The Insider's Guide
Fifteen steps to owning the company that's right for you
Frank Shannon worked for AT&T for 27 years. His goal was retirement at age 50. But when he was jettisoned with a golden parachute, about two years ago, at age 47, he changed his mind. "If I could run operations for AT&T," he says, "I could do it for myself." He bought a small metal-plating business in Colorado.
Bert Helfinstein bought a business, too. For him the issue was control. He had managed some big companies and grown tired of being second-guessed by boards of directors. "I wanted a situation in which my judgments could prevail," he says.
When Phillip H. Harris purchased a business, this year, he just wanted equity. "I'd always been successful in growing the organizations I was managing," he explains, "but I was never in a position to reap the rewards."
Such sentiments, already common, are becoming epidemic. Business brokers report a surge of interest in small and midsize companies. And the new breed of buyer, typically age 35 to 49, is better educated and more managerially sophisticated than buyers in the past. "We're seeing a lot of people with advanced degrees in business," says Ron Chernak, a broker with First Business Brokers Ltd., in Colorado Springs, Colo. "Before, you saw buyers who just wanted to make a living -- they were buying a job. Now they're looking for good rates of return and accumulation of wealth."
Companies change hands constantly, of course; hundreds of deals are consummated every day. Still, the process of actually buying a business remains stubbornly bewildering. How do you find the right company? How much should you pay for it? Where are the traps along the way?
We put those questions to the experts -- people who have bought companies in the past few years. We also sought the counsel of lawyers, business professors, brokers, and others who traffic in the business-selling world. The result is less a definitive manual (see "The Company Buyer's Resource Guide," pages 5-6, for help finding those) than it is an insider's guide to the steps every prospective purchaser should take. Some are obvious but difficult. (You'll have to price the thing, but how?) Others aren't as tough but are nearly always ignored. (Is this seller ready to leave? Is this an industry you'll really want to work in?)
If there is a general warning running through the comments we collected, it is that business buyers rarely think hard enough about the personal and professional questions that should shape their searches in the first place. The outcome of the hunt, then, turns not on a clear understanding of the role your business will play in your life, but on timing and opportunity -- which is to say, on luck. And there are, unfortunately, two kinds of luck.
The steps:* * *
1. Make sure you shouldn't be starting a company, instead.
You should have solid reasons for buying a company instead of starting one -- and you should know what they are. Buying will reduce risk and save time. Anyone who has started a company knows that it is a long, tough slog to viability. If, on the other hand, you buy smart, your company's operational practices, supplier relationships, and distribution channels will already be established. Key employees and managers will already be there. Customers will know your company and believe, to some degree, in your product or service. And since you are buying existing cash flow, you'll also have a reasonable idea of how much money you can make, not to mention how much operating cash will be needed to make it -- seldom the case in a start-up.
If the risks are lower, however, so are the rewards. Available cash flow will be stunted by the debt you incur to buy the business. And business buyers in any event sacrifice the sheer investment leverage that founders (sometimes) enjoy. You're paying for someone else to assume the risks of starting up; that makes for a bet with shorter odds, true, but also for one with a smaller upside return.
Recognize the buy-versus-start trade-offs, and satisfy yourself that you'll be happy making them.
2. Determine the kind of business you want -- and whether you're capable of running it.
Before you look for a business, do an honest, unflinching self-assessment -- and keep in mind that it will provide the blueprint for everything that follows. What are your goals? What kind of business would enable you to meet them? Are your managerial skills compatible with that business?
In the entire business-buying process, those may be the most important questions that you have to answer. Think hard about what you want. Do you want a healthy business for the long haul or a fixer-upper you can invigorate and sell in a few years? Do you want a retail store, a service business, a manufacturing operation? In what industry? According to brokers, most small-business buyers don't know. "They can pretty much define what they don't want, like maybe fast food, but it's harder to define what they do want," says Don Cunningham, an associate broker with Watson Co., in Spokane, Wash.
