a) Insist on seeing income tax and sales tax returns 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!).
(b) Whatever you do, be careful when the seller tells you that he reports low income on his tax returns because he takes cash from the register 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? Take this with a grain of salt. Many financial advisors and accountants will not advise their clients to pay for such "skim". Unfortunately, skimming does exist in the real world , especially in certain types of businesses like restaurants, deli's, Laundromats and dry cleaners and many buyers don't care. If you have in interest in buying a business of this nature, and you are willing to take the inherent risks that go along with it, you should absolutely verify that the income is what is being said to be by the seller. If you go this route, the best method of determining the extent of this "skim" is to mutually agree to review the systems, procedures, and books and records of the seller during an observation" or "trial" period. If the seller is not willing to show you just how he skims, or, if you are not reasonably satisfied that skim exists, it probably doesn't. If this is the case, your purchase offer should discount anything that cannot be proven to you by the seller. If you are not satisfied, then just say "thanks but no thanks" and walk away. There will be plenty of other deals and opportunities down the road.
c) As with most small businesses, the objective is to minimize the income tax effect on profit, consequently, many owners will write off everything they can, therefore, you may have to spend some time with the owner reconstructing the income and expenses taking into consideration all of the perks.
He may be writing off an unnecessary automobile, his wife may be on the payroll without actually performing services, and he may be providing health and life insurance benefits for himself and his family. This is all part of the cash flow of the business. Don't be afraid to ask.
AVOID PAYING TOO MUCH. One of the biggest concerns in buying an existing business is paying too much for it, as compared with what it would cost you to start a new business from the ground up, or 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 years of hard work to recover this "hidden" cost of doing business.
When buying a business, the following basic rules should be followed, and if all three can be accommodated, you probably paid the right price. Remember the 3 R's.
The business should provide sufficient cash flow to pay you a REASONABLE SALARY for your time. If it doesn't, stay where you are, you might be better off.
The business should provide enough cash flow to allow you to REPAY THE DEBT if any part of the purchase price is financed, either by the seller or an outside lending institution
The business should provide you with a REASONABLE RETURN on your invested down payment. Otherwise, keep your money it where it is.
Before you make an offer to purchase a business, review this with your accountant or accredited business broker. If your consultant is comfortable with the price, and you are comfortable with the price, the price is right. It will also give you piece of mind knowing that you have obtained a second opinion.
ARE YOU GETTING ALL THAT YOU BARGAINED FOR? One of the key items in investigating a business is finding out what makes it tick, and make sure you are buying that, whatever it is. For example, if it appears that the business has well developed customer lists or mailing lists, those should ordinarily be included in the sales agreement; if there are favorable 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!
DON'T BUY SURPRISES - You need to carefully assess the assets you are acquiring and the liabilities 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, or if the landlord plans to raise the rent drastically or not renew the lease at all when the current term expires. Insist that all equipment be in good working order. Do a walk through of the facility and make up your own "punch list" of items not to your satisfaction, including any repairs and maintenance required on the building. Ask the owner what kind of allowance he will offer you against the purchase price if you perform the repairs and maintenance. If available, review the receivables (Accounts Receivable Ageing) with a fine-tooth comb, looking for over due accounts. If a significant amount of these receivables are over 90 days old, there could be trouble. 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.
UNDISCLOSED LIABILITIES - Not all liabilities of a business show up on its accounting records. There may be any number of claims against the business, 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. Run a title and lien search in the local courthouse. This will disclose some of the problems. You may even insist on receiving a tax clearance certificate from the State Department of Revenue. If you are going to assume liabilities of the business, the written agreement of sale should specify exactly which liabilities are being assumed and the dollar amount of each. Watch out for any environmental issues. They can come back and haunt you. Many states now require an inspection by environmental engineers for ground contamination. If you are buying a dry cleaners, Laundromat, gasoline station, auto repair shop, salvage yard, fuel oil company, trucking company, or any similar business. You may have some environmental exposure.
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 buy the business assets from the corporation, rather than buy the stock of the corporation itself. The latter approach will subject the buyer to all hidden or contingent liabilities of the old corporation, whether or not you have agreed to pay for any liabilities 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, unlike a direct purchase of the assets. (One exception would be where the corporation has unused tax losses or tax credit carry over that could be used to shelter some future income from tax. However, the '86 Tax Reform Act has severely restricted the use of such carry over where there is more than a 50% change of ownership of the stock of a corporation in a 3 year period.
NON-FINANCIAL CONSIDERATIONS - All of your focus shouldn't be on the books and records of the company. Financial statements do not tell the entire story. There are historic documents. You are not buying the past profits, but rather you are buying the right to future profits. A few of these non-financial considerations are:
New and Pending Legislation - Try and research any possibilities of forthcoming legislation that might have a future impact on this business. Laws and legislation can and do ruin businesses and propel others.
Social and Lifestyle Changes - Lifestyles, concerns and attitudes are changing everyday. Detecting social trends can lead to substantial profits. By the same token, failing to recognize a social trend can prove fatal. Some examples like cigarettes, disposable diapers and auto emissions are just a few items that concern us today. The mom and pot grocery stores are long gone. Video stores were hot, now there not. The cable T.V. business and mobile communication are business that have boomed and which have a bright future. Be aware of changes.
Research The Industry and Your Competition - In our free market system, competition is a fact of life. Check out your competition before you buy. Check product lines, pricing and, if possible, observe the operations. Is your prospect any better or worse? Is a new competitor coming to town? Ask around. Check the township or county for any new business filings. If so, is there enough room for two of you? Spend some research time investigating your industry. How is your target business doing in comparison to other companies in the industry? Trade and professional associations can help you find this information along with the U.S. Department of Labor Statistics. Many business brokers have comparable company and industry information you can use as a gauge. Stock brokerage firms are also an excellent source. Robert Morris and Associates of Philadelphia, Pa. is one of the best-known information sources in the country and can provide ratios and statistics for just about any industry. Accounting firms and bankers frequently use this source. Our beloved Internal Revenue Service provides statistics of partnerships, proprietorships and corporations that can be obtained from the Superintendent of Documents, Washington D.C. Your local Chamber of Commerce is another good source.
Facilities - Be careful about a business that has equipment that could become or is inefficient by today's standards. If a competitor has superior equipment, you may find yourself at a disadvantage. If you have to upgrade, can you afford to? Maybe you can't afford not to. You may have to plow additional capital into the business sooner than you think.
Economy & Industry Projections - There are certain industries that become extremely sensitive to economic conditions and interest rates. The home building, retail and automobile industries tend to flatten in sluggish economic times. Conversely, used car dealers, auto parts stores, auto repair shops, home improvement centers and shoe repair shops tend to remain steady or slightly increase during slow economic times. How does your business size up?