Step-by-step guide to buying a business
1. Cash Flow Requirements. No one buys a business unless they feel confident they can make it grow, however, the net cash flow of the business following change of ownership must meet, or come close to meeting, your monthly expenses. Be realistic about how much cash flow you need in the first year of operation.
Let’s say you determine, for example, that you require $10,000 a month, or $120,000 per year, in net cash flow. Will your needs be met by a business that advertises that amount in Seller’s Discretionary Cash Flow (alternatively referred to as Seller’s Discretionary Earnings)? Only if you pay all cash! Otherwise, you must consider debt service. Whether you borrow money from the SBA, or from the Seller, your net cash flow after debt service will depend on how much you borrow, the interest rate, and the term of the loan. As a general rule, figure five years for a Seller note and 10 years for an SBA loan.
Example: If you buy a business for $300,000, with 20 percent down ($60,000) and 40 percent ($240,000) financed at 5 percent with a 10-year SBA loan, your monthly debt service (principle and interest) will be approximately $2,545. If the business generates $10,000 per month in Seller’s Discretionary Cash Flow, that amount is reduced to $7,455 after debt service.
2. Cash Investment and Working Capital Requirements. Most businesses sell for a multiple of two to three times the Seller’s Discretionary Cash Flow (SDCF). In the current lending environment, with a purchase price of $300,000, you will need a cash down payment of 20 percent ($60,000). In addition, you will need at least two to three months of working capital (fixed costs like payroll, rent, etc.). You will probably need total cash of between $75,000 and $100,000.
3. Prepare a Personal Financial Statement. Virtually all brokers representing sellers of businesses will require two documents from you prior to releasing detailed, confidential information about the business opportunity. One document is a standard Non-Disclosure Agreement. The other is a personal financial statement, required by the broker so that he can fulfill his obligation to the Seller to fully qualify buyers. Most brokers will accept an up-to-date statement prepared on your computer in lieu of their financial questionnaire. Your statement, similar to the balance sheet of a public company, should clearly show all assets and liabilities, including the cash available for investment, and the equity you possess in real property. To really get the attention of the broker and show how serious you are, turn this statement, as well as recent bank and brokerage statements, into PDFs that can be attached to an email.
4. Consider the color of your parachute. The more successful you are in finding a business closely aligned with your passions, talents and work experience, the greater the chance you will run a profitable and growing operation. If you can leverage your skills running a business in a growing industry, you’ve hit a bull’s eye. But be flexible in this regard, too, because a rare opportunity may present itself in a business type that represents your second or even third choice.
5. Hire a broker. Why do all the leg work yourself, when a professional can do a large part of it, at absolutely no cost to you? As in real estate, a business broker representing the Buyer receives a split of the commission paid by the Seller. A broker can help you track down opportunities, conduct preliminary due diligence, and set up a question and answer meeting with the Seller. One caveat: not all listing agents “cooperate” with brokers representing buyers. They are not compelled to do so, and they may feel that the opportunity is lucrative enough that buyers, of their own accord, will knock down their door. In that case, the listing agent may end up representing both sides of the transaction, a practice referred to as “dual agency.” If your broker tells you that the listing agent is not cooperating on the sale, do not ignore the opportunity. Instead, make your own, direct inquiry to the listing agent.