Next, think about your expertise. No one is strong in every management discipline, but some skills matter more than others, depending on what the business demands. Several years ago Frank Agliata and his partner moved from New Jersey to Florida and bought Volusia Van & Storage, a North American Van Lines operation in Daytona Beach. Only later did they realize that their background, in sales and marketing, had left them ill-prepared in some fundamental areas.
"We needed a working knowledge of accounting and the ability to read financial reports and profit-and-loss statements," Agliata says. Computer expertise, too. "I knew nothing about computers, and it was a great disadvantage. You often need them for bill generation, payroll, taxes, and sales data -- real basic stuff." The shortcomings hurt a lot, and they could have been anticipated.* * *
3. Consider lifestyle.
Sure, it's nice to have your own business: you've always wanted to be your own boss, you'd like to make more money, and there's prestige in running your own show. But it's hard work. As a rule of thumb, figure the amount of time you think you'll spend running the business, and then double it.
"If you have a job, you can go home at 5, and even with a responsible position it's a lot easier to block things out," says Agliata.
Frank Shannon, the former AT&T manager, did the right thing: he adjusted his business aims to meet his lifestyle goals. "My wife, Linda, and I sat down and said, What do we want our lives to look like?" he explains. "How hard do I want to work? Do I want to hustle sales all day? Linda had been in real estate for nine years, and we wanted our weekends back. We prepared such an extensive list of criteria that it entirely eliminated some business sectors, like retail and a lot of service stuff. But it really helped us narrow the search."* * *
4. Consider location.
Your financial resources will be the most important factor in determining what size business you can buy, but location affects the affordability equation, too. If you are wedded to a specific area, not only do you narrow the field of potential candidates, you also might wind up bending your objectives to meet the area's economic environment.
Shannon lived in San Francisco. He thought he couldn't swing an acquisition there, but he could in Colorado Springs, where real-estate, labor, and other costs are lower. He bought his metal-plating company, Finishes Ltd., in July 1990 for $180,000. He doubled revenues to about $400,000 in his first 12 months, and he expects to double them again this year.* * *
5. Consider lifestyle again.
The truth is that far too few prospective buyers address this question seriously enough -- and far too many sad tales result. Realize that you may own this business for a long, long time. It had better be something you enjoy. If you're miserable in it, it doesn't matter how much money you make.
6. Cozy up to lenders in advance.
The nitty-gritty of financing a deal will come later, once you and the seller have agreed on a price. But nobody will even consider selling you a business if you can't pay for it. Where will the money come from? In nearly all acquisitions today, the seller finances a significant portion of the purchase price, sometimes more than half. But you're going to need more capital to make the down payment and operate the business, and smart sellers will want to know you can get it.
Lawyer Susan Pravda, a partner in the Boston office of Milgrim Thomajan & Lee, specializes in middle-market acquisitions. She recommends building banking relationships at least four months before the purchase. "Go to three local banks, and explain that you're thinking about buying a business," she counsels. "Tell them you can't provide specifics, you just want to know their lending parameters. Take bankers out to lunch; develop a rapport. When the seller asks if you have a bank, you can say you're on good terms with some bankers."* * *
7. Prepare to sell yourself to the seller.
Expect sellers to be skeptical of you. You're asking to buy their baby; what's more, you're asking them for the money you'll need to do it. Can you carry the deal to fruition? The sellers know that if the deal collapses prior to closing, the business will be tarnished; even if the company is fine, new prospective buyers will suspect otherwise. To allay sellers' fears, you have to enter negotiations fully prepared.
"Think about what the seller is going to ask you, and get answers in advance," Pravda advises. "Create the résumé you need to be a good buyer."* * *
8. You've defined the kind of business you're after; now find the right company.
When you buy a house, the multiple-listing service can tell you every property listed for sale in your area and price range. There is nothing really comparable for businesses. News-papers advertise some offerings, as do several national listing publications. But most of the quality companies that are sold are never marketed or advertised. How do you find them?
