Buying a business brings about an exciting change in your life, but first you have to look for one to buy and finish paying for it. A lot has to be done to complete the transaction. Here’s everything you need to know about paying for a business when you find one you want to buy.
You may want to check out our full guide to buying a business here before you read up on paying for one.
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Paying for a business: looking at purchase prices
As you narrowed down your list of businesses to buy, you probably looked at the price tag associated with each one. However, you won't know until you dig into the financials whether the business is actually worth what they are asking for it.
For this reason, you shouldn't focus too much on the price tag when you're looking at businesses to buy. You might decide to rule out a business with a price tag that seems like it's more than you can afford, but since you will probably have to line up financing for it, that price tag can be a bit deceptive at first.
After all, if a business is healthy and making good profits, you will be able to pay it off much faster than if it isn't in good condition. That means you really need to understand how the business is valued before you can decide if it is worth the price they are asking for it.
Understanding business multiples
The basic foundation of figuring out how much to pay for a business is to look at the multiple the owner is asking for. Some common multiples to use are the earnings multiple or revenue, which means you would pay a certain number of times the company's earnings or revenue to buy the business.
According to Bizbuysell, an online registry that lists businesses for sale, the national average for earnings multiples of small businesses is 0.6 times annual revenue. That means you would take whatever their annual revenue is and multiply it times 0.6. Larger businesses usually come with bigger multiples attached.
In the case of earnings multiples, most business transactions use earnings before interest and taxes. In the case of revenue multiples, you use the company's annual sales with the multiple.
Beyond multiples in paying for a business
If you're using an earnings or revenue multiple in paying for a business, you must decide which year to use. Many business owners sell their business the year after having a sizable jump in earnings and revenue. If that's the case with the business you're looking at buying, you should think about how sustainable those earnings and revenue numbers are, whether they will be repeated, and whether there is further opportunity for growth.
Other factors that go into figuring out how much to pay for a business include cash flow, tangible assets and intangible assets. That means some companies will go for multiples that are much higher than the average.
In addition to thinking about the current financial health of the business when paying for it, you should also look at the potential for growth. This will impact the multiple you will pay for a business. Companies with higher growth potential will typically go for higher multiples.
Other tips for valuing a business
Businesses in different industries will go for different multiples, so that average 0.6 times annual revenue isn't necessarily a good guideline. You should research to find out what the average multiple is in the industry you are buying the business in and use that as a factor when determining the correct multiple to pay for a business. You may want to consult a business broker or appraiser or another expert about the multiple you should expect to pay in the industry you are entering.
To determine the correct multiple, you should also look at comparable businesses that are for sale or that have been sold recently. This is what an appraiser or broker would do in determining what a business is worth.
You should also look at what assets the business has and whether any of those assets will need to be replaced soon. For example, a business may have a key piece of equipment that will have to be replaced because it's near the end of its life. If that's the case, you shouldn't include the value of that equipment in the price of the business because you will have to replace it. This topic could be up for debate with the seller of the business, so keep that in mind.
After you have nailed down what the business is worth, it's time to start thinking about how you will pay for it. In most cases, financing will be required, although you might have enough cash to finance the transaction yourself.
Getting financing to pay for a business
In the case of financing, you will need to write a business plan to convince a bank to provide the funding for you to pay for the business. Other than banks, you may also be able to get financing through the Small Business Association, especially if you will be a minority business owner, which includes women of all ethnicities. SBA loans typically come with much lower interest rates than bank financing, so you should explore that option first. You should speak to your local SBA office about financing options to determine whether to shop your business plan to the SBA first.
The business plan will include details about you and your work experience to demonstrate that you have the experience and knowledge necessary to run the business you want to buy. The plan will also include details about the company's financials so the bank or SBA can see if it's worth the price you have agreed with the seller to pay.
You will also have to write about the industry the company is in, so the bank or SBA will have an understanding of how it makes its money and can see what its competition looks like. The bank will also want to read about the potential for growth and see future revenue and earnings projections for the company.
Finally, you will need to include a suggested interest rate and loan payment amount in your business plan, so you should research current interest rates. For the SBA, a good rule of thumb for the interest rate is to use 6%. Business plan software like Ultimate Business Planner can make figuring out the payments and how to write your business plan easy.
Documents required for paying for a business
When you are finally ready to pay for a business, you will need to gather the required documents. Many documents are required, so you should make sure you have everything on hand when you're ready to close the transaction. You should review some of these documents before you agree on a price with the seller, but you should also have them on hand when you actually sit down to close the transaction. Here's a checklist to get you started:
- Financial statements for the business
- Business expense statement
- Profit and loss statement
- Status of machinery, equipment, building and inventory
- Letter of intent to buy the business
- Contracts and leases
- Confidentiality agreement
- Sales contract
After you have gathered all the required documents and written your business plan, you are ready to move forward with the transaction. It's not a bad idea to work with an expert in the field such as a broker to make sure all the requirements are met. You should also have a lawyer review all contracts and business documents to make sure everything is in order.
Paying for a business takes quite a bit of work, but once the transaction is closed, you will be in an exciting new stage of life as a new business owner.