Leap Of Faith

Risk Management

For some business buyers, the decision to buy an established business instead of starting a new one is the first step they make toward giving themselves wiggle room. In 1996, when Texan Michael Garrety was downsized out of the oil industry, he felt his time to run a small business had finally come. But he wasn't interested in risking everything he'd built during his 20-year career. "Everybody says it takes three to five years to build a new business from scratch, and during that time, there's a fair amount of uncertainty," Garrety says. "I'm a middle-aged guy; I'd rather buy an existing business and take that same five-year period to pay a note back, knowing I've got cash flow from the first day." Garrety bought San Jacinto Staple & Supply, a Houston-based commercial distributor of packaging and shipping supplies, in September 1996.

Caution is especially important when planning your debt load, Yegge advises. While it's tempting to buy the biggest business your financing will allow, that tactic doesn't leave much of a safety net if the business doesn't do as well as expected. "What if the seller inadvertently takes 20 percent of the sales with him because the customers loved him? What if Wal-Mart decides to build down the street?" Yegge asks. "The safe [move] is to buy less than you can afford, even though the real psychology of all of us is that we always buy more because of enthusiasm."

While there's no broadly applicable way to calculate precisely how much money to keep off the table for emergency use, Yegge advises buyers to use the tools of leverage to their advantage, thereby reducing their own cash investment. Finance as much of the sale as possible using the assets that come with the company. Whenever possible, he says, "get a list of the target company's assets, take it to your banker and ask what you can borrow on each of the components individually."

Getting detailed asset information from the owner of a small business can be difficult; that sort of data is held very closely in private firms. That's why Houston business broker Jeff Jones explains to prospective buyers that they're not the only ones who need a little wiggle room; the person on the other side of the table, the seller, needs some, too.

"It's a big mistake on the very first meeting with a seller to start asking for tax returns, leases, maintenance schedules, and the rest of the laundry list of documents the bank has told you to get," Jones says. "The seller won't release that information to somebody who is just starting to snoop around. He doesn't want to end up seeing his tax returns floating around the countryside." Even the broker who lists the business may not provide all the financials right away, Jones says. "I may have that information in my files," he says, "but I won't give a buyer copies until things get serious."

Instead, Jones recommends an approach that is almost courtly in its deference to the seller. Understand that reputable sellers know all the financial data has to be provided and will eventually hand it over, Jones says. But first, they need to feel confident that you're examining their records in earnest. Once they trust you, he says, they'll open their files.

You can accelerate the process by opening up first. Yegge advises buyers to prepare a document that is a cross between a resume and a personal financial statement. Typically, it should include a one-page write-up of your financial condition, including how much money you have on hand for a down payment, the value of your assets and other relevant figures. It should also include a one- or two-page summary of your own education, training and work history. "Offer it to a seller as a way of saying `Here's a little something about me,' " Yegge says. "Once you've shared something about yourself, the seller is more inclined to believe you're genuine."

To determine how much down payment you'll need, most experts say you should calculate what your rock-bottom annual income needs are. That figure is roughly equivalent to what you should expect to have for a down payment, except in industries with high operating costs due to big equipment needs or other special circumstances. In other words, says Ron Hertenstein, president of Anthony Wayne Business Exchange in Ft. Wayne, Indiana, "if you need $50,000 a year to keep your family afloat, then you'll probably have to spend about $50,000 of your own money to get a business that will pay that [much]."

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This article was originally published in the February 1998 print edition of Entrepreneur with the headline: Leap Of Faith.

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