How to Buy a Business

Step 5: Consider funding and financing options

If the business already produces fairly stable quarterly profits, you should know how much it's worth now and how much it will make in the future. The process only becomes murky if the business hasn't turned a profit, but you expect it to in the future.

In a situation like that, consider the value of the business' assets (equipment, inventory, real estate, intellectual property, etc.) and how those assets could bring in during future months.

To arrive at a fair valuation, many prospective buyers also look at how much comparable businesses have sold in the market. Local factors like location and consumer demand are baked into the price.

Income-based valuation methods

This determines the value of a business based on the income you expect a business to earn using one of the following valuation methods:

• Asset-based valuation: Determine the business' value based on the value of its tangible and intangible assets.
• Market-based approach: Determine the business' value based on the value of comparable businesses within the industry.
• Discounted future cash flows method: The discounted cash flow valuation method estimates how much a business is currently worth by looking at future cash flows.
• Capitalization of earnings method: The capitalization of earnings method shows the business's future profitability by looking at how much you expect the business to earn based on its current earnings.

Business purchasing financing options

To finance the acquisition of a company, you can:

• Use your savings or borrow money from family members
• Find a business partner to purchase the business with you
• Negotiate a rent-to-buy deal
• Take out a loan from the bank or set up a payment plan with the seller
• Explore additional loan options, like an SBA loan

But you should read up on the laws around seller financing. In many cases, other loans take a higher priority. For example, if you secure a loan from the U.S. Small Business Administration, you're usually required to pay that back before you pay a seller back.

Step 6: Sign a letter of intent

Before reaching a final agreement, consider drafting a letter of intent. Think of this as the first draft of your agreement.

It's typically short and sweet and includes the terms of the deal, price information, descriptions of any assets involved in the transaction, and other important information.

Letters of intent aren't typically binding. Instead, they're a way for buyers and sellers to negotiate a transaction without fully committing and to demonstrate that both parties are interested in the transaction.

Step 7: Close the deal

Finally, it's time to close the deal. In addition to settling on the appropriate price in your final agreement, you'll also want to consider how to transfer leases, vehicle ownership records, intellectual property, and other assets into your name.

6 Business purchasing mistakes to avoid

The business buying process is complicated, but there are some clear-cut things you can avoid to protect yourself and your investment.

1. Don't purchase without knowing why the business is for sale
2. Don't underestimate the value of goodwill toward a company
3. Don't just skim the surface—make sure you do your due diligence
4. Don't overextend your business purchasing budget
5. Don't buy into an industry you know nothing about
6. Don't buy to make a total overhaul immediately.

Pros and cons of buying an existing business

Buying an existing business has numerous advantages and disadvantages, but it's generally considered a low-risk way to become a business owner.

"If you buy a business, there are customers and clients, systems and processes in place, and documented financial performance that will allow a new owner to predict future income; and the future former owner is a mentor to help the new owner grow the business," John R. Allen III, the managing partner of Allen Business Advisors, a business brokerage firm, says.

Advantages of buying a business

When you start your own business, it can take several years of trial and error to hone in on your niche and develop a loyal audience. But when you purchase a business, you can skip over this tedious process altogether and enjoy numerous other benefits.

Perhaps the biggest advantage to buying over starting a business is the existing business's potential. You may see growth opportunities the current owner doesn't, or maybe you have a winning business plan in mind.

Your enthusiasm and excitement for the business can revive it and help it to flourish, and often relatively minor changes in advertising, personnel, or procedure can greatly improve profitability.

Some pros of buying a business are that you can:

• Get a glimpse at the company's operating history to understand its successes and brainstorm solutions for its failings.
• Understand which advertising efforts are most effective and will provide a high return on your investment.
• See if cash flow consistently outweighs operating expenses.
• Determine if you have enough money to purchase the company and make updates before making an offer.

When you start your own business, numbers are much more difficult to estimate, potential issues are harder to anticipate, and it can be more difficult to secure funding because investors consider start-up businesses higher risk.

Disadvantages of buying a business

There are also some disadvantages when you buy an existing business instead of building one. For one, you miss out on the excitement of growing something from the ground up.

It can also get expensive if the company is already underwater due to poor management, which is why you must do your due diligence before closing a deal.

Once you better understand the issues a company has, weigh them seriously against the advantages to decide if it's right for you.

You may decide some things are simply too much of a hassle. For example, you may need to:

• Re-staff, the company, collaborate with employees you don't know and didn't hire, or motivate employees who became complacent under old management.
• Deal with internal and external resistance to changes you make to company offerings and practices.
• Schedule health and building inspections and pay for updates.
• Do a deep dive into company financials and address any debts or account deficits.
• Think of ways to entice customers who shop there because they are loyal to the former business owner to continue working with the company.

If any of these things are applicable and too much of a red flag, pass on the business opportunity. Even if you don't notice any significant issues on the surface, keep in mind that the seller may try to downplay certain business problems.

How much does it cost to buy an existing business?

Generally, franchising costs new owners between $20K and $50K, and buying a successful existing business comes with a median sticker tag of $150K to $200K.

The cost of buying a business depends on several factors—the primary ones being the revenue the company generates each month and its debt.

To determine the value of a company, calculate all of its monthly earnings and recurring revenue and subtract its debts and recurring expenses. You'll want to pay off your debt and become profitable in two to three years, so you should only pay about one to three times the amount of the company's annual profits.

When does buying a business make sense as a business investment?

Many investment experts are encouraging younger generations of entrepreneurs to buy existing businesses. Of course, anyone who has the time, money, and drive to take on a new business and add some value to it could be a good business acquisition candidate.

"Buying from a seasoned owner allows you to learn from decades of [the seller's] experience, taking a shortcut in the school of life," Lisa Kipps-Brown, the author of Boomer Cashout: Increase Your Business's Value & Marketability to Sell for Retirement, says.