Consider the experience of Bert Helfinstein, who had run six companies, including a $500-million computer retail chain. In seeking a business of his own, he encountered a basic paradox: sellers don't want it publicly known that their companies are for sale. If word gets out, it can be disruptive. Employees might leave; customers might go elsewhere.
In the end Helfinstein identified three ways to find companies that, in some sense, don't want to be found.
* Networking. In any community, there are people privy to the business grapevine. Usually they are confidants of company owners: lawyers, accountants, venture capitalists, investment bankers. "You have to find these people," Helfinstein says. "Take them to lunch. Ask them who else is in the know. Develop a network of people who can help, and over time you start hearing about potential deals." Helfinstein's network led him to Viteq Inc., a $6-million manufacturer of computer-power equipment with headquarters in a suburb of Washington, D.C. He bought it in April 1990.
* Business brokers. As a rule, they handle deals worth less than $5 million, although a few outfits work in the $10-million-to-$100-million range. You'll probably end up talking with a broker at some point; brokers know which companies are formally on the market. The danger is that if you look only at businesses that happen to be for sale, you may end up acquiring one merely because it is available -- not because it meets your carefully assessed needs.
Another caution: this is a largely unregulated industry. In 19 states and Washington, D.C., brokers must have a real-estate license. Elsewhere they need no permits or credentials. Some of them are good, particularly those who are CPAs or lawyers. Others, it's sad to say, can be shady. In virtually all cases, brokers work for the seller. With commissions of a hefty 12% for a small transaction and negotiated fees for the larger deals, they are looking to get top dollar. Moreover, there's a revolving door -- whatever they tell you they are telling the next person who walks in. Exclusivity is zilch.
* Targeting. Once you know the kind of company you want, identify all those businesses in the location you'd like. Look in the phone book. Call the owners and ask them, point-blank, if they're interested in selling. On average, 3 of every 10 such cold calls attract some interest. The owner says, "Yeah, maybe. Let's talk."
Often the best business to buy is one the owner has never considered selling. For one thing, it probably has fewer problems. For another, by being the one to introduce the idea, you get the inside track. Chasing this sort of deal may take longer. But your hit rate will be higher, and without competing buyers you'll end up getting a better price.
Phillip Harris drew a circle around Boston, where he wanted to live, and used the federal government's standard industrial classification (SIC) code system to narrow his search. He went to Dun & Bradstreet Information Services, which refines and tailors SIC data for a price, and said he wanted a list of all companies in certain SIC codes, by location and size.
Some 250 Boston-area prospects fit his profile. He liked 20 of them, made offers on 10, and ultimately purchased QuadTech, a $12-million maker of test and measurement instruments in Bolton, Mass.
A successful search requires hard, painstaking work. "You can't do this casually," Helfinstein says. "You have to plan it, make it a job, and go about it in a businesslike, systematic way. Get an office. Keep careful notes of every contact."* * *
9. Choose the right seller.
The big question is, Why is the seller selling?
Sometimes it's obvious. Pravda describes the perfect seller as a 75-year-old whose children have no interest in the business, who has no idea what the business is worth, who never wears a jacket and tie to work. "I want to walk in there and get him to tell me about his business, take me to lunch, bring me home to meet his wife. This isn't his business, this is his baby. He created it. And I want him to look at me and say, 'I want you to own my business.' Because once you've made this connection, money is no longer the most important thing to him. He's not going to sell his baby for a better price to some jerk from Wall Street. You are already part of his family -- he's adopted you."
But what if the seller is 45 and in good health and has no clear reason to sell? It is critical to determine the veracity of his or her explanation. Is the seller trying to unload a dog? Is there pending litigation? Is the market collapsing? Apply the smell test. If something doesn't square, back off.
It's not imperative that you like the seller personally, but it is important that you trust him or her. In many cases, you might want the seller to remain for six months or so to introduce you to suppliers and key customers. Also, if the former owner stays for a while, employees will have a sense of security and continuity.
