Buying a Company (or how I got into this)

When I describe what I do, the most common reaction is for people to ask "So how did you get into that?" The answer, as they used to say in the old electric razor commercials, is that it interested me so much, I bought the company.
Now, at some level, corporate acquisitions were not new to me -- I had worked with acquisitions and acquisition analysis in many of my corporate jobs. But these were large acquisitions - at least $20-$40 million in sales, and it was funded out of a large corporation's cash flow.
One fateful day, I decided that A) I hated working for other people and B) I had no groundbreaking entrepreneurial ideas of my own so that C) if I wanted to own a decent sized business, I would have to buy one.
Unfortunately, I had NO CLUE how to go find companies that were for sale and that I could afford. In fact, I was not sure at that point such opportunities even existed (again, when the rubber met the road, my Harvard MBA let me down). And, if the questions I get asked all the time are any indication, I was not the only one who didn't know how any of this worked.
So, let me share how it all worked for me.

First Step
OK, the first step was relatively straight forward, and may be one you have already tried. I went to Google, and plugged in "business for sale arizona". Now, that looks encouraging - pages of results (actually, a lot more comes back today than when I first did it). Now, start clicking the links. Hmm, kind of thin, huh. That's because most of the stuff that ever makes these web sites is either out of date (ie sold or off the market) or the dregs that have been listed for years and months.
This did not necessarily daunt me - the same issue often exists with Internet home listings. But these listings do give you a very good lead on who are the brokers selling companies in your area.

Who are these brokers?
Business brokers are like real estate brokers in that they generally get paid by the seller based on a percentage of sales (8-12% is not uncommon). The buyer can (and should) have a broker representing them, and, again like home sales, the buyer's broker is usually (but not always) paid out of the seller's commission. Brokers, in terms of their skills and outlook, tend to fall along a continuum. At the low end, selling smaller businesses like retail shops, they look and act a lot like real estate agents, and in fact many are both. These brokers tend to handles smaller sales up to a few hundred thousand dollars. At the other end of the scale are full fledged investment bankers, who tend to handle sales of $20 million or so and up. In between are the dedicated business brokers, who really specialize in mid-sized transactions.

Why is no one returning my call?
So, based on my web searches, I started writing and calling and emailing various brokers. Nothing. No answer. If you grew up watching Loony Toons, think Daffy Duck on stage with the crickets chirping. I could not for the life of me figure this out - if I had called real estate agents, they would be pestering me every 5 minutes.
It turns out that business brokers are inundated with what they consider unqualified buyers. People apparently read one of these "nothing down" get rich quick investment books and start calling brokers, trying to buy large companies with no down payment, no relevant experience, and no real liquid assets. No matter what is written in any book, its not going to happen. To buy a small company, you need AT LEAST one and preferably both of these:
1) available, liquid assets or home equity value equal to a substantial percentage of the purchase price or
2) vast, directly relevant experience and history of success in the exact industry of the target company
Without #1, you will need a loan, and no one, including the SBA, will make any kind of substantial loan without #2
So, inundated with twenty hopelessly unqualified buyers for every one good one, brokers seldom return calls. Finally, one broker took the time to at least explain the above to me. I then sent a new set of letters to brokers. In these letters, I was more precise about the target company I was seeking, I explained, in the same detail I would for a job interview, my experience in these industries, and I even included a detailed balance sheet to show my financial capability to buy something.

Finding a Company
The approach above was ultimately successful. Once I had a broker, we starting going through the lists of what was available. Most communities have what amounts to an MLS for companies, though it is much less developed than its real estate equivalent. If you want a restaurant or a micro-brewery or a craft store, you are probably in luck. Every time I have looked, our local listings were dominated by these type businesses (though if you are smart, you might want to try to learn something from the fact that so many are up for sale). I was looking for a manufacturing or industrial products distribution company in a certain price range. Sometimes, the right company is available, and sometimes you may wait for years for one to come up. In my case, I was lucky, and something likely was already on the list.

