,000 is the buyer’s pre-tax discretionary cash flow after debt service. If you wanted to get your $50,000 back in 12 months, you’ll add $50,000 to the financed part of the sale ($100,000) and the business value is $150,000. If the business has shown excellent growth or has some other highly desirable component, you can justify getting your down payment back up to 24 months out. To get your down payment back in 24 months, the down payment would have to be increased to $100,000. This would increase the business value to $200,000. So our hypothetical business that had gross annual sales of $400,000 would sell for approximately $150,000 to $200,000.
Of course, there are many acceptable variations on this theme that fall outside these specific parameters. But if you stay fairly close to the method I’ve outlined above, using cash flow as your guide, your chances of paying too much will be significantly reduced. Just remember, paying too much due to a poorly structured transaction is the leading cause of business failures after businesses change hands. Don’t let it happen to you.
Bill Broocke is the founder and CEO of The Success Connection Inc., a business and professional practice brokerage. With 16 years of business brokerage experience, Broocke is a authority on business valuation and the buying and selling of small businesses and has often been a featured writer and speaker on the subjects.