Essential Considerations When Buying a Business
Acquiring a business can be an exhilarating and promising endeavor. However, the path to success always has its challenges, especially when it comes to buying an existing business. Whether you're a hopeful entrepreneur or an experienced business person looking to expand your portfolio, purchasing a business requires careful consideration and strategic planning.
Consideration #1: How Will I Pay For This?
When you are buying a business, securing your finances is critical. If you aren't financially positioned to buy a business outright, there are several financing options out there that may be available to fund the purchase. These can include business acquisition loans, private equity or venture capital investors, seller financing, or even crowdfunding.
We’ve laid out the pros and cons of each of these options below. Be sure to keep the specific circumstances of your situation in mind when considering your choices.
Business Acquisition Loans
A business acquisition loan is a common approach for entrepreneurs and investors looking to finance the purchase of an existing business. You may be able to obtain a business acquisition loan from a traditional bank, a credit union, an online lender, or through a bank’s Small Business Administration (SBA).
The major benefit of a business acquisition loan is the immediate access to the necessary capital for purchasing an existing company. These types of loans also allow you to spread the repayment of the acquisition cost over a defined period, which helps manage cash flow and eases the burden of paying a lump sum upfront.
On the other hand, traditional bank loans may not be as immediate. They typically require good personal credit or at least a minimum desired credit score. Additionally, you'll most likely need to provide a 20% to 25% down payment, and many traditional bank loans require personal guarantees on the amounts borrowed. That means you'll be personally responsible for the loan if the business fails.
SBA-backed loans can enable entrepreneurs who cannot secure a business acquisition loan from a traditional bank to obtain funding to purchase a company. While a personal guarantee is typically still required, SBA loans are more flexible than traditional loans, often allowing for smaller down payment requirements, longer repayment periods, and lower interest rates.
There are several types of SBA loans, including 7(a) loans, microloans, and 504 loans. You can check out the SBA website or discuss your situation with an experienced business attorney or lender to determine the best option for your particular set of circumstances.
Private Equity or Venture Capital Investors
Both private equity and venture capital investors can provide funding to finance a business acquisition as well. In most cases, unlike with bank loans, you typically do not have to repay the initial investment. Instead, your investors will acquire equity in your business and thereby receive a share of its profits.
Because accepting private equity or venture capital investment often involves giving up a portion of ownership and control of the business, you can expect to lose at least some of your autonomy as the business owner, along with the investors' shares of the profits. Additionally, differences in priorities, risk appetite, or strategic direction between you and your investors can lead to conflicts of interest down the road.
Doing your due diligence before partnering with any investor is essential. You should ensure that any potential investor is legitimate, reliable, and a good fit for your business and its goals before moving forward.
Each business's situation is unique, and it's important to consider the potential impact on ownership, control, decision-making, and the overall vision for the company. You should be sure to seek legal and financial advice when exploring investment options and negotiating terms with potential investors.
Seller Financing
With seller financing, the current owner of a business takes on the role of lender and extends a loan to the buyer for a portion of the purchase price, with the rest being paid upfront as a down payment. The buyer then makes regular payments to the seller, typically with interest, over an agreed-upon period until the loan is fully repaid.
Buyers who may have difficulty qualifying for a traditional bank loan can benefit from seller financing, which often will come with lower credit requirements. However, there are several disadvantages to taking this route. First, seller-financed loans usually have a higher interest rate than traditional loans. Secondly, they often come with shorter repayment periods, and finally, they will often require a large balloon payment at the end of the loan. All of these reasons make it more difficult for a seller to feel comfortable with this option.
Before proceeding with seller financing, it is imperative that you consider any alternative options and consult with legal and financial professionals about the viability of this type of funding.
Crowdfunding
Crowdfunding has recently emerged as an alternative financing option for people who are interested in buying a business but cannot obtain traditional lending or find traditional investors. The two most relevant types of crowdfunding for business acquisitions are ‘debt’ and ‘equity.’
Debt crowdfunding platforms provide an avenue for borrowers to access funding from a broad pool of individual lenders who are willing to contribute smaller amounts. On the other hand, equity crowdfunding allows buyers to raise capital by offering equity or shares in the business to a large number of individual investors.