Valuation
You could write a book on corporate valuation, and in fact many people have. There are many ways to value a company, and I spent a lot of time with big spreadsheets at large companies doing sophisticated cash flow analyses. You can do these for small companies, but most brokers and sellers will stare in confusion at your work. Do these analyses anyway, if you know how, but no matter what, you need to understand how the seller and broker are valuing the company. The good news is that the standard approach tends to yield some pretty attractive valuations.
First, you need to get to a number known as the annual cash flow to owner. To get to this number, you begin with the company's stated profits from the previous years, hopefully arrived at by some acceptable accounting method. You then adjust this number as follows:
1) add back non-cash expenses (such as depreciation)
2) subtract out cash expenditures that aren't booked as expenses - generally capital investments
3) add back the salary or other compensation the owners took for themselves
4) add back any one-time expenses that aren't expected to recur in the future and subtract one-time revenues that won't recur
Number four is where sellers get especially creative. They will claim all kinds of things are unusual one-time expenses that won't recur. Take these with a grain of salt (or two). Also, in number 4, depending on the owner, you may start finding odd stuff. For example, I was looking at a security alarm company, and the owner had an add back of $100,000 in cost of goods sold. That was very odd - I had never seen an ad-back in COGS, since ad-backs are usually overhead items (e.g. cost of special insurance policy that covers the owners). It turns out that the owner had the company purchase $100,000 of materials for his vacation home construction and had slipped these personal expenses into COGS so that he could write off the cost of his 2nd home. Once verified, I agreed that it was a valid ad-back, but for me, it was also a huge flashing red light that caused me to lose trust in the sellers and their business. If they were cutting legal corners here, where else were they cutting them? I could probably shelter myself from liability for their past actions, but what if I had to raise costs to get in compliance - e.g. if, as actually happened in the business I ended up buying, I had to raise labor costs to come into compliance with wage and overtime laws.
To this cash flow, owners and brokers will apply a multiple to arrive at a sales price. These multiples usually range from 3 to 6 times the annual cash flow to owners. So, if a company has a cash flow to owners of $100,000, they might try to sell it for anything from $300,000 to $600,000. Note that many large companies can pay 8 or 10 or even more times cash flow when they acquire companies. When you buy stocks in the stock market, you might be paying 15 or 20 times cash flow.
This makes small companies potentially attractive acquisitions. But there is a reason for the low multiples. Much more can go wrong with small companies, and small companies are much more likely to have hidden problems, falsified financial statements, etc. Companies without much performance history and dodgy accounting statements will trade at the low end, while companies with very clean financials and solid performance history will trade at the higher end.
Of course, this value analysis is only a starting point. Far more important will be your estimates of future earnings and cash flows.

A second way to find a target company
If you were reading the first post carefully, you will note that I am running a recreation services company but initially started to buy an industrial products distribution company. As it turned out, I got all the way through due diligence and within 24 hours of signing the agreements with company A when the owners (and founders) got cold feet about selling daddy's company and changed their mind. Bam, back to square 1. Four months work down the drain. I then found a second company, a marketing products company, and went three months down the road to buying them and - oops, they changed their mind about selling too. Eventually the third time was indeed a charm, and I ended up buying the recreation services company. Apparently, while my experience was extreme, it is not that uncommon for sellers to get cold feet.
Anyway, back to the point about finding companies to buy. When the first company backed out, I had already quit my job. I was left unemployed and without a company to run. Worse, though I did not yet know it, the SBA had stopped writing larger loans of the type I had obtained to buy the first company (we'll get to financing in a minute). Since I had no job, I could not sit around for months hoping for something interesting to come onto the market. My broker (Janice Staripoli referred me to a second broker name Walt Lipski who had a process for cold-calling on local businesses to see if they might be thinking about selling. (By the way, if you are in Arizona, I would recommend either of these folks to you - Janice handles smaller businesses while Walt handles larger ones).
Walt created a letter and sent it out to businesses in SIC codes that were of interest to me. From over 1000 letters, we ended up with 20 or 30 interested companies, many of which we went to visit. In retrospect, this was a very fun time - never had I imagined the diversity of businesses and interesting ideas right in our area. Anyway, through this process we identified company B, which fell through, and eventually company C which I bought.

