Dear Dave

Dave,

It’s always been a dream of mine to buy and own a business. A few weeks ago, I was approached with an opportunity that could make this dream come true. How do I know if what I’m being offered is a good deal and if I’m ready for something like this?

Lee

Lee,

Buying a business can either be one of the greatest purchases of your life, or one of the biggest mistakes you’ve made. And I’m going to do my best to keep you from making a mistake.

I want you to think seriously about a few things and keep some questions in mind. Then, at the end, if you still think buying is a good idea by the end of this article, you might be in business. 

Imagine waking up on a Monday morning one year from now. Are you still enthusiastic about this line of work? Your vocation needs to be a vacation. Otherwise, running a business is too much work. If you’re only in it for the money, you’re setting yourself up for failure, because there isn’t enough money in the world to make you work as hard as you’ll have to work running a small business.

Think about spending some time around the business. Sit in there for a week to see how it operates, and learn all the ins and outs. Then, if you’re truly invested and passionate about this new business opportunity, move on to my next question—what’s the business worth?

A business is only worth the income it creates. It doesn’t matter if it’s in a really great location, or if it’s a well-known brand name. Those things have no value if they’re not creating income, so figure out the net profit of this business.

Notice that I said net profit, not just sales. When determining the business’s worth, you need to focus on all three areas—gross revenue, expenses and the profit it generates as a result. Become an expert on the business’s financial performance. Ask to see their past three years of financial statements, so you know what you’d be getting yourself into. Once you’ve done that, ask what you’ll make on your money. You can make about 12% with a good mutual fund, so if you’re going to take the risk of buying a small business, you’ll want to make at least 20% on it.

Another number to look at is the book value. If you collected all the receivables, and you sold all the equipment and the inventory and closed the business, what would you have in your pocket? That’s the book value. If the business currently has $40,000 in inventory, $30,000 worth of equipment and $30,000 in receivables, the book value of that business is worth $100,000. Somewhere in between net profit and book value is a fair price. If the net profit of this business is $60,000 and they’re asking $185,000 for it, then that’s a pretty good buy. But you need to really get into their books and make sure their numbers are real.

And even if you’re great with numbers, it’s a good idea to find a financial expert to help you through this process. It’s an extra set of eyes to review and verify all the documents and give you an unbiased opinion on the deal.

Next, what are the costs of running the business? As you’re researching what the business is worth, you’ll come across the costs of keeping the business running while you’re researching what the business is worth. But your homework doesn’t stop there.

Take time to really examine the business and understand everything that goes along with keeping it afloat. This includes employee payroll and benefits, insurance, taxes, contracts, inventory, leases, cash flow—and anything else that helps run the business. Take time to think about the future, too. Do you want to keep the business where it’s at, or grow it? What are your five-year goals for this business? Are there any expenses you may need to factor in to get there?

Finally, what’s included? When buying a business, you need to find out exactly what’s included in the asking price. How are they deciding the value of their business? Does the price include current inventory? Office equipment? Furniture? Get a list of everything that’s included from the seller and what kind of condition it’s in. And don’t just take their word for it. Go check out their stuff yourself. It’s also important to know all the baggage that might be included in this buy. Are there any debts or liens involved? You don’t want to buy a business only to find out you bought someone else’s problems.

One of the best benefits of buying an established business is that customers are included. The business should come with at least something of a reputation (hopefully a good one) and customers already in place. But be aware, many sellers will try to exaggerate how much their reputation and customer base are worth in finding their selling price. That’s why studying their books and knowing their customer satisfaction is so important.

So, how’re you feeling about things now, Lee?