While crowdfunding can provide access to capital, the individual amounts contributed are often low. This may pose challenges for buyers seeking larger amounts of funding to acquire higher-value businesses, as they will need to convince a significant number of investors to contribute to their crowdfunding campaign in order to succeed. Further, compliance and maintenance of significant numbers of owners and/or lenders results in more people to answer to as well as additional work once a business transaction is funded.
Consideration #2: Should I Work With a Broker?
Business brokers facilitate the purchase and sale of businesses by connecting and acting as intermediaries between potential buyers and sellers. Working with a business broker can offer several advantages when purchasing a business, but there are also potential drawbacks to consider.
In general, a good business broker will be able to help you identify and evaluate potential acquisition opportunities that align with your preferences, industry, and financial criteria. Additionally, a broker should possess industry expertise in facilitating business transactions and be able to provide guidance through the acquisition process.
However, business brokers typically charge either a commission based on the final sale price or a flat fee for smaller companies. This commission typically ranges from 5% to 15% or more, depending on the size of the business, the complexity of the transaction, and the broker’s rates.
Whether or not it makes sense to partner with a broker depends on the specific circumstances of your situation. For instance, when acquiring a smaller business, hiring a business broker may not be worth the expense, particularly if you have previous experience purchasing a business or have other professional support in the process. It ultimately comes down to whether a particular broker is able to provide a sufficient amount of value to justify paying the requested fee. It is also important to engage an attorney to review a selected broker’s agreement. There are often broad provisions explaining when a fee is earned that are important to understand before signing.
Consideration #3: What Happens in the Diligence Phase?
The phrase “due diligence” refers to the comprehensive investigation and analysis conducted by a buyer before finalizing the purchase of a business. It is a critical step in the acquisition process that allows the buyer to assess the financial, legal, operational, and commercial characteristics of the business and make an informed decision.
Generally speaking, due diligence involves examining various documents, conducting interviews, and performing analyses to verify the information provided by the seller and to identify potential risks, opportunities, and challenges associated with the business.
The scope of due diligence may vary based on the complexity, size, and nature of the business being acquired. However, a typical due diligence process could involve reviewing and verifying the following information about the business you are interested in purchasing:
Financial details, including financial statements, debts, tax returns, credit reports, and profit analysis
Operational structure, including incorporation documents, bylaws, investors, shareholders, and brand and marketing details
Employee and customer details
Legal documents, including all contracts, obligations, and agreements
Potential legal issues, including any pending litigation and current legal representation
Intellectual property
Real estate and other physical property that would be part of the purchase
During the diligence phase, you may want to engage professional assistance, such as a business lawyer, to assist with the investigation and analysis. The findings from due diligence will inform your decision-making process and the negotiation of the purchase agreement, so it’s essential to fully investigate every aspect of the business you may be acquiring.
Consideration #4: What Should I Expect in the Agreement Phase?
The agreement phase is a crucial stage in the acquisition process that involves drafting and negotiating the purchase agreement and its ancillary documents. A purchase agreement is a comprehensive legal document that governs the sale and outlines the terms and conditions of the transaction.
This part of the process typically begins with negotiating and generally agreeing on the key terms of the acquisition via a mutually agreed upon letter of intent, such as purchase price, payment terms, and the assets or shares being acquired, before an actual agreement is drafted. Your due diligence findings will typically play a significant role in shaping the terms of the purchase agreement.
Once the key terms are agreed upon, the next step is to draft the purchase agreement. Typically, there will be some amount of back-and-forth between the seller, where both parties can propose revisions, clarifications, or additions to the agreement based on their respective interests and concerns. After the buyer and the seller have reached a consensus on the terms and conditions and all necessary revisions have been made, the purchase agreement can be executed.
Whenever you acquire a business, it is advisable to seek the assistance of a business attorney with significant experience in handling mergers and acquisitions. Your lawyer can assist in securing financing and due diligence, draft the purchase agreement, advocate for your interests during the negotiations, and provide significant guidance throughout the entire process.