Due Diligence
Due Diligence is a fancy legal word for kicking the tires. You need to gain confidence on a number of issues:
1. Are the historical financials trustworthy - do they really reflect how the business has been performing
2. Are there any hidden liabilities, like lawsuits, unpaid debts, aging equipment that needs to be replaced, pensions, etc.
3. Are there any looming business problems or opportunities that could radically change the company's performance in the future. For example, if you are buying a small hardware store, the fact that they are planning to build a Home Depot around the corner might make a difference. Or, if the business depends on low cost labor, a looming hike in the minimum wage may be significant
4. Can the business survive without the previous owners, or does it depend on their unique skills and/or relationships
5. Does the business make sense to you? Is the customer base strong and growing? Do they have a good plan for starying ahead of competitors?
Accountants are the perfect resource for answering question 1. There are many local accountants (your broker can recommend some) who have experience checking sellers' income statements. In my case, my accountant compared the sellers tax returns, bank statements, and income statements. Your main worry is that the seller is overstating income. Sellers who do this seldom also overstate income for taxes (because it would increase their tax bill). Even if they misstate taxes as well, it is very hard to explain why all that extra income is not appearing in the bank accounts. If these three match, the seller's statements are probably (but not definitely) OK. Also, you can learn a lot about the sellers by the quality and detail of their statements. If they are detailed and well-organized and meticulous, they probably expended the same care in the rest of the business. If they are cheating the IRS (which I found a LOT in looking at small companies) they may be cheating you too.
Questions 2-5 have to be answered by you. You need to question everything and everybody. You need to inspect all the facilities. Do not rely on others - its is your money. You need to have confidence that there are no surprises. When you and your attorney write the legal documents, you can protect yourself on some of this stuff but not all!

Equity Purchase vs. Asset Purchase
While this issue may strike you as arcane, it is critically important to you as a buyer. The answer to which is better depends on the situation, and you definitely need to have a long talk with your lawyer, your broker, and your accountant about this issue. Here is how they differ:
In an equity purchase, you are buying the stock of the company. In doing so, you are buying everything - their assets, their debts, their corporate shell, their tax ID numbers, their pending lawsuits, everything. You are also buying the whole company history. You can get sued for past actions of the company even before you bought it. If the company has taxes or debts it owed, even if you did not know about it, they are your debts and liens now. You never, ever want to buy the equity of the company without first:

1. Having the previous owners indemnify you and the company for all debts, taxes, lawsuits, etc. prior to the acquisition date, and
2. Setting some money aside to assure that the previous owners have the resources to satisfy #1. For example, it is very normal in an equity purchase that 20-50% of the purchase price be deferred payment for several years. The purchase agreement will specify a process where the buyer can net out costs to satisfy the indemnity from the deferred money owed.
Despite these problems, equity purchases happen a lot, for at least 3 reasons:
1. The company is a C corp, and the seller refuses to tolerate double taxation of the proceeds of an asset sale
2. The seller has a really high equity basis and low asset basis, such that an equity sale results in a lower capital gain
3. The corporate shell has value. This is sometimes the case for multi-state businesses, where there are a lot of tax and business registrations necessary, or businesses where there are contracts that are not transferable to another company.

