Buying a business: What you don’t know can hurt you

Many people consider owning their own business to be a big part of the American Dream. However, what sounds good in theory does not always work out in practice. Without taking the proper steps to legally protect yourself during the business purchasing process, your dream of business ownership can quickly turn into a nightmare. However, the more you know about the process of purchasing a business and what you need to look out for, the greater your chances at success will be.

Working with business brokers

If you're looking to buy a business, you may have the option of working with a business broker online. This can serve as an excellent source of information on the availability of businesses for the purposes of researching options and getting an idea of pricing. However, this method should be approached with caution. Don't believe everything you hear or see. 

The law requires you to protect yourself during this process. What is meant by this is that if you enter a bad business deal the courts will not bail you out – the courts are not a social welfare agency except for social welfare cases. It is up to you to provide your own protection.

Why you must conduct due diligence

If you do not do research to find out everything about the history of the business you want to purchase, you could end up with a bad deal on your hands. 

Some business owners will attempt to hide or delay showing you their income statements and tax returns. You must demand to see these documents, and if the owner refuses, it is in your best interest to walk away. If you do decide to move forward with the purchase, do not offer to pay more than the net asset value of the business.

Here's why seeing tax returns in advance of purchasing a business matters:

• People can lie to you about their taxes but they are less likely to lie to the IRS.
• If you assume the worst, you can take steps to protect yourself from it.
• Demand to see 2-3 years of tax returns and income statements.
• Remember – if they hide it, don't buy it.

Valuation of the business

The business broker or seller may add "discretionary expenses" when valuing the business. This means tacking on additional items, for example, a personal truck or art on the walls, for the purpose of increasing the true "higher net income." When this process has not been overdone, it is legitimate. However, as the buyer you should discount the net earnings 20-25 percent. This will allow for mistakes, loss of information, losses due to change of ownership, fraud and more. If the business is not worth buying after the 25 percent discount of net income, it is not worth buying.

If you're thinking of buying a retail business, you'll want to look for the long print-out of records that are printed at the end of each day, which are called Z tapes. For a non-retail business, you'll want to look at the invoices sent and bills paid.

Importantly, create your own profit and law statement. Don't buy your own dream – many new buyers purchase their dream and cannot see the reality right in front of them of why the business was started.

Reasons for selling

Businesses are sold for two reasons – the stated reason, and the real reason. More than half of the time, the owner will give the reason of "selling due to retirement," even when this is not the real reason.

Go beyond checking the numbers and also check the customer's location and traffic. Consider posing as a customer to see if the business looks successful – do the seller, customers and employees look happy? What is your overall first impression of the business?

Consider the industry

Think about the industry the business is in – it may be doing well today but will it be thriving tomorrow? Gift shops and card shops are wonderful, but can they survive?

Does the business have a special niche? Can you describe in 25 words or less what makes your business special or unique? If not, your business does not have a competitive edge.

Additional considerations

• Consider the tax aspects. Do you want to do an asset purchase or an entity purchase? Usually the buyer wants to sell the entity. Talk to an accountant or tax lawyer about this.
• Look for judgments, liens and other public records that may not be disclosed.
• Check to see if the machinery is leased.
• Get representation and warranties from the seller. What you are buying is not the company's assets but what the purchase contract says about these assets.
• Never use the broker's business purchase documents. The broker's job is to make the sale, not to protect you. This is why due diligence and legal documents are important.
• Ask yourself – What will change when the seller leaves? Is the business based on personal relationships? Who are the customers? Can you talk to anyone else besides the owner?
• Draw up a non-compete agreement with the seller. You are buying goodwill; you may have none if the seller can compete.
• What are your upside potentials? Being the buyer, are you bringing anything special to the business, like unique knowledge of the product, experiences, contacts or relationships?
• Can the business be improved? Or are you fighting a downward trend?
• Does the seller have good marketing and good practices? Business strategy is important.

Owning your own business can be the most important thing in your life. This is your dream, not the seller's dream. The seller's dream is to leave. Like raising your kids, your business needs to be managed correctly. Consult a Phoenix, AZ small business attorney to learn more about the process of buying a business.

Categorised in: Business Law

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