Buying a Small Business: Tips and Tactics

I don’t want to be negative about you buying a small business. Buying a small business can be a great option.

But you need to be careful. Getting a purchase like this to work right is tricky…

Accordingly, let me share some tips to help you find the right small business and then structure a solid deal.

Buying a Small Business Tip #1: Don’t Overpay

A first tip—and maybe one of the most important: Be sure you don’t overpay.

The rule of thumb for small business values, by the way, is roughly 2.5 times seller’s cash profits.

A business that makes $100,000 in cash profit for its owner is probably worth about $250,000.

But note that some variability occurs. Some firms sell at two times cash profits or less. And, sometimes, especially attractive small businesses sell for as much as four or five times the seller’s cash profits.

In all cases, however, small businesses sell at very low multiples. Way less than the multiples that get used to value large publicly traded companies. And so you should pay a very low multiple.

Tip: Your accountant can help you size up a seller’s price by first helping you calculate a good estimate of the owner’s cash profits and then looking at a database of comparable sales of small businesses (like the bizcomps database). You can also get a rough idea about fair market values and cash flow multiples by looking at one of the online businesses for sale websites, such as bizbuysell.com. Just keep in mind that listing prices regularly exceed the actual sales price paid in the end. And keep in mind that potential sellers are often more than a little starry-eyed…

Buying a Small Business Tip #2: Do “Do” Due Diligence

Sellers, I am sorry to report, sometimes sell their businesses at the high water mark. Right before they know they’ll lose a major customer or client. Or when they know a major vendor or product is going away.

You want explore these sorts of possibilities by doing as much free-form research as possible. And then with your attorney’s help, you want the seller to represent that none of this stuff is already happening.

Sorry I don’t have more to say about this issue. But don’t let my brevity suggest this issue isn’t big. It is big. HUGE, in fact.

Buying a Small Business Tip #3: Allocate the Purchase Price to Minimize Taxes

When you buy a small business, and maybe you know this, you typically don’t buy the business.

For example, if the business operates as a corporation, you don’t buy the corporation. Or buy all of its stock. At least not if you’re smart.

What you do is buy the assets of the business. Whatever you pay for these assets gets allocated to the specific assets you buy. If you buy a small business for (say) $300,000, you might end up allocating $100,000 of the purchase price to the inventory you bought, $100,000 to the equipment you bought, and $100,000 to the remaining intangible value of the business, which is usually referred to as goodwill.

The allocation matters because it makes all the difference as to how fast you deduct the amount you pay for the business. Inventory you purchase will be deducted on your new business’s tax return as soon as you sell the inventory. (That’s good.) Furniture and equipment can be deducted pretty quickly—maybe even immediately—via depreciation expenses. Goodwill you purchase gets deducted very slowly—over fifteen years typically—so you want to minimize this chunk if possible.

Accordingly, you want to “work” the purchase price allocation to your advantage if possible. Getting this part of the purchase right can reduce your tax bill by a ton—especially in those early years when cash flows may be tight.

Caution: If you buy a business by buying stock in a corporation, you probably don’t get to deduct much or any part of your purchase price. For example, if you paid $300,000 for the stock of a corporation and inside that corporation was $100,000 of inventory, $100,000 of fully depreciated equipment and implicitly $100,000 of goodwill, you would be able to deduct the $100,000 of inventory when you sell it… but not anything for the equipment or goodwill.

Buying a Small Business Tip #4: Verify the Financial Engineering Works

Let me share another subtle tip provided by a well-known broker who sells CPA firms, Mark Hause.

Mr. Hause has said something very wise concerning making the purchase of a small business work. He points out the buyer needs to get paid for their new job working in the business. He makes the obvious but important statement that there needs to money to pay any loan payments. And then he points out the deal needs to provide enough cushioning so some little bump in the road doesn’t cause you to drive into the ditch.

To illustrate, if you need to make $50,000 for your work, need to pay $50,000 annually in loan payments, and then ( just to keep the math simple) need $50,000 of cushioning, you need the business to generate $150,000 in profits.

You see the simple but critically important logic. If this business generates $200,000 in profits, things should work out great. (Fingers crossed.)

If this business instead generates $100,000 in profits, things will probably end poorly. With $100,000 in anticipated profits, the first time you experience a hiccup, you’ll either need to short yourself or default to the bank. That simply doesn’t work.

Hause’s advice sounds obvious. But you’d be surprised how many people structure deals that work only if everything—and I mean everything—goes perfectly.