Buying a Small Business? Beware!

Attorney Mitchell Stern lays out some of the pitfalls a potential purchaser must negotiate before inking a contract

Utter the word "entrepreneur" and the image that almost inevitably springs to mind is that of a small-business owner bootstrapping a startup. There is, however, another route to being the boss: buying an up-and-running operation.

Recently, BusinessWeek Online's Alison Ogden spoke with lawyer and writer Mitchell Stern about what to look for when purchasing a business. A senior partner at New York City law firm Gursky & Ederer, Stern is the author of Buy Your Own Business, The Definitive Guide to Identifying and Purchasing a Business You Can Make a Success. Edited excerpts from their conversation follow:

Q: What team of experts should a person have at his back when researching business prospects?


The principal ones to have lined up are lawyers and accountants. They are going to be pivotal in helping you evaluate a target company, work with the contracts involved in the acquisition, and also negotiate the price with the seller. A business broker can also be helpful in finding a good business to begin with. Depending on what type of business you're looking into, you might need additional professionals later on in the game.

Q: In your book, you talk about the importance of gaining the trust of the seller. Will having the support of the sorts of professionals you mention help with the trust factor?


That's a key point. A lot of people say to me, "A seller isn't going to want to tell me their financials," [so] establishing the trust between seller and buyer is key.... You want to give yourself legitimacy in the eyes of a seller, and having a team of experts with you is going to show the seller you're professional and serious about looking into his business.

Q: Any other ways for a potential buyer to project legitimacy?


I would have a lawyer give you a nondisclosure and confidentiality agreement to give to the seller at the very first meeting. It shows him that you are genuinely interested in his business and you understand his concerns about sharing information. This approach is going to make him feel comfortable and let him know that you've thought about his position as well. No matter what, having a document makes all the difference.

Q: And if they still don't show you their financials?


Walk the other way. That's a serious red flag.

Q: Let's say they do show you the books, how do you know that what you're looking at is the real thing?


You need to find an experienced accountant to help you evaluate tax-return statements and profit-and-loss statements. Somebody who is familiar with the area you're looking into is going to know what types of categories to look for in the statements and what reasonable expenses and profits are for those categories, given the size of the company, inventory, and product turnover.

It takes years of experience to become on expert on this type of thing, so a person shouldn't feel badly about putting income towards it -- and it's worth it! Ballooned profits in an area where similar companies in the market aren't experiencing them is going to take some more explaining on the seller's part.

Q: Are there other practical suggestions for the prospective buyer?


It's the buyer's job to be educated on these issues so he/she can direct the accountant and ask the right questions. Other practical advice would be to hire an independent appraiser to assess the value of the inventory and talk to every source you can outside of the seller's influence. Other investigative techniques would be to conduct a lien-and-judgment search.

Q: Can you explain those terms, lien and judgement?


Well, say for example, a person goes to a bank and borrows $50,000 and mortgages the inventory, accounts receivable, and equipment of that company as security. Well, that lien is filed as a public record and, as a buyer, this is certainly a case where you'd want to make sure that the loan has been paid off. There are also things you can set up at the closing to protect the buyer from claims that might not come in until later.

Q: For example?


Well, not releasing monies to the seller until a certain amount of time goes by, making sure the state has given sales-tax clearance -- these are things your lawyer should set up for you. You're also going to want to make sure the lease you're getting for the space is authentic. Does the person selling you the business have the right to transfer the lease, or is the landlord suddenly going to be asking you for more rent? A favorable lease can really make or break a business.

The [issue] that comes across even more than, "How do I know if I'm getting the right set of books?" is [when the seller says], "Here are my books and my tax returns, but I'm doing a lot more business then what this is showing you." Usually, they're expensing more things then it actually costs to run the business -- that's a very typical thing for small business. People have different thresholds for what kind of information they're comfortable giving, but often, they'll get across that the books aren't necessarily reflective of how well the business is doing.

Q: You devoted an entire chapter of your book to advising how to assess the value of a business, can you touch on the main points?


A business is difficult to value. There is no formulaic process that you can apply across the board. It depends on the customer base, the longevity of the business, the value of the lease, and the location itself. These can't be looked at in a vacuum...get your accountant to use two or three of the valuation methods available..... Also, look at the historical analysis and the financial records of the company, and project what you're income will be going forward with the business.

    Before it's here, it's on the Bloomberg Terminal. LEARN MORE