The small business-for-sale marketplace presents an opportunity for the budding entrepreneur to try their hand at business ownership without having to start from scratch.

By purchasing an already established business, new owners have a head start on success: Inheriting an existing customer base and a trained workforce to name are among the top benefits. And unlike a startup, existing small businesses have proven cash flows, approved credit lines and many of the licenses and permits necessary for operation.

Once the decision to purchase a business has been made, buyers then face the often overwhelming task of finding the right business fit. Geography and industry are obvious filters for prospective buyers; however, buyers need to analyze the financials and terms of the deal to truly understand if a listing is priced fairly and whether the business is built for long term success. Before you begin combing through financial statements, it's first important to understand the following terms and tools used to measure business performance:

  • Cash flow. Cash flow statements are like a business' checking account -- it shows the money flowing in and out of a business and the amount of "cash" on hand at any given time. A positive cash flow means there is more money coming in than going out and that the business owner has enough cash to cover all of the bills. Similarly, if a business' cash flow is negative, buyers should be cautious and only dive in if they have a true plan to make the business increase sales and/or decrease expenses.
  • EBITDA.Known as the earnings before interest, taxes, depreciation and amortization. EBITDA removes the cost of debt capital and taxes to gauge the earning potential of a business. EBITDA is often used in valuation ratios and is essentially the net income with interest, taxes, depreciation and amortization added back into the equation. In stripping away depreciation and amortization, an EBITDA valuation reveals how well a company is doing financially and gives buyers an idea of how much cash a business can generate before paying off its debts. 
  • Multiples.Used as a multiplier of revenue and/or cash flow, multiples are used to assess the value of a business compared to similar businesses in the same sector and location. For example, according to BizBuySell's Insight Report, the average revenue multiple of restaurants sold in 2017 was 0.39. Based on this multiple, a restaurant with $500,000 in revenue would have an estimated worth of $195,000 ($500,000 cash flow x 0.39 multiple). While it's best to use a professional appraiser or business broker to assess true value, multiples are a great method for an initial valuation. 
  • Balance sheet.A business' financial health can be evaluated using a balance sheet, which balances a company's assets against the sum of liabilities and shareholders' equity. With a solid balance sheet, buyers can better understand how a business is performing financially before committing to an investment. 
  • Income statement. Also known as a profit and loss statement, an income statement calculates a business' profits by weighing revenue against expenses. For buyers, an income statement reveals a company's ability or inability to generate profit. To calculate this report, buyers should start with revenue and subtract the cost of doing business, like the cost of inventory sold and additional operating expenses, to get a business' profits or earnings. 

The ability to spot and evaluate any one of these financial figures and documents prior to negotiating with a seller can provide a big advantage in find the right business, however they may not tell the complete story. Buyers should use provided financials as a starting point, but plan to take a deeper dive with the selling owner. The is especially important as one-time expenses such as a company car will impact the bottom line, but may not be relevant to the incoming owner. Understanding the true nature of expenses in specific gives the buyer a better projection the true potential of the business.

Once a buyer is ready to move forward based on a business, a transaction purchase agreement should be made to condense negotiations into a single legal document that describes the sale. To prevent delays in the transaction process and ensure there are no surprises once the transition begins, here are four questions buyers should ask themselves before shaking on the deal and signing that agreement:

  1. Does the purchase description include an asset addendum?As part of the transaction agreement, the purchase description must include details like the business name, address and interests. The description should also provide a comprehensive itemization of assets related to the final sale. If a business has more than one location, the purchase description needs to include all the locations and clearly state what assets will be transferred to the new buyer.
  2. Is the price broken down into categories?From the initial point of contact to the final closing, the asking price will undergo several rounds of negotiation. That's because the value of certain assets are also subject to change. Buyers should clarify with sellers that every asset is broken down into specific categories, such as "inventory" and "equipment", and ensure each category is assigned an accurate value. Businesses that continue to operate during the transaction, for example, will result in a change in inventory. It's important that buyers take into consideration the final value of each asset category at closing, as these adjustments will influence the final price. In addition, a manageable level of working capital should be included as part of the deal. This can be a complicated topic in negotiations, but it's important in ensuring the business has the resources to operate seamlessly after the transaction.
  3. Are there any outstanding warranties or seller responsibilities?Even after a business changes hands, the relationship between the buyer and seller doesn't have to end. A seller can make certain promises to buyers in the form of warranties, which serve as an extension of due diligence for any hidden liabilities that could devalue the business. Sellers also have several operations-related responsibilities they will need to fulfill before final closing. Buyers will want to ask for written assurances to ensure the business they inherit is the one they agreed to the day they signed.
  4. Was a seller's discretionary earnings (SDE) number provided?Also known as discretionary cash flow, SDE shows how much the business earns after backing out the owners salary and non-recurring and discretionary expenses. It also helps buyers accurately predict their return on investment. Using the owner provided SDE as a baseline, buyers can factor in their own desired salary and set of non-recurring and discretionary expenses when estimating how much money the business will generate for them.

Purchasing a business is a daunting task, but by taking the time to properly understand the financial history and terms of the deal, buyers can reduce their risks and ensure a smooth transition. Understanding what to look for will help determine the true value of a business and provide more power to successfully negotiate and close the deal.

Published on: Jun 13, 2018