What You Need to Know Before Acquiring a Small Business
In this article, you’ll learn:
- How to decide how much to pay for a small business
- What you need to know about your business before acquiring a small business
- What information needs to be gathered before acquiring a small business
- How to finance a small business acquisition
So, you’re interested in acquiring a small business – that’s great news! A good business acquisition can provide you with immediate cash flow, business assets, and other benefits. But if the business fails to meet your expectations? You could face consequences for years.
The stakes are high with a business acquisition, so you have to get all of your ducks in a row before making a decision.
Here’s what you need to know before acquiring a small business:
How D0 You Decide How Much to Pay for a Small Business?
A very important step in a business acquisition is determining the value of the business. You can buy an extremely well-run business, but if you pay 50% above the market value, you’re going to be facing an uphill battle.
There is no one metric that can give you an accurate business valuation, but a combination of metrics can help you settle on a fair number.
Here are a few things to consider:
- What is the target’s annual revenue? Is it growing or shrinking? By looking at the purchase prices of similar companies, you can determine an appropriate multiple to apply to the revenue. You can complete the same exercise with earnings.
- Look at the value of the company’s balance sheet, taking the business assets and subtracting the business liabilities. There are some things, like real estate, receivables, and payables, that won’t be hard to value. But you might have intangible assets, such as patents, copyrights, and other types of intellectual property that have harder-to-estimate values – you should use your best judgment for these categories.
- Do a discounted cash flow analysis. In a discounted cash flow analysis, you calculate the present value of future cash flows. This valuation method is an excellent way to determine the value of a business – in theory. The problem is that it’s difficult to estimate the future cash flows – particularly the ones that are 5+ years into the future.
So, you have a lot to consider when deciding how much to pay for a small business. How do you put it all together?
Let’s look at an example:
- The target has annual revenue of $100,000 and comparable companies have sold for four times revenue. Based on this, the value is $400,000.
- There are $20,000 in earnings per year, and the market is paying 15 times earnings. Based on this, the target is worth $300,000
- The company is growing both revenue and earnings at 10% each year, right in line with peers. This means that the revenue and earnings multiples don’t need to be adjusted.
- With assets of $150,000 and liabilities of $100,000, the balance sheet adds $50,000 in value to the business operations.
- The discounted cash flow analysis comes up with a valuation of $350,000.
Based on the revenue, earnings, and cash flow, the company is worth somewhere between $300,000 and $400,000. The balance sheet adds another $50,000. So, the company is probably worth $350,000 to $450,000.
The valuation metrics are likely to spit out different numbers, so you are likely to have a range when you value a business acquisition. But that range is still very useful, as it prevents you from paying an unjustifiable purchase price.
So, you’ve settled on a number for your business acquisition. You’re ready for the next step – which is an important step, but one that is often overlooked.
What Do You Need to Know About Your Business Before Acquiring a Small Business?
Your existing business impacts the viability of a new business acquisition. Here’s what you need to consider:
Synergy is the interaction between two organizations that creates a whole that is greater than the sum of its parts. There are many types of synergies, but one example is a combined company that reduces costs by streamlining manual processes. Or you could have a business entity that can achieve higher sales through cross-promotions. In any case, synergies are a big motivator for business purchases, so the presence or absence of synergies should play a role in whether or not you go ahead with a business acquisition.
Are you going to take on debt to finance your business purchase? If so, you need to calculate the expected cash flows of your own business and the new business to see if they are sufficient to repay the debt.
Let’s say you expect a cash flow of $20,000 a month between both businesses, but the monthly payments are going to be $18,000. You would have a very small margin for error in this scenario.
What Information Do You Need to Gather Before Acquiring a Small Business?
Before acquiring a small business, you want to make sure that the target has everything in order. This is one of the least exciting aspects of a business acquisition, but it’s necessary – you could face an unwelcome surprise after finalizing the purchase if you skip this step.