In an asset purchase, you the buyer are going to form a new company, with all new registrations, and then that company is going to buy the assets, contracts, trademarks, name, and intellectual property of the selling company. Unless agreed to in the purchase agreement, you therefore inherit none of the debts or liability or history. (there are some exceptions to this - for example, most states require that you inherit the selling company's unemployment reserve account and history whether you want it or not.)
Asset purchases are generally more work for the buyer. You have to form a new company, and get all the necessary pieces of government paper for that company (Federal tax ID, state sales tax number, state unemployment number, state withholding number, foreign corporation registrations, trademark registrations, local occupancy licenses and health inspections, etc.) and you will have to amend many contracts and vendor files.
I guess the obvious question was, what did I do? The seller had an S-corp with a very low equity basis. While they initially asked for an equity deal, they accepted an asset deal. After seeking lots of advice, I formed an S-corp to act as the purcahse vehicle. In the case of the company I bought, the paperwork to get things set up in this new company was ridiculously difficult, since the assets I bought were in 11 states. I spent months and months learning what every state needed, and I guarantee that in the fine federalist form of government we have, every state does things differently. Trying to get this all in place was probably the most stressful period of my whole life.
One other note - it is absolutely critical that in the purchase agreement for an asset purchase, you and the seller agree as to what value you are going to be putting on the assets for your taxes - its has to be the same. Lets say you did a $200,000 asset purchase. While there are other factors, basically you will allocate this price either to the purchase price of the assets themselves or to goodwill. Goodwill is the accounting way of saying "purchase price in excess of the asset values". It is basically the amount you spent for the intangibles of the business - their place in the market, their customer relations, their good name, etc. It is generally in the buyers interest to allocate as much as possible to the asset values, and as little as possible to goodwill, since you can depreciate tangible assets much faster than you can goodwill. The seller, due to a little known tax concept called depreciation recapture, often want the opposite.
In our case, the assets were relatively new and still on the books for a high value so there was not a lot of debate about their value. In addition, since a lot of the value of the company was in the contracts I was purchasing, we were able to assign some of the purchase price to these contracts and depreciate these values over the life of the contracts. As a result of the asset purchase approach, for the first few years of operation, we are getting a tax break as these assets and contracts are creating a lot of depreciation, which reduces taxes without affecting cash flow. Like most tax breaks, this is really just a deferal, with the taxes getting paid whenever I resell the assets. So the trade-off in the selection of the asset purchase has been a huge amount of work vs. some tax benefits.

 

Financing the Purchase
First, you have to figure out how much money you will need. The obvious answer is the purchase price, but this is usually too low. In the vast majority of small company sales, the sellers will strip out all of the cash and working capital. In addition to the purchase price, then, you will need to be prepared to inject additional cash as working capital. Go back over historical financial statements to get a sense of the requirements - and don't forget seasonality. In most businesses, there is a time of year when sales drop but costs stay up and the business demands more working capital. And, if you are growing the business, you will probably need even more (unless you have figured out how to have negative working capital like Dell).
No matter what any book has told you, you are going to have to put in some of your own cash. And that cash needs to be real equity, meaning cash you own and not cash you have borrowed. I don't know how low you can go with equity, and it probably varies a lot anyway. You probably need to plan to put in at least 20% as equity.
The rest you will have to borrow. The first, best source of borrowed funds is the seller. It is very, very usual that sellers will "carryback" a part of the purchase price. If you remember from part 2, we said that it is important to make sure that some of the purchase price is deferred, so that you have some leverage to recover funds against the sellers various guarantees and indemnifications. Thus, this seller carryback or loan serves two purposes. Sellers should always be willing to carryback at least 20% of the deal, and I have seen cases where they will carryback 50% or more. It all depends on the deal and how eager they are to sell to you.
The next source may be family and friends. This is where I ended up closing the financing gap for my company. This might be in the form of gifts or loans. If the funds are a gift, make sure you get a letter stating that from the giver - many banks will ask for this if they ever are considering a loan for you. If it is a loan, you will probably want to try to get them to agree to subordinate their loans to any current or future bank debt. Banks will be willing to lend to you even when you have family or personal debts IF those other lenders are willing to sign an agreement subordinating their debt to the banks (basically, this means that if you go belly-up, the bank gets paid first).
Then, there are the banks. From my experience, it is very, very difficult to get a bank to make an uncollateralized loan - i.e. a loan that is secured only by the cash flow of a company rather than by assets. In fact, I have never been successful at that. About the only way that I have found that banks will make a loan is if it is an SBA loan, where the SBA basically guarantees the loan for the bank. The SBA goes through cycles of being very open to lending to being very tight. I have not dealt with them for over two years, so I don't know what their stance is today. Remember, though, that the SBA is not going to approve any loan where the buyer has no experience in the industry or where the buyer is not putting down his own money as well. The SBA has a lot of information here.
The other way that banks will lend to you is if you have some asset you can commit as collateral. Your home equity is an obvious source. A less obvious source is the very assets in the company you are about to purchase. If you are buying a company with a lot of equipment, particularly with a few large expenses pieces of equipment (e.g. street cleaning trucks in a street cleaning company) it may be possible to get a bank to lend against these assets. Or, if these already have loans on them, it may be possible to assume the loans. Remember that assuming a $50,000 loan from a seller is just the same as paying him $50,000.
Finally, try not to max yourself out. Ideally, you would like to have a bank line of credit with some extra room in it to handle emergencies or opportunities. I began with a line of credit equal to 4% of sales that I have grown to 10% of sales. This credit line has become a competitive advantage for us - it lets us quickly take on new opportunities that our competitors cannot finance.
Once you put together a financing package you think will work, you need to test it to make sure you can make all the payments. You need to put together a spreadsheet by month for at least three years of what you think the P&L and cash flow of the company will be, and make sure that you can make your loan payments. Then try things - what happens if sales drop 30%? If wages go up a dollar an hour? Get comfortable that you can live with this transaction. You are buying a company to make your life better, not drive yourself to an early heart attack.

