There is no doubt that buying an existing business has its risks, but it’s still a lot safer than starting one on your own. After several attempts to find that perfect business opportunity, seasoned entrepreneurs develop a natural ability to sniff out all the red flags and recognize that “diamond in the rough.”
Unlike startups, an existing business already has the necessary equipment and inventory necessary to run efficiently. In addition to its customers and employees, these businesses already have a location, and might even have a few years left on the lease. But perhaps more importantly, the business has a track record; meaning as a buyer you can look at their records, books and tax returns to get a sense of your potential income. So, you may be asking yourself, where is the risk?
Keep in mind that when you review an existing business and its records, you’re looking at the past. This doesn’t mean things won’t change going forward. Beware of an opportunity that appears “to good to be true,” because it probably is. While a newly minted entrepreneur might be tempted to make an offer, a seasoned business owner might become suspicious. Pay attention to your instincts and do your due diligence on any small business you want to buy, but consider these factors:
- Political and/or demographic change: When a seemingly successful business owner is suddenly looking to sell, there is usually a reason. Perhaps the community is changing, population is declining, or a new construction project is diverting traffic away from the business. A visit to the local township planning office will help you find out if any zoning law changes have been proposed that would impact the business in its current location.
- The Owner’s Discretionary Income: Also known as ODI, this is what the seller is taking out of the business after paying employees’ wages, rent, suppliers and taxes. If the ODI has been declining over recent years, this is a red flag indicating that the business is also declining. However, if the ODI is healthy you should ask the seller to put that in writing; then refrain from making an offer for a few months until you can confirm the seller’s ODI numbers are on track.
- Location of competitors: If you are considering a retail or service-related business, there’s a good chance one major franchise or “big box” competitor that could come to town and wipe you off the map. Don’t be afraid to call the largest competitors in your industry and find out about their plans for expansion. The owner of the business just might know something you don’t.
- Sales tax: When you purchase the assets of a business, you avoid the necessity of paying off the seller’s obligations, debts and liabilities; that is unless you expressly agree to pay off a lease or other debts.) The only exception to this is sales taxes. If the seller has been underreporting sales tax and the state learns about it after the sale, you become liable for everything they owed. When buying a business it is crucial to confirm that the seller has filed all their state and local sales tax returns. You can also ask your lawyer to get you a “clearance certificate” from the taxing authority to be sure they won’t come after you for taxes the seller might owe.
- Reputation: When it comes to the reputation of the business; don’t just rely on hard data. Research some local newspapers going back at least five years and find out about any negative publicity. Ask the local police station about any complaints that might have been filed against the business or its current owner.
- Local business reputation: Don’t rely on just “hard data.” Go to the library and skim the local newspapers going back at least five years. Is the business active in the community? Is it written up frequently? Is there negative publicity? Go to the local police station and ask if there are frequent complaints by or against the current owner.
Spend some time talking to the locals–hang out at the local library, senior center, coffee shops and public parks and talk to the “old timers” who congregate there. Yes, it’s tedious and time-consuming, but it may save you from making a deal you will live to regret.