There's no doubt that buying an existing small business is less risky than starting one from scratch. Why? Because, unlike a startup:
- the business has equipment and inventory;
- the business already has a location, and maybe there's a few more years left on the lease;
- the business has employees, some of whom you may actually want to keep;
- the business has customers, most of whom probably will stick with you (unless this is a professional service business or practice); and
- most importantly, the business has a track record--you can look at the business' books, records and tax returns and get some sense of how much money you will make.
But there's still risk. Whenever you buy an existing business and look at its records, you're looking at the past. There's no guarantee things won't change going forward. If you're negotiating to buy a business and you think the seller is giving you a great deal, be very suspicious--there's probably something heading down the road at 90 miles an hour that will blow this business apart when it hits.
When doing your "due diligence" on a small business you want to buy, consider these five factors:
Demographic and political changes: If lots of business owners in town are looking to sell, there's a reason. How is the community changing? Is the population increasing, or declining? Is the population skewing older, or younger? Is a "miracle mile" shopping strip diverting traffic? Go to the local Planning and Development Office and see if there are any proposed zoning law changes that would change the "permitted use" at the business location.
Owner's Discretionary Income, or ODI: This is what the seller is taking out of the business after paying his suppliers, his employees, his rent, his overhead expenses and his taxes. If you can't live on the current ODI, or if ODI has been declining for several years, watch out! The business is going downhill. If the ODI seems healthy, get the seller to put it in writing, and hold back on naming your purchase price for a few months so you can confirm the seller's ODI numbers are accurate.
Beware the seller who tells you his actual ODI is greater than what he reports--if he's taking extra cash out of the till, understating income on his tax returns, or treating personal expenses as business write-offs, what are the odds he is being scrupulously honest with you?
The location of the nearest big competitor: If you're looking to buy a retail or service business, chances are there's at least one franchise or "big box" competitor that will wipe you off the map if they ever come to town. Where's the nearest outlet or franchisee? If you're buying a local hardware store, don't be afraid to call Home Depot and Lowe's and find out if they have plans to build a local store anytime soon. You might just learn what they're going to build on that 2-acre parcel just off the interstate.
Sales taxes: When you buy the assets of a business, you avoid responsibility for the seller's debts, obligations and liabilities (other than his lease and other debts you expressly agree to assume and continue paying). Except . . . for sales taxes. If your seller has been underreporting his sales taxes, and the state tax authority finds out about it, they can come after you for everything the seller owed. You can sue your seller, of course, but by then he's fled to Timbuktu and can't be tracked down.
Don't pay a penny for a small business until you know the seller has filed all state and local sales tax returns. Ask your attorney if you can get a "clearance certificate" from the state tax authority saying they won't come after you for any sales taxes your seller owed.
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.