What to Look For When Buying a Small Business

Like any investment, you want to assess the risks and growth potential before moving forward with your decision. When it comes to acquiring a small business, how do you value the business in question, and how do you know if you are mitigating your risk and not walking into a crumbling business?

There are several different things to take into account when you are looking to acquire a small business. Whether this is for a roll-up to your existing business, looking for a new career path, or simply wanting to add an asset to your portfolio.

I want to address the process, or route, to take when analyzing a business you are about to buy. Not just from a financial standpoint but other factors as well.

This information comes from my experience and background as a business broker. I have helped clients sell their businesses, and I have also helped clients buy businesses. Over the years of helping on both the buy-side and sell-side transactions and watching these transactions post-close, I started noticing some of the major things you want to look for when buying a business.

So, let's begin. But where do we begin?

My first step for myself and when speaking with investors who are looking to acquire is having your initial search criteria. This obviously varies for everyone depending on the ultimate goal. However, there are a few things everyone should have in their search criteria.

Looking for an Established Business

If you are looking to buy a business, you should look for something that is established. We are not taking a risk on a start-up; we are looking to acquire a successfully established business. So, I always recommend looking for a business that has been around for a minimum of 5 years. Why? According to the Bureau of Labor Statistics, around 20% of businesses fail during the first 2 years, 45% fail during their first 5 years, and 65% fail during their first 10 years.

Ideally, a business that is 10+ years old is what we want to look for. This means we are instantly skipping over the 65% failure rate and immediately reducing risk. We like that.

I get a lot of people who comment on my Instagram posts or during conversations who always ask me: Why not just take out a loan for half the amount and start the business?

It is a great question, and you can. However, my response to that is: because starting a business is not as easy as it sounds and you have a 65% chance of failing within 10 years. Not to mention that when you buy a business that has been around for 10+ years, you are also getting brand recognition, employees, customer and client relationships, vendors set up, back office set up, word of mouth is already out, etc.

All of these things take time and hard work to build up to.

So, my first item on my search criteria is a business that is a minimum