Show notes for podcast episode 26.
On one hand if someone is selling a business I’m immediately a little skeptical. it must have some problems. Why would they sell it if not? It might require too much of their time and energy. It might be stressful. It might be losing money. The future might be looking bad for the industry as a whole. You are often buying yourself a problem that you will need to fix. You are often buying yourself a job.
On the other hand if it is a very healthy business and it runs without the owner that owner will want too much money. It will be too expensive for you to buy. It would make much more sense investing in starting a company and growing it from scratch and copying that business model.
That said it might just make sense for you. I recently read an article that highlighted the fact that a lot of businesses are going to come on the market for sale as the baby boomers approach retirement. Baby boomers rule in the service area. They own the contracting companies. They own the home service businesses. I’ve designed this podcast around the fact that most of them run their businesses like its 1985 and you can out operate them, but still as these businesses either go up for sale or shut down I look at this as an opportunity. So lets discuss when I think buying a business might just be a great decision.
Lets look at a series of questions. No matter what business you are looking at you need to think seriously about these questions and answer them honestly.
Do you understand the business? Have you worked in the space? Do you know how each aspect works?
Have you done a complete market study? Do you know the competitors in the space like the back of your hand? Have you called them and played a customer and taken notes on what you’ve learned? Make sure to call the business you are considering buying as well, playing a customer and asking a laundry list of questions.
What are the barriers to entry? Do strong brands in the market have a serious advantage?
Is the service itself repeatable and scalable? Can you train others to do it? How long would training take?
What are the risks associated with the service or business? Do you have 18 year olds driving around box trucks? Thats the number one risk in my student storage business.
Is the industry in general growing in size? Is the service getting cheaper or more expensive? Are more customers coming on the market each day or are less?
Does the company have a good online reputation? Make sure to look at the customer service inquiries for the entire previous year during your due diligence. Look at online reviews.
Is the real estate it sits on included with the purchase?
How valuable is the human capital within the business? How long have the key employees been there? How skilled are the service providers? How likely are they to leave if the business is sold? Are they easily replaceable? Don’t count on buying key employees and having them stay. Businesses that rely on extremely talented people and fail without them aren’t the types of businesses I like and this is a risk if you are counting on this.
The big million dollar question is how does the business get their customers?
Does the business have infrastructure in place beyond marketing spend that brings in a lot of business? A top google ranking? A lot of word of mouth? Brand awareness in your area? A prime physical location? Or on the other hand are they spending money on new fresh leads each time they get clients? Obviously you are looking for the former.
Is the business repeatable or subscription based? Do they have a book of clients that come to them for service on a schedule? What contracts are in place with customers? How long are they committed? Do they have 50 accounts that are in place for eternity until they cancel? Thats serious value and you want this. On the other hand if a business spends marketing money to bring in every ounce of revenue thats a red flag. Low barriers to entry and not much value in the brand as it exists.
If I’m starting a lawn care company, a pest control company, or a cleaning company I would consider buying an existing one because they would come with a book of accounts. You would automatically inherit their scheduled customers and the revenue that comes with that. On the other hand if I’m considering buying a brick and mortar mechanic shop and the customers all come in off the street there isn’t much value in that to me unless you are also going to own the prime location and real estate associated with it.
What is the owners role? Does she personally know the big clients? Did she bring in the clients? What is her day to day at the company? What will happen when she leaves? Will she take the clients with her?
What will happen to the operations if she leaves? Is there a massive hole in the company? Would you be required to take it over and basically be buying yourself a job?
Okay those are the main questions to ask yourself. Now lets talk about situations where I think buying a business might be the best move.
If you own a competing business in the same industry and owning that business aligns with your strategic plan.
Lets give an example from my experience. We own a student storage company. Our strategic long term plan is to develop relationships with universities and sign contracts with them to be the preferred vendor on campus. We would consider buying another student storage business if they had contracts with universities. We know those contracts are critical to our growth so that would add serious value to our business.
Its worth more to you than it is to anyone else.
As you know we are in the student storage and the self storage business. In October 2018 we bought out a neighboring storage facility that was more valuable to us than it was to anyone else..
