Embarking on a small business venture takes courage, lots of energy, and a willingness to take risks. This guide to buying a small business, instead of starting a new business from scratch, will showcase several advantages that buying an established small business venture offers.
The current owner has already done the crucial, real-world testing, and established a cash flow track record, which proves the products or services have a market. Learning how to buy a small business is largely a matter of paying attention to due diligence, and evaluating three core concepts.
1. Cash Flow and Profit Margin
One of the most important questions to ask when buying a small business is what is its profit margin? Profit margins vary between industries, and you should do your homework on what is a competitive level to shoot for.
The income and cash flow statements should give you a window into what is working for the company, and if there are products or services that are dragging down the profits. What to look for when buying a small business is the breadth of the customer or client base. If losing one or two major customers would jeopardize the cash flow of the venture, you should develop a marketing plan that brings in new clients.
2. Human Resources
What to consider when buying a small business in terms of human resources are the following: employee morale, work ethic, and commitment to quality. Taking the time to talk with as many of the employees as possible is a great investment. You need to find out if they are committed to staying with the business, and if they have ideas on areas in which the business processes can be improved.
Just like a business that is too dependent on a few customers, the loss of key employees can also destroy the venture. You need to make sure the crucial employees are willing to stay, or train in their replacements.
3. Processes
There are processes the business uses for everything from marketing, customer service, manufacturing, inventory, billing, receivables, etc. By asking lots of questions on the current processes, you gain a clearer picture of the true health of the business. This post is a good guide to the legal processes which may be involved.
What is the cost to acquire a new customer, and how is it accomplished? Does the business rely on advertising, trade shows, or word of mouth, and is there a marketing plan to test new ways to generate more business? How much is an individual customer worth over time, and is there a system to sell them additional products or services?
How current is the business on paying its bills? And how efficient is it in collecting its receivables? The balance sheet may list receivables as assets, but the employees may know which ones really are unrecoverable.
How accurate does the business know the cost of goods sold? Many small businesses have very poor inventory control systems, and manufacturing often is delayed by parts shortages. Does the business check with several vendors to keep its costs down?
Is there space allocated to dead inventory? Just like bad receivables, some inventory listed as assets may well be worthless. Even worse, the dead inventory continues takes money to store, count, and manage.
If it is a manufacturing process, how current is the equipment? If a piece of equipment breaks, what is the repair or replacement cost? And what does the work flow look like. Many companies have just grown over time without any thought to work flow, and have ended up with an inefficient process.
What is the quality of the products and services the business produces? Do customers continue to buy from the business, and refer new customers to it? How good is the business at meeting its time commitments to customers? What is percentage of products that are defective, and returned?
Final Thoughts
After taking the time to investigate as many of the business processes and employees as you can, you will be in a position to evaluate the numbers. Is the business sustaining growth, or have revenues and profits margins dropped? What is the reason the business is now for sale?
Before you make an offer, you need to have a clear plan on the direction you want to take the company. Does it require more working capital, new equipment, new product development, expanded marketing efforts and better customer service?
By doing the appropriate due diligence, you can deduce the inherent risk of ownership, and the investigation process itself can uncover new ideas for your success!
