Starting a business is both one of the most rewarding and scariest things you can do. It’s understandable why some think it’s safer and a better use of resources to buy a well-established business than starting something entirely new.
However, buying an existing business has its own share of pitfalls that can quickly turn your entrepreneurial dreams to nightmares. Before you take over someone’s business, here are three questions you must ask yourself.
- Do I understand what I’m buying?
Do you know whether you’re buying the assets or the shares? When you buy the latter, you might be able to negotiate a better price as the owner will be obtaining a tax advantage in the form of a capital gains exemption. However, buying shares means you are taking on existing liabilities, tax disputes and litigation so it’s important to get a clear written statement on these from the owner. Otherwise, you risk problems coming to bite you in the butt after the owner has retired with your money.
- Do I truly understand the finances?
You have to be really clear on where the revenue comes from and what the true expenses are before you sign the purchase agreement. While it’s a given that you will want to see revenue numbers, sometimes they don’t show the whole financial picture. A business may look like it has low profit but If the owner passes large amounts of personal expenses through the business the real picture may be rosier than it appears at first glance. Conversely, the numbers may look great but it’s only because the owner doesn’t take any money from the business and has lent it a ton of money. Make sure that you can run this business profitably when you take over, however attractive the numbers look at first glance.
- Do I understand the key relationships in this business?
Who are the clients? The vendors? The suppliers? Key employees? Are there strong contracts in place with the key persons which make the business run?
One of my clients was eager to purchase a business which appeared to be immensely successful. The financial statements showed revenue in the high six-figures and the owner lived a lavish lifestyle. The owner sought a high price on the basis of lucrative agreements with large clients. But when we dug a little deeper, 90% of the “lucrative agreements” were not reflected in written contracts. The few written contracts in place had less than one year left to run, did not automatically renew and were with the owner personally, not the business. If my client had been blinded by the numbers on the balance sheet and the owner’s million dollar house and bought the business without understanding the key relationships, she could have been left with zero clients within a year of the purchase.
A business owner I know discovered after the closing that there were no non-compete and non-disclosure agreements in place, so key employees took valuable client information and business procedures and set up their own competing business. Of course, clients knew the employees better than the new owner and the business soon sank from the competition.
Be patient and do as deep a dig as possible to find your diamond in the rough. With the help of experienced advisors who can see and help you avoid pitfalls you might not even think about will help, you can build on the shoulders of others and jump-start your entrepreneurial success.
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