You need to get the following information from the previous owner:
Business Licenses and Permits
In certain industries, you need a long list of licenses and permits to operate a business – restaurants are one of those types of businesses. You may need licenses and permits on the local, state, and federal levels. You should do your own research or consult with a lawyer to make sure that the business isn’t breaking any laws.
Does the new business have a long-term lease agreement? Or agreements with vendors? As the new owner, you are going to take on any existing agreements.
Say you want to move to a new office, but the previous owner still has five more years on their lease agreement. You should either be comfortable with staying in that space for five more years or see if the landlord is open to terminating the agreement.
Letter of Intent
A letter of intent (LOI) is a document that spells out the terms of a prospective deal between the two parties. With an LOI in hand, you can proceed with the more time-consuming aspects of your due diligence, as there is a high chance of a finalized deal if everything checks out.
You may have already reviewed some financial statements when settling on a purchase price, but you should look at all of them before signing on the dotted line. You should carefully evaluate the cash flow statement, tax returns, balance sheet, and debt disclosures.
You should have a second set of eyes – ideally a Certified Public Accountant (CPA) – look over the financial statements to identify any irregularities and give an opinion on the long-term viability of the business model.
Here are other things to put on your due-diligence to-do list:
- What are the zoning laws? Is the business in compliance with them?
- Are there any environmental regulations that are relevant to the new business?
- Ask for a certificate of good standing – this is necessary to operate in the state.
- You need articles of organization for an LLC and articles of incorporation for a corporation.
This is by no means an exhaustive list. You should have a lawyer help you through the due diligence process to ensure that you request everything you need and properly evaluate all of the documentation. The process varies depending on your type of business, so you should try to find a lawyer who has experience in your industry.
How Do You Finance a Small Business Acquisition?
You should consider using a term loan, U.S. Small Business Administration (SBA) 7(a) loan, or seller financing to finance a small business acquisition.
Let’s look at these options one by one.
A term loan gives the borrower a lump sum of cash that is to be repaid at predefined intervals at a fixed or variable interest rate. You can get a term loan through Biz2Credit for between $25,000 and $500,000, with payment plans ranging from 12 to 36 months. A term loan usually has a relatively low interest rate; Biz2Credit, for example, has rates as low as 7.99%.
The advantages of using a term loan are reasonable monthly repayments due to the relatively low interest rates, tax deductibility, and the possibility of fast approval. The downsides are the loan limit (many business purchases exceed $500,000), high credit score requirements (if you have a low credit score), and the inability to get fast approval in some cases.
SBA 7(a) Loan
The SBA 7(a) loan, like the term loan, typically has a low interest rate. The maximum loan amount of $5 million is higher than the term loan, however, so it is an option if you want to make a seven-figure business acquisition.
But there are a few issues with the SBA loan:
- The road to approval can be long – possibly months.
- To get an SBA loan, you need to have exhausted all of your financing options and have a high FICO score.
- You might not be able to finance the entire business acquisition with an SBA loan.
The SBA loan is a fit for a small number of entrepreneurs, but it can be an outstanding financing option in certain instances.
Are you having a tough time getting a business loan with attractive terms? If so, you may want to consider the possibility of seller financing. As the name suggests, seller financing is financing provided by the small business owner.
You may be able to get seller financing if the following conditions are satisfied:
- The current owner is highly motivated to sell the business.
- The seller doesn’t need the cash up front.
- There are few if any competing bidders.
It can be challenging to meet all of those conditions. On top of that, you need to negotiate an agreement that works for both sides. But in certain circumstances, seller financing is a win-win.
While you might be able to wait a long time for approval when acquiring a small business, you should look for a lender with a fast approval process.
With Biz2Credit, you can get that fast approval.
Ram Ajjarapu, President of consulting firm Global Information Technology, wanted to acquire another company. He knew that a traditional lender would take too long to get him funds… so he turned to Biz2Credit.
Biz2Credit was able to quickly provide $3 million of financing. Ajjarapu said, “I was quite impressed with Biz2Credit’s expediency” and gave Senior Funding Specialist Kamal an “11 out of 10 when it comes to customer service.”
Learn more about how Biz2Credit can help you acquire a small business.