Remember, too, that in almost all cases the seller will "carry paper" to help you finance the deal -- an arrangement that will make the two of you quasi partners until the debt is retired. That's another reason to be sure your relationship is built on trust, not just on contracts, which can be hard to enforce.* * *
10. Do research before setting the initial price.
The process of doing research to determine an initial price, and getting the seller to agree to it, will help ensure that the seller has cleared whatever emotional hurdles exist and will indeed sell the company.
You'll need to make a "book" on the company. Spend a day or two there, poking around and meeting with management. Ask about market share, sales trends, and growth potential. Get tax returns, balance sheets, and if possible, at least five years' worth of audited financial statements. Obviously, you must pledge to keep that data confidential.
Expect to see some shabby record keeping. "Entrepreneurial businesses are often run sloppily because the owners have everything in their heads," says David Jensen, a management professor at Bucknell University. "They want to save money, so they don't pay for formal audits. They may just have an accountant do a limited review."
Another caution: the owners of a privately held company often use it as a personal checking account. The business pays for everything from their cars to their country club. The goal is to suppress earnings and minimize taxes. When it comes time to sell, of course, they want to show cash bulging out of every nook and cranny. In cases like that, you might have to reconstruct the cash flow. Accountants can help.* * *
11. Make sure your letter of intent is specific.
Writing a detailed letter up front can save you a lot of time and money later. It's smart to involve a lawyer experienced in acquisitions. According to Susan Pravda, the document should set out such terms as deadlines for signing the letter and, later, completing a purchase-and-sale agreement; payment terms; an escape clause that rests on due-diligence findings; a management-equity plan; a definition of what -- stock or assets -- is being sold; confidentiality for the seller; and exclusivity for the buyer.
The matter of management equity is often ignored, but Pravda says it's common in smart deals to set aside 10% to 20% of the stock for managers. Sellers who care for their key people want to do well by them, and buyers want to keep key people on the team.
The question of whether the sale involves stock or assets is even more important, but Pravda finds that a third of buyers and sellers never discuss it. "Maybe they don't know the difference," she says. "If I'm the seller, it's easy. I always want to sell the stock, because I only pay tax as a stockholder, and I get rid of everything -- all my assets but also all my liabilities.
"But if I'm the buyer, I want all the assets and no liabilities. I want all the good stuff, and the bad stuff is yours. Maybe I will take some liabilities, but only those you tell me about."* * *
12. Don't skimp on due diligence.
During this phase, which can take several weeks or even months, you essentially ascertain whether what the seller has told you is true. Exercise extreme caution, and assemble the finest team you can afford. There is no substitute for top-notch advisers.
You need an accountant who understands how small businesses keep their books. You also need a lawyer to examine all papers and to check on any liens, litigation, or tax problems. Has the company ever been audited by the IRS? If the seller doesn't know, find out. "Be aggressive as a buyer on the tax side," counsels Pravda, "because it can really come back to bite you."
You can also be hurt by misunderstood inventory values. When Dennis Houser bought B&P Duplicating Ser-vices Inc., in Ormond Beach, Fla., four years ago, he thought he'd save money by relying on an audit by the seller's accountant. "It wasn't far off," he says, "except that the inventory that showed on the books was obsolete junk. I looked at it myself but didn't know what I was looking at." Consequently, when he bought the business for $310,000, he overpaid by $100,000. "It was just from stupidity and ignorance," he says now.
Beyond that, get lists of major customers and suppliers. Evaluate their relations with the business. Check for long-term purchase agreements. And evaluate the company's, and the owner's, reputation in the industry. Talk to competitors. The more you know, the better off you are.
Last, if there is any chance of environmental liability, have an expert conduct an audit. If you buy a business that ends up in a lawsuit -- even if the damage happened long ago -- it will likely be your problem now, and it can put you out of business.
Investigating all that is tedious, but you must be relentless.* * *
13. Be skeptical.
This point can't be overemphasized. Even if you love the company, look for reasons not to buy it. Base your decision on fact, not emotion; this is probably the biggest financial event of your life. "I was not skeptical enough. I looked for the positives," says Frank Agliata of Volusia Van & Storage. "That was a mistake."
