Monster Media 1996 #14/Monster Media No. 14 (April 1996) (Monster Media, Inc.).ISO/business/sba961.zip/F216.SBE

Text File | 1996-01-01 | 10KB | 189 lines

@156 CHAP 3

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       │TRAPS AND PITFALLS IN BUYING AN EXISTING BUSINESS│
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While there are some definite advantages in buying an estab-
lished business, as compared to starting up a new business
from nothing, it can also be a lot more complicated and in-
volves many potential pitfalls that you must avoid.  The
watchword in buying any kind of business should be CAVEAT
EMPTOR -- Let the buyer beware!

Common pitfalls you want to avoid include the following:

   .  WHY IS THE BUSINESS FOR SALE?  This is probably
      the first question you should ask.  However, take
      the answer with a grain of salt.  Often the res-
      ponse will be that the owner wants to retire or is
      in poor health (never that he is having to work 80
      hours a week just to break even). Or the real rea-
      son may be that the owner has been robbed several
      times lately, and he wants O-U-T.  Or the owners
      of a profitable little corner grocery store may be
      anxious to sell out while they can because they
      have just learned that a major chain store super-
      market will be opening on the next block in a few
      months.  Pity the poor buyer who swallows the
      "bad health" story in the latter case!  One of
      your toughest jobs in deciding whether to make an
      offer to buy an existing business will be to be-
      come a sleuth and find out the REAL reason the sel-
      ler is selling.  Just remember that a good and
      profitable small business is not something that
      most people walk away from, in most cases, unless
      there is a strong personal reason, or the price
      that has been offered them is ridiculously high.

   .  WHAT KIND OF REPUTATION DOES THE FIRM HAVE?  If it
      has a good reputation, this may be the most impor-
      tant thing you are paying for.  On the other hand,
      you may be much better off starting your own busi-
      ness from scratch than acquiring one that has a
      poor reputation because of shoddy merchandise or
      sleazy service.  It could take you years to over-
      come such a reputation.

   .  IS THE REPUTATION TRANSFERABLE?  Even if the pre-
      sent owner has an excellent business reputation,
      you will want to know whether that goodwill is
      based on personal relationships built up between
      the owner and customers (that will not be easy to
      transfer to you) or not.  This is particularly
      important if the business relies heavily on a few
      key customers or suppliers with whom the owner has
      very favorable business arrangements.  Those ar-
      rangements could evaporate when you attempt to
      take the owner's place and you could wind up pay-
      ing for a handful of air.

   .  HOW PROFITABLE IS THE BUSINESS NOW?  Unless you
      have some very good reasons to believe you can run
      it more profitably than the current owner, stay
      away from a money-losing business or one that does
      not produce a satisfactory profit.  Thus, it is of
      crucial importance to find out what the business
      has actually earned for the last few years, since
      the figures the owner shows you will invariably be
      inflated to make the picture look rosy.  Even if
      the owner has audited financial statements, don't
      blindly rely on them.  You can be sure he will
      have used every possible means to make recent ear-
      nings look good, from deferring maintenance to cap-
      italizing every possible expense, and so on.  Here
      your job (with the help of a good financial advi-
      ser, probably an accountant), will be to unpaint
      the carefully painted picture, to find out how the
      business has REALLY been doing.


        HINTS ON FINDING OUT ABOUT WHAT THE BUSINESS EARNS:

       (a) Insist on having the seller make the business's
           financial and business records available to your
           accountant and lawyer at an early stage in the
           negotiations.

       (b) Insist on seeing income tax and sales tax re-
           turns for the last few years, not just financial
           statements.  (You can be sure the owner will not
           have overstated his income on his tax returns!).
           To be on the safe side, ask the seller's CPA to
           transmit copies of the returns directly to you,
           along with some kind of written assurance from
           the CPA firm that those are the actual returns
           that were filed, as last amended.

       (c) Whatever you do, don't buy the old line that
           the seller reports such low income on his tax
           returns because he takes a lot of the profits
           right out of the cash receipts drawer without
           telling Uncle Sam.  He may be telling the truth,
           but why should you expect that he's telling you
           the truth when he admits he's cheating on his
           taxes?  Particularly since there is no way to
           tell how much, if any, he has been skimming.

   .  ARE YOU GETTING THE THINGS THAT MAKE THE BUSINESS
      TICK?  One of the key things you have to do in in-
      vestigating a business you intend to buy is to find
      out what makes it tick, and make sure you are buy-
      ing that, whatever it is.  For example, if it ap-
      pears that the business has well-developed customer
      lists or mailing lists, those should ordinarily be
      included in the sales agreement; if there are favor-
      able leases or other contracts, make sure they can
      and will be assigned to you as the new owner; if
      patents, trademarks, trade names or certain skilled
      employees are vital to the business, be sure that
      you will get them as part of the package.  And, in
      many cases, you will want the seller to sign a non-
      competition agreement, so he or she won't simply
      continue the business across the street under a
      different name, financed with your money!

   .  ARE THERE ANY TIME BOMBS?  You need to carefully
      assess the assets you are acquiring and the liabili-
      ties you are assuming if you buy the business.  You
      should personally inspect the premises, looking for
      things like obsolete or unsalable inventory, out of
      date or rundown equipment, or furniture or fixtures
      you may soon have to repair or replace.  Review the
      terms of any leases.  One reason some businesses
      close or sell out is the imminent expiration of a
      favorable long-term lease, if the landlord plans to
      either raise the rent drastically or not renew the
      lease at all when the current term expires.  Also,
      go over receivables with a fine-tooth comb, looking
      for significantly past due accounts.  You may even
      want to run credit checks on a few major customers,
      if they make up a large part of the receivables.
      The bankruptcy of one of those customers could also
      bankrupt you.

   .  OTHER LIABILITIES.  Not all liabilities of a busi-
      ness show up on its accounting records.  There may
      be any number of hidden claims against the busi-
      ness, such as security agreements encumbering the
      accounts receivable, inventory or equipment, unpaid
      back taxes of various kinds, undisclosed lawsuits
      or potential lawsuits, or simply unpaid bills.  If
      you are going to assume liabilities of the business,
      the written agreement of sale should specify exact-
      ly which liabilities are being assumed and the dol-
      lar amount of each.

   .  BE WARY OF BUYING STOCK OF A CORPORATION.  If the
      business you are about to buy is incorporated, you
      will usually be well advised to offer to buy the
      business assets from the corporation, rather than
      buy the stock of the corporation itself, since the
      latter approach will subject the business to all hid-
      den or contingent liabilities of the old corporation,
      whether or not you have agreed to pay for any liabil-
      ities of the corporation that pre-dated the sale.
      Also, you will frequently incur a tax disadvantage
      if you buy the stock, since you will not get a free
      step-up in the basis of the corporation's assets, un-
      like a direct purchase of the assets.  (One important
      exception would be where the corporation has unused
      tax loss or tax credit carryovers that could be used
      to shelter some future income from tax.  However,
      the '86 Tax Reform Act has severely restricted the
      use of such carryovers where there is more than a
      50% change of ownership of the stock of a corpora-
      tion in a 3-year period.)

   .  AVOID PAYING TOO MUCH.  One of the biggest potential
      disadvantages in buying an existing business is that
      you may pay too much for it, compared with what it
      would cost you to start a new business from the
      ground up, or compared with what someone else is
      likely to be willing to pay you if you decide to
      sell out.  Even if the business turns out to be a
      good one, if you overpay significantly it may take
      you years of hard work to recover from this exces-
      sive "hidden" cost of doing business.