8 Factors to Consider When Buying a Business

The process of buying a business can be a daunting task that can take months of negotiation, or longer if you count the time required to identify a suitable target company. However, with careful planning and the help of an advisory team, it can be a rewarding process ending in the acquisition of a successful business. Consider this high-level overview of the buying process and the 8 factors to consider during each phase.

Build Your Team

Assemble a team to help you through the process. Work with an attorney experienced in business transactions. You need someone who can review and properly structure the agreement to protect you from misrepresentations from the seller, and to ensure the deal closes successfully. Work with your CPA to perform due diligence reviews, business valuations, tax planning on deal structure, and future cash flow projections to ensure a successful transition. Your banker can advise on available financing options and projected repayment terms. You might consider a business broker to help find qualified business leads.

Define Your Goals

Are you looking to expand into new geographic markets or add a new product/service to your offerings?  Purchasing a business could be the quickest way to make it happen. You don’t have to start from scratch creating a business plan, developing processes and procedures, hiring employees, and building a customer base. By defining your goals, upfront you can focus solely on business opportunities that have the characteristics you are looking for, have a workforce and culture that is compatible with your goals, and are priced to allow enough return on investment to support the purchase.  In addition to the financial investment, you also need to consider your time investment.  If the business is in a new industry or lacks management depth, you might need to invest significant hours to make it work.

Perform Due Diligence

How do you know accounts receivables are collectible, inventories, and fixed assets exist, and the company is compliant with all tax filings? Even if the company has reviewed or audited financial statements, you still need to perform a due diligence review of the company.  While an audit or review typically focuses on the balance sheet and ensuring the financial statements conform to Generally Accepted Accounting Principles (GAAP), a due diligence review will dig deeper into the operations of the company and qualitative issues surrounding financial results. Quality of earnings reports should be produced to determine how well the business is performing and the sustainability of earnings into the future. Unusual trends, non-recurring income and expenses, transactions with related parties, changes in accounting methods, and concentrations in customers/vendors are all things that could be identified and skew the financial results. Tax returns and business licensing should be reviewed to make sure the business is registered and current on taxes in all required taxing jurisdictions.

Stock vs. Asset Purchase

Should you buy the stock of the company or purchase the company’s assets?  Buying stock or company assets depends on each unique situation. If you buy the company’s stock, you essentially take the place of the prior owner. The business entity stays the same, and all prior debts and legal liabilities carry over to the new owner. If you buy the company’s assets, then you can set up a new legal entity to purchase those assets or have an existing business purchase the assets. You can also determine what assets you are purchasing if you want to assume any liabilities, and you generally don’t have to worry about prior legal liabilities. By creating a new entity to acquire the assets, you can determine the legal and tax structures of the entity that works best for you.

Negotiating a Contract

Negotiations around the purchase price go far beyond the agreed-upon value of the company. Payment terms can have a significant impact on whether the deal closes. Does the seller want cash upfront? Are they willing to take partial cash and a promissory note for the remainder? Earn-out provisions or commission agreements can be used to keep prior owners or critical employees involved for a period while you are building relationships with the customer base. Typically, a target working capital will be determined for the business and compared to actual working capital at closing. The purchase price will be adjusted up or down to account for the excess or shortfall in working capital. An escrow or holdback could be negotiated as part of the deal to protect the buyer from losses due to misrepresentation by the seller, pending litigation, or post-closing working capital adjustments and tax issues.

Drafting Agreements

A confidentiality agreement is usually required upfront to protect sensitive information shared between the buyer and seller during the process. A letter of intent (LOI) is next laying out the terms and conditions of the potential sale and the negotiation process. This letter is not intended to be a binding purchase contract, but it could have contractually binding components such as an exclusivity period. If you decide to move forward with the acquisition, the actual sales agreement will include the final purchase price, a detail of everything included in the purchase price, and the final terms and conditions. The agreement might include an employment contract for the prior owner to ensure stability during the transition. There could also be additional agreements for the assumption of leases, debts, and other contracts.

Funding The Deal

Once you’ve identified the company and negotiated a price, how will you fund the purchase? You might be able to use personal funds or loans from family members. If you pull money from a retirement plan, be aware of the tax consequences. You could lose a significant amount of the distribution to taxes and early withdrawal penalties. Work with your banker to determine how much bank financing is available, and to understand the financing terms and repayment schedule. Perhaps the seller is willing to finance a portion of the deal. The seller could provide favorable terms or repayment periods. In addition, the seller will have your success in mind if it means being fully paid for the business. You could also look to other investors to help fund the purchase or look to venture capital. In addition to funding the purchase, you should also understand the additional investments required after closing. This could be maintenance or replacement of capital equipment, investment in software, or hiring of employees.

Post-Close Review

As discussed above, there will be post-closing adjustments to the purchase price based on the difference between target working capital and actual working capital. At closing, this difference will be based on estimated working capital. It could be weeks to months after closing before the actual working capital at closing is determined, and the final adjustment is known. In addition, there could be activity occurring in the seller’s bank accounts after closing while the buyer is transitioning payroll activity, automatic withdrawals, and ACH transactions. These items need to be tracked and reimbursed to the buyer or seller. Also, pay attention to the time period available for claims against representations and warranties or escrow funds. You don’t want to find out something was not as represented after the agreed-upon time periods have expired.

How DHJJ Can Help

If you are interested in acquiring a business or need assistance with a current business acquisition, please contact DHJJ’s Mergers, Acquisitions, and Divestitures Group at 630-420-1360 or fill out the form below.