Evaluating a Potential Acquisition: What Makes a Business Worth Buying?
Now that you have started your search, it's time to evaluate each business that sent you more information after signing the NDA. This step will involve reviewing buyer information packets also referred to as the executive summary. These should include 3-5 years of financial statements. At minimum, the packet should have current and previous year P&Ls and a balance sheet. Many brokers will also attach business tax returns to verify the financial documents provided. Other information found in the packet could be a summary of the business history, key employees, sales numbers, and growth potential.
To help you understand how to find a profitable business to buy, the top 5 characteristics of a good business acquisition are below. It may be difficult to find all of these in a business priced under $500,000. If the business is lacking in one or two of these categories, you have to calculate the risk and decide whether to move forward or cross it off the list. For example, a business with only a few key customers is a higher risk than a business with a diverse customer base. However, it could still be a good buy if those key customers continue to buy from the business.
If you do find an existing business that has all the elements below, take it to the next phase and schedule an interview with the owner. From that meeting, you can assess if a potential deal would work. Here are the key features to look for when evaluating each business to buy:
#1: Stable Revenue and Profit
The single most important factor in finding a business worth buying is profitability.
Profit and stable revenue are the reason for buying an existing business. To actually skip the startup phase, a business needs to have established revenue and make money. Otherwise, you could build a company from scratch and not take on the debt.
When you are looking at businesses online and collecting executive summaries from brokers, always take some time to study the P&Ls and balance sheet. Review the revenue over the past 3-5 years. Has it stayed about the same? If not, what occurred in the outlier years that caused a decrease or increase in revenue?
Lately, I've noticed businesses in the home services and renovation industries had significant growth in the past few years due to the pandemic. For example, a gardening center with steady, slow revenue growth in the years leading up to the pandemic experienced a revenue jump of 40% in 2020-2021. In the area this store is located, everyone went under lockdown and many people started changing their houses during Covid. Is that number likely to continue or was it a one year wonder due to the circumstances? Make sure you are not buying based on numbers that are not sustainable. Remember the price of the business is based on the profit of the last few years. A second great example was the growth in the RV and boat dealership industry. There was a huge spike in sales due to the pandemic.
Another common thing sellers like to do is combine the sale of the business with the real estate asset where the business operates. This has advantages and disadvantages for the buyer. For the SBA loan, you can be at an advantage. By combining the real estate with the business purchase, the bank will give you a longer loan term which will lower your monthly payments. The disadvantage comes when the real estate is overvalued and the new payment for mortgage would be significantly more than what is in the current P&Ls. For example, I recently looked at a company that wanted to sell the real estate with the business for a million dollars more than the current owners paid for it five years ago. The SDE for the company was right under $300k, and the P&Ls included paying $36,000 a year for the mortgage on the building. The debt service on the business with the real estate would be $168,000 a year, which cut the SDE in half. The business had a few other problems, but this was the ultimate reason I walked away from the deal.
Pro Tip: If you are provided with handwritten financials, this is a huge red flag. Clean books can be hard to find, but you should think twice about a business that doesn't have more sophisticated financial records. One business I inquired about actually provided a scanned copy of a napkin with only cash transactions handwritten on it. That one went to the "no" category immediately.
#2: Opportunity for Growth and Improvement
It may seem early to think about exit planning before you even purchase the business. However, if the goal is to grow the business and sell it for a profit, there needs to be growth potential. There are many ways to improve the business. The first and most obvious place to consider is sales. Are there ways to increase sales or products that could be added that fit with the type of business you are considering? What do competitors offer? Are there potential new referral sources that would promote growth? Many times, the executive summary will have a section about growth potential. If it doesn't, these are excellent questions to ask the broker or current owner.
Research the industry. Is the business in an industry that is steady or growing? If the industry is declining, that may be a reason to reconsider the deal. Is there potential for Amazon or a similar large company to cause the business revenue to decline? One business I reviewed recently eliminated themselves from consideration by sharing that the business sales had increased dramatically due to supply chain issues with bigger corporations. Their product was more expensive than the national brands, but problems caused by the pandemic increased sales. What happens when those short-term supply chain issues are solved and the national competitors offer cheaper products? These are all things to consider when thinking about growth.
Lastly, ask questions about how the business is currently run. Think about how you can add value. Do they have outdated systems that could be improved to promote better efficiency and more customer satisfaction? This could lead to more sales and referrals. Are the systems in place maximizing the potential of the current employees? Increasing productivity is another way to increase revenue. Always ask questions that give you a full picture of how the business operates to understand ways to improve the operations.
#3: Business Longevity and Knowledgeable, Tenured Staff
Look for a business that is established. According to data presented by the Bureau of Labor Statistics’ Business Employment Dynamics, about 20% of businesses fail in the first year and by the fifth year approximately 50% have failed. For that reason, I'd recommend finding a business that has been established for at least 5 years. The longer the better. This is part of what you are buying.
The other important part about buying an established small business is the knowledgeable, trained staff you will inherit. Look at the length of time each employee has been with the business. Ask about key employees and their years of service at the company. According to Indeed, a long-tenured employee is considered anyone who has been with an organization for 5 years or more. A short-tenured staff is one possible reason for not buying a company.
Pro Tip: Understand that nothing is guaranteed with employees. Under new ownership, they may leave or become less productive. Ensuring a smooth transition period with the help of the current owner is key to gaining the trust of employees. It is good practice to learn the roles of all employees during your first six months just in case you need to step in temporarily or replace any employees that leave.
#4: A Good Reputation
The reputation of the company is a big part of what you are buying. Keeping customers happy and continuing to have a good referral base will help ensure the success of the company and grow it in the future. Do a search of the company online to determine its reputation within the industry and with customers. If they work with the public, how are the online reviews? If they sell a product, are customers satisfied with it? You can learn a good amount from a quick google search.
When looking at the reviews, consider the complaints. Could you fix these problems when you take over ownership? That could help grow sales and improve reputation. Is there a specific employee getting the negative reviews? That might be an easy fix. Reputation isn't always a deal breaker, but it helps when customers have an already established good opinion of the company.
#5: Diversified Customer Base
Lastly, it is a good idea to look for a business with a diversified customer base and a number of referral sources. You don't want to put all your eggs in one or two baskets. Speaking from experience, it can be stressful keeping one or two key customers happy because they make up over half of your sales. Losing one of those customers could sink your business or significantly impact your profit.
Having a diversified customer base mitigates some of the risk in acquiring a business. There is no guarantee all your customers will support a change in ownership. Having a large number of customers will help you in being successful when you take over and start running the business.
To summarize, the top characteristics to look for when selecting a business to buy are stable revenue and profit, opportunity for growth and improvement, business longevity and knowledgeable staff, a good reputation, and diversified customer base. If you find all these characteristics in a business, it could be a perfect opportunity for your venture into entrepreneurship.
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