What is the due diligence process?
What are some creative financing options?
What are the benefits of buying a business instead of starting one?
Merriam-Webster Dictionary defines due diligence as “research and analysis of a company or organization done in preparation for a business transaction.” Ultimately, due diligence is the process of being sure that things are as they appear before a deal is sealed. For someone considering a merger or the purchase of an existing business, the review of documentation and the answers to your due diligence questions are critical. It’s a complex process that can be time-consuming, but with so much on the line with any merger or acquisition, you don’t want to make a decision to purchase without all the information you need. You want to be absolutely sure everything is reviewed and all questions are answered to your satisfaction.
During the due diligence process, an often lengthy list of documents should be provided. The list of documents should cover a range of areas, including:
- Legal structure and incorporation of the company
- Internal Revenue Service (IRS) records
- Organizational structure
- Personnel policies
- Capital and real estate
- Contracts, licenses, agreements and affiliations
- Technology and Intellectual Property
- Current or potential legal liabilities
- Marketing materials
Today more than ever, buyers are putting more emphasis on the due diligence process. And while the financials are a key component, the due diligence process should also consider organizational items. Be sure to seek documentation and ask important questions about the company’s culture, strategy, leadership and competencies. An experienced business broker can provide consultation through this entire process.
Although the due diligence process may take considerable time, it’s a critical part of any transaction and should be considered the foundation of the entire deal.
The evaporation of small business capital markets and other economic factors have made creative financing the norm for today’s business buyer. There are a number of creative financing options that you can consider.
- Seller Financing – Increasingly, buyers and lenders are looking to the seller for financing as they try to put a transaction together. In such a scenario, the seller will hold a note at an agreed upon interest rate for a specific term or amortization – generally ranging from 1 to 7 years. It’s a way of giving the buyer time to get up and running and to establish a successful track record with the business. Seller financing makes the bank more comfortable with the transaction. Lenders know they have a seller who has a vested interest in the success of the business rather than one who will take their money and run. There are a number of benefits for business owners who are considering seller financing:
- Fast sale
- Tax Breaks
- SBA Loans – In business sales, conventional bank loans may not be available, so a buyer may want to consider going to a Small Business Administration (SBA) lender, which has a number of loan options. The SBA guarantees a portion of the loan. The buyer pays an SBA loan fee that allows him or her to get funding for a loan the bank couldn’t do conventionally. If an SBA guaranteed loan goes into default, the SBA will pay the lending institution a percent of any deficit left after liquidating the collateral. There have been several changes to the Small Business Administration’s lending guidelines and standard operating procedures. You will want to speak with an advisor who is familiar with these recent changes.
- Earnouts – Earnout financing involves a certain dollar amount agreed on by the buyer and seller to be paid to the seller based on the performance of the company after the transaction is completed. Earnouts can be structured in a variety of ways and can be based on different financial benchmarks such as a company’s revenues, gross profits or net income. Earnout financing is often used for companies that are in a turnaround situation or when buyers are purchasing on potential, rather than on historical cash flow.
- Mezzanine Financing – In mergers and acquisitions, mezzanine financing is another alternative for a buyer looking for capital where the financing package may include interest rates up to 30 percent. The lenders in this situation are typically high net worth individuals who are expecting a larger return on their investment. They are lending in a junior lien or a position behind the bank and seller financing. The loans are typically made with limited sources of collateral, thus the request for higher interest rates. Again, this financing is often used in funding goodwill or reputation in an acquisition.
- Funding Scenario – In a million dollar transaction, the buyer would be expected to have a 20 percent down payment. The seller may hold an additional 5 to 15 percent in seller financing, and the lending institution would offer a combination of conventional or SBA financing to cover the difference, depending on collateral available. A buyer and the lending institution must evaluate a company’s cash flow and determine if it is adequate to cover their debt service and provide a reasonable return on their investment. Lending institutions will also be examining whether a buyer’s coverage ratio, or excess cash flow after all debt is paid, is adequate to cover their needs.
So you want to be your own boss. There are certainly pros and cons to both buying and starting a business. If you do a careful analysis, you’ll learn what many seasoned entrepreneurs have discovered…the risk-to-reward ratio is tipped in your favor when you purchase an existing business.Starting a business of your own can pay great dividends, but it’s important to understand that the risks are significant. Most start-up businesses will falter and eventually die. According to Michael Gerber, author of The E-Myth Revisited, 40 percent of new businesses fail in the first year and 80 percent fail within five years.On the other hand, purchasing an existing business reduces an entrepreneur’s risk while creating opportunities for tremendous profit. There are a number of reasons to consider the purchase of an existing business rather that starting one:
- Proven Concept. Buying an established business is less risky – as a buyer you already know the process or concept works. Financing a purchase is often easier than securing funding for a start-up business for that very reason—the business has a track record.
- Brand. You’re buying a brand name. The on-going benefits of any marketing or networking the prior owner has done will transfer to you. When you have an established name in the business community, it’s easier to place cold calls and attract new business than with an unproven start up.
- Relationships. With the purchase of an existing business, you will also be buying an existing customer base and vendor base that took years to build. It’s very common for the seller to stay on and transition with the business for a short time to transfer those relationships to the buyer.
- Focus. When you buy a business, you can start working immediately and focus on improving and growing the business immediately. The seller has already laid the foundation and taken care of the time-consuming, tedious start up work. Starting a new business means spending a lot of time and money on basic items like computers, telephones, furniture and policies that don’t directly generate cash flow.
- People. In an acquisition, one of the most valuable and important assets you’re buying is the people. It took the seller time to find those employees, develop them and assimilate them into the company culture. With the right team in place, just about anything is possible and you will have an easier time implementing growth strategies. Plus, with trained people in place you will have more liberty to take vacation, spend time with family, or work on other business ventures. When start-up owners and independent contractors go on vacation, the business goes too.
- Cash Flow. Typically, a sale is structured so you can cover the debt service, take a reasonable salary, and have some left over to take the business to the next level. Start up owners, on the other hand, often “starve” at first. Some experts say start-ups aren’t expected to make money for the first three years.
- Risk. Even with all these advantages, some entrepreneurs believe it is cheaper, and therefore less risky, to start a business than to buy one. But risk is relative. A buyer may pay $1 million, for example, for an established business with strong cash flows of approximately $200,000 to $300,000. A lending institution funds the transaction because historical revenues show the cash flow can support the purchase price. For many people, however, that is far less risky than taking out a $300,000 loan with an unproven concept and projections that may or may not be realized.
Becoming your own boss always involves a risk. When you buy a business, you take a calculated risk that eliminates a lot of the pitfalls and potential for failure that come with a start up.