We built our facility in 2017 and had originally planned for a two phase development. We have a very high traffic location which is great for our business but the site has some geographical issues and we were required to build our building into the slope and make it two stories. So not only was there a ton of earthwork to do but we also had to build a two story building which requires a lot more infrastructure and steel. This makes it very expensive to build our second phase. We made a budget and it was going to cost us around $60 per square foot. We needed the space badly because we were about to fill up our facility.
There happened to be a neighboring facility that was around the corner and off the beaten path. It had almost no traffic and no sign so it was very hard to see from the road. But it was only about a quarter mile from our main facility. 12,000 beautiful square feet of rentable storage space. This was $10k a month in revenue if we could get our hands on it.
I reached out to the owners. They were interested in selling. The facility was underperforming. It was only about 20% full. The lack of traffic was killing it. Nobody was interested in buying it because it had no traffic. The buildings were in good shape and it even had a gate and fence around it.
We had the traffic and it could be rolled into our current operations easily because it was so close. We could direct customers from our main location over there easily and wouldn’t even need to rent the units at a discount.
We knew we were on the short list possible buyers so we came in with a low price. They countered. We stood strong. We came to an agreement at $400k. $33 per square foot. Instead of building more space on our parcel for $60/sf we purchased for $33/sf and this was a win win. They would have struggled to find anyone willing to buy at that price but it was worth more to us than it was to anyone else. We closed shortly after and rolled the buildings into our operations seamlessly. It was a huge win for my partner and me.
Another time I love to buy is when I’m one of a very very small group of buyers or possibly the only buyer.
I like to shop in a market that is small. That’s the problem with buying rental properties on zillow right now. If it’s on zillow you’re competing with thousands of other people looking to buy a rental property. Not ideal right? The person who is able to clean up tax liens or buy foreclosures is always getting a better deal because they are competing with a smaller market of buyers.
What makes the buyer pool smaller? Problems. Problems like the ones that come up when you ask the initial questions we started with.
Consider looking for a business with some problems with the business that you can solve but others can’t. That makes you the only possible buyer. That was the case with the self storage facility we bought. Traffic was their problem. We had the solution and we were the only ones with the solution. Perfect situation.
Don’t look for the perfect business to buy or you’ll be in a tough market and you’ll overpay. Consider buying the business that has some problems and being the only person to bring an offer at all. That puts you in the power position during negotiations and you can find some great deals that way.
Opportunities do come up. Maybe you work at a company on the management team and the owner (who is very involved) gets sick. Or maybe he needs to retire. You are in prime position to be one of the few people to buy the business.
The way the process works is you are first asked to sign a non compete and non disclosure. Basically stating that you won’t use what you learn to try to steal customers or share it to the public.
Then you get basic financial and customer numbers that can give you what you need to make an offer and go under contract to purchase. Then you will want at least 90 days due diligence to really dig in to the nitty gritty. Make sure the due diligence you want to do is explained in the contract. During due diligence you can often uncover things and then negotiate the price further and that is very common.
If you are going to buy a business make sure you do very in depth due diligence. Do extensive interviews with all key employees. If they don’t allow this then thats a bad sign. The employees should be in the loop with what is going on. Ask them all the same questions. Anything fishy? Do you they would leave when the company is sold? Do you need them at all?
Depending on the type of business consider interviewing key customers and talking about the business reputation and their experiences.
Make sure the accounting and bookkeeping is well organized and the record keeping is tight. Run the other way if the owner talks about taxable income in a different way than the amount he pulls off the business. This is a huge red flag. How are the books? Are the accounting practices solid and organized? Don’t give an inch here. If the tax returns don’t prove it it didn’t happen and discounts are coming.
Consider including a performance hurdle that the business must hit in the coming years to finalize the payout figures agreed upon. This is a way you can hedge risk but you’ll also end up paying more for this and it could complicate things.
Consider keeping the owner on board in a hired position during the transition. This can help you learn the business but is also complicated and you must realize they will not be very interested in working hard.
Lets talk briefly about the valuation of the business you are considering buying. This is extremely tricky. Owners often overvalue the work they have put in as well as the future potential. I’m not going to be able to give you 100% accurate advice here because all businesses are so different but lets go over the basics.
Before you even start you need to figure out what the business is worth to you.
Make a pro forma to estimate your cashflows. I have a sample pro forma on the website. Search cashflow projections. Spend a lot of time on this. Run them 5 different ways ranging from as expected to better than expected to worse than expected. You need to have the capital to make this fail proof. Even if things go as horribly as possible it won’t force you into bankruptcy. This likely means you need a lot more cash to make the purchase than you think you do.