14. Don't forget to assess the employees.
You're not just buying a company; you're also buying the people. Give serious thought to who they are. Are they bright and competent? What are they paid, and exactly what do they do? Is there good chemistry -- are they the sort you'd invite home to dinner? And do they seem honest? Several years ago a Virginia woman bought a natural-foods store. The clerk, who came with the deal, had a strong rapport with the customers -- so strong, in fact, that she started selling them natural foods out of the back of her car. It took the new owner, baffled by plummeting sales, three months to figure out what was happening.
Meet with employees individually, without the seller. They can tell you things the seller never would. "I chatted at length with all of them," says Frank Shannon. "Before I'd buy any business, I'd want to do that."
Be aware that they're concerned about their jobs -- a change of command can be traumatic. So provide whatever assurances you can. Unless the company is tiny, you can't run it without key people. If their allegiance is to the old owner, will they stay?* * *
15. Make sure the final price reflects the real value.
There is no magic formula for valuing a business; in truth, even the owner usually doesn't know what the company is worth. Nor can your accountant tell you. Nor your lawyer. Setting the price is as much art as science, but there are some guideposts. David Bishop, president of American Business Appraisers, based in Sunriver, Ore., suggests thinking of a business as a money tree. It exists to bear earnings.
First, define which earnings base you're dealing with. Are you talking about earnings after tax, after depreciation, and after interest on debt, or before those items are deducted? The owner's compensation -- at fair market value -- should enter the equation, too.
The next step, Bishop says, is to come up with a multiple for that earnings base. It likely will fall between one and eight, depending on variables. If 80% of sales are to one customer, for instance, the company's earnings are more at risk than if sales are broadly based. If the company has equipment and vehicles that could be liquidated to recover much of your investment, it's worth a higher multiple than a service business with few hard assets is. Does it have patents, copyrights, or proprietary technology? What is the level of competition? How elastic is the demand for its products?
Let's say you've weighed all the factors, and the seller insists on getting eight times earnings, while you think a multiple of five is more realistic. What then? You can hire a certified appraiser, pay $4,000 to $10,000 for a comprehensive report, and wait 30 days for it. Or you can negotiate.
But be careful. "One of the main reasons businesses fail once they are bought is that their real value has never been identified," Bishop says. "Price and value get distorted. If the buyer is overloaded with debt that the company's cash flow can't service, both buyer and seller lose. If the buyer defaults, the seller never receives the great price he thought he got."
Throughout the process, the old saying applies: let the buyer beware. If you execute all the steps well, in the end you'll own a business. Then all you'll have to do is make it work.
GETTING IT WRONG
How buyers sabotage their companies before even closing the deal
There is no end to the errors of commission and omission made in the buying of businesses. It's a complex procedure, and you don't get to practice -- most people do it only once. How do business buyers most frequently undermine their chances to succeed as owners?
* By acting under pressure and buying a company that's a poor personal fit.
* By paying too much money up front, leaving insufficient working capital.
* By placing too much faith in existing management and failing to bring in new blood.
* By assuming that sales will remain stable after the acquisition -- not realizing that competitors view a change in ownership as an opportunity to strike at existing customer base.
* By acquiring a business in which the buyer has neither experience nor, ultimately, any real interest.
* By assuming that the technology is proprietary and therefore cannot be duplicated.
* By underestimating how difficult it is to change an established company's culture.
* By assuming unwanted inventory, divisions, or real estate can be quickly disposed of to reduce debt.
* By failing to realize that the market is more mature than it appears, leaving little room for growth.
* By learning too late that the seller, by retaining title to real estate or equipment, can continue to extract serious capital from the business.
* By relying too heavily on a contract with the seller, leaving the legal system as the main recourse in disputes.
THE COMPANY BUYER'S RESOURCE GUIDE
Business-for-sale listings services
FirstList (Vision Quest Publishing, P.O. Box 1481, Highland Park, IL 60035, 800-999-0920).
Quarterly listing of 1,600 to 1,900 private businesses for sale. Annual subscription ($350) includes four additional midquarter updates. Entries include selling price, profit levels, product or service description, and general location.
