The Five Questions to Ask Before Buying a Business
Millennials are reaching the age when they start thinking seriously about buying or buying into the business where they are working. These young professionals may have mastered their profession, but may not know what questions to ask before buying a business. This Article covers the Five Questions to Ask Before Buying a Business:
- What exactly am I buying?
- What is the fair price for what I am buying?
- How do I pay for the business?
- What baggage comes with the business I am buying?
- What happens to the previous owner?
Let’s look at each of these questions further.
First, you have to know exactly what you are buying.
This is not as easy as saying you are “buying a business.” Actually, there are two things you could be buying: assets or the stock / membership interests of a business.
You may be buying assets, or property, of the business. The list of business assets could include:
- Real estate, like an office or business location;
- Equipment, like trucks, tools, or office supplies;
- Inventory for the business;
- Customer lists, or existing customer accounts;
- The company’s previous name and the right to use it and the marketing good will it generates.
If you buy the asset, typically you own it and have the right to use it as you see fit.
That may not be the case when you buy stock or membership interests in a business. Buying stock or membership interests means you literally purchase units of ownership of the company, just like investing in shares through Wall Street. Even though you may be an “owner,” you may be a minority owner and may not have the right to lead the company where you want it to go. Think about the Green Bay Packers: it has 361,000 “owners” but none of the owners has the right to control the operation.
The rights and obligations of the business stock owners will be described in a document, like a shareholder agreement or operating agreement. When buying stock or membership interests, it is important to read and understand these documents to see what rights and obligations you are actually buying.
Second, you have to decide the fair price for what you are buying.
The price depends on what you are buying. If you are buying assets, like trucks or equipment, you can typically use the fair market value for the assets and add it all up. If, on the other hand, you are buying stock or membership interests, the company value will typically be calculated through a formula described in the shareholder agreement. The company may be valued based on its historical earnings, future earnings, or through comparable businesses.
The point is that there are a lot of ways to value a business. Make sure you understand the way it is being valued and that you agree that the value is fair.
Third, you have to know how you will finance the purchase of the business.
Unless you are writing a check for the entire amount, you will use either bank financing or owner financing. Under both scenarios, you sign a promissory note and make payments against the debt. The main issues here are the interest rate to be paid, the term of the note, and whether you will personally guarantee the debt.
You also need to know whether the bank or owner will take a security interest. A security interest is a lien or mortgage on the property you are buying. If you do not make payments as agreed, the bank or owner can foreclose on the property and take it back.
Fourth, figure out what baggage comes with the business you are buying.
The “baggage” is all of the headaches you may have purchased along with the business, like:
- Difficult partners or employees;
- A lopsided shareholder agreement that limits your rights in the company;
- Bad debt owed by the company;
- Unfortunate long term obligations, like leases that are too expensive; or
- Legal problems.
It’s better to know about and understand this baggage before you buy. Your due diligence process should help you uncover and understand these issues.
Finally, you have to know what will happen to the previous business owner.
You almost never want the previous owner to cash their check and ride off into the sunset. Instead, you want them to stay close and help you transition the business. This may mean that they actually run the business with you for a period of time, that they help introduce you to customers, or simply that they answer your questions. You should decide what type of help you want and include it as part of the deal.
You should also add a non-compete agreement. This type of agreement prohibits the former owner from getting bored one day and starting another business to compete against you. This is a layer of protection for your investment.
Those are the Five Questions you should ask before buying a business. Obviously the information above is very simple and non-specific; there are a lot more details and issues hiding within those questions and answers. That is why you should retain a trusted advisor to help you with this huge and life-changing purchase.