The Purchase Agreement
This is the key legal document you will prepare. It should include:

1. What you are buying, for what price. In an asset purchase, it includes exactly what assets are purchased - don't forget soft assets like trademarks, contracts, customer lists and other intellectual property. In asset purchases, it also includes an allocation of purchase price to the various asset classes. In an equity deal, you will need to agree on exactly what the balance sheet will look like. Since levels of working capital tend to fluctuate daily, there usually is a price reset mechanism to adjust the price based on the net working capital on a certain day.
   2. Guarantees, certifications and indemnities by the seller. For example, they should indemnify you against all past legal actions, against any past taxes due, etc. They should also certify that the historic financial statements you used to buy the company are true and accurate, that there are no undisclosed legal problems or lawsuits, etc. In out case, we attached almost all the key due diligence documents (tax returns, bank statements, P&L's, insurance loss runs, etc.) to the purchase agreement with a certification by the sellers that it is all true and accurate. These certifications and warranties are important - get your lawyer and broker to help. Note that what the seller will not do (unless he is a real sucker) is certify or guarantee that the financial results you get will be as good as his were.
   3. A good purchase agreement will specify a mechanism that allows the buyer to net out penalties for these certifications and warranties being incorrect directly from the carryback without going to court.

Non-Compete Agreement
The next most important agreement is the non-compete. Get one. Every time. No matter what the seller says about not ever wanting to be in that business again (and he may be sincere at the time), at some point in the future he will probably want to get back in. The entrepreneurial recidivism rate is higher than for ex-convicts returning to crime. The non-compete should be for at least 3 and preferably for 5 years, and clearly define what businesses the seller cannot get into. It should also specify defined penalties for breaking the agreement.

Other Documents
Assuming you have a carryback, you will probably have a loan agreement specifying terms and interest rates. In many cases, you may want to retain the seller as a consultant or to help with certain tasks. They should generally provide 90 days of help for free - after that, it is up to the two of you to decide what kind of agreement to hammer out. In my case, the previous owner still works for me part time nearly 2 years later.

A final note on documents
You need to understand and "own" every word in these documents. DO NOT just rely on your attorney to draft and negotiate them. Your attorney does not have to live with the deal, you do. By the third time I did this (remember that I had two sellers back out at the last minute) I was writing everything myself and getting my lawyer to check it. There is no magic about legal work. Yes, they know things you don't, and have standard clauses that need to be added that you don't know about, but that's their job and they will fix those things. Believe me, if you are going to run a small business, you can't run to a lawyer for $400 an hour to draft every little document -- you are going to start learning a lot about being a lawyer whether you like it or not. You might as well start learning now how to write these documents yourself.
Conclusion
I hope this is helpful. Please don't be intimidated -- yes there is a lot to learn, but I started out knowing just about none of this stuff and I managed to figure it out. Running my own company has been fantastic. The actual acquisition and startup part was hugely stressful and time consuming, but I am happy I did it. Good luck.

By the way, I am not a lawyer, accountant, investment adviser, and broker. More importantly, even if I was, I am not your lawyer or adviser. Please don't take this post as advice - treat it as background so you can be better prepared to work with your own advisers.