If you take over the business how profitable will the customers that come with that business be?
Use your data to run the cashflow projections at your margins and come up with a projected profit figure. Now what return are you looking for on your investment in the business? I would think at least 20% for most service businesses. If you spend X on the business you are going to get a 20% annual return on that purchase. Now you have a price that the business is worth to you.
Now secondly you need to get a professional valuation. Pay for an appraisal to determine the market value. Consider paying for it yourself (or through your bank) and keep the numbers to yourself early on because you might not want to pay market value.
No matter how you do it you want to have a value in mind before the negotiation begins.
You want the seller to be the first to name a price. It will likely be a lot higher than what you’d like to pay. React accordingly with a short response email “this is much much higher than we had in mind and we are not in the market at that figure.” and let the days tick by. You can get more and more aggressive with the negotiations depending on the position of the sellers and the amount of buyers in the market.
A little off topic here, but while negotiating it helps to have some “partners” that need consulting, even if they don’t exist, between communications. You can use this to your advantage in a few ways as you play good cop bad cop and draw hard lines in the sand.
Should you use a business broker? If a business is already for sale you probably aren’t going to have much of a choice. But if I’m buying a business I don’t like going through a broker. They don’t have my best interests in mind. They just want to sell the business and take their 10% cut.
They also keep me from having initial conversations with the owner that I think are critical. I love to get on the phone with an owner and listen to them talk. Ask some open ended questions and just listen to them. I can learn so much about someone and the situation that way.
I call around businesses and ask the person on the phone to get me in touch with the owner because I’m a local business owner who is interested in a partnership. I say partnership because often a business owner doesn’t want his employees thinking hes going to sell the company. Once I get the owner on the line I begin the conversation about an acquisition.
Now just because I don’t prefer using a broker doesn’t mean I’m not going to enlist some professional help. I’m going to hire a great attorney and accountant to help me with my due diligence and with my contracts. I’ll also pay for a third party valuation of the business.
Funding can be tricky. If you are buying a service business without any physical income producing assets you will likely only be able to finance about half of it through a local bank. That means you’ll need some serious capital on hand.
Remember that you can get creative with the structure. You can do seller financing and have them hold the note for you. You can pay out over several years and the amount can change based on performance hurdles. You can keep the owner on board as a salaried employee and structure an earn out over a few years. There is really no limit to how it all can work so consider thinking outside the box.
Overall, buying a business can be great. Now lets look at the other side of the equation.
Generally speaking if you aren’t a business owner already and you don’t have extensive experience in the industry buying a business is rarely the right call.
Use that capital instead to start a business and pour rocket fuel on it in the early days to get it to grow very very fast.
If you aren’t an experienced business owner buying a business is often just buying yourself a job and taking a lot of risk to make it happen.
So many people buy businesses because of their own interests and their own passions and not the needs of the markets. I can’t overstate the importance of doing a serious market study and looking at this whole thing through clear non-biased eyes.
Put the principles in this podcast to work and build your own business. Start small. Add value first. Work on the stuff that is important but not urgent. Simplify the job for your employees so normal people can do really well with minimal training.
Think about your time in the early days of building a business as adding long term value in the form of appreciation. Not just an hourly wage based on your income at the end of the year but the value that you are adding to the business in the event of a sale down the road.
In year one you might only make $20 per hour of your time in income at the end of the year. A lot of reinvesting. A lot of marketing and equipment purchases.
But what if the business you started 12 months ago is now worth $100,000 on the open market. What does that do to your hourly pay? Now we’re talking.
I know every situation is complex. There are a million variables at play here. You might have a great opportunity to buy a business right in front of you and taking my advice might lead to a bad decision or a missed opportunity. Keep these things in mind but don’t think what I say is the golden rule. Its impossible for me to give accurate advice on every situation out there based on the generalizations I’ve made here.
It comes down to weighing the pros and cons, getting professional advice and looking at this stuff with a clear logical mind. Don’t let your emotions get involved. Don’t sort information and accept only the stuff that supports your personal directive.
If you are in this situation and want an outside non-biased opinion (for what its worth) I’d love to help out and give you some advice. Reach out to me by email at email@example.com.
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