World M&A Network (International Executive Reports, 717 D St. NW, Washington, DC 20004-2807, 202-628-6900).
Quarterly listing of approximately 1,000 private businesses ranging in price from $1 million to $100 million, arranged by industry, size, and location. Annual subscription ($345 and $445, depending on delivery options) includes supplemental updates, sent by fax.
Business Ventures Magazine (Business Service Corp., 569 Division St., Suite F, Port Orchard, WA 98366, 206-876-0204).
The publication ($30 per year) lists approximately 1,000 businesses for sale each month.
Books and publications
Business Valuation Manual, by Thomas W. Horn (Charter Oak Press, P.O. Box 7783, Lancaster, PA 17604, 717-560-9338); $29.95 plus $2.50 postage.
Useful techniques for pricing companies.
Buying a Business: For Very Little Cash, by Joseph R. Mancuso and Douglas D. Germann (Simon & Schuster, Mail Order Billing, 200 Old Tappan Rd., Old Tappan, NJ 07675, 201-767-5937); $14.95.
A soup-to-nuts guide to buying small and midsize companies; includes information on franchises.
Buy the Right Business at the Right Price, by Brian Knight and the Associates of Country Business Inc. (Upstart Publishing Co., 12 Portland St., Dover, NH 03820, 603-749-5071); $18.95.
A comprehensive guide to the process of acquiring small and midsize businesses.
The Business Planning Guide, edited by David H. Bangs Jr. (Upstart Publishing Co.); $18.95.
Valuable information on writing a solid business plan.
Guide to Buying or Selling a Business, by James M. Hansen (Grenadier Press, 7900 E. Mercer Way, Mercer Island, WA 98040, 206-232-8300); $41.
Advice on analyzing financials, evaluating management, and valuation.
Valuing a Small Business, by Shannon Pratt. (Business-One Irwin, 905 W. 175th St., Homewood, IL 60430, 800-323-4560); $75.
Information on the arcana involved in setting a price.
Directories of companies
Thomas Register of American Manufacturers (Thomas Publishing Co., 1 Penn Plaza, New York, NY 10119, 800-222-7900, extension 200); $240 plus $15.80 for shipping.
A listing of 145,000 U.S. companies, their addresses, and the things they make.
Million Dollar Directory: America's Leading Public and Private Companies (Dun's Marketing Services, 3 Sylvan Way, Parsippany, NJ 07054, 800-526-0651); $1,250.
A five-volume series listing 160,000 companies and their addresses, officers' names, and SIC codes, along with a brief description.
Directory of Corporate Affiliations (National Register Publishing Co., 3004 Glenview Rd., Wilmette, IL 60091, 800-323-6772); $687.
A "Who Owns Whom." The family tree of every major corporation in the country. Comprises about 25,000 companies.
The following are trade publications useful to potential business buyers. The journals can provide background about market leaders, major customers, and economic trends.
The National Review of Corporate Acquisitions (Tweed Publishing Co., 49 Main St., Tiburon, CA 94920, 415-435-2175); weekly; $295.
Buyouts (Venture Economics, Suite 700, 75 Second Ave., Needham, MA 02194-2813, 617-449-2100); every three weeks; $395.
Mergers and Acquisitions (MLR Publishing Co., 229 S. 18th St., Philadelphia, PA 19103, 215-790-7040); every two months; $269.
Brokers and appraisers
Brokers: To find reputable business brokers, contact the International Business Brokers Association (118 Silver Hill Rd., Concord, MA 01742, 508-369-5254). The IBBA bestows a designation called "certified business intermediary" (CBI). To earn it, brokers must take classes and pass examinations.
Appraisers: To locate qualified appraisers, contact the Institute of Business Appraisers (P.O. Box 1447, Boynton Beach, FL 33435, 407-732-3202). Or get in touch with the American Society of Appraisers (P.O. Box 17265, Washington, DC 20041, 800-272-8258). Both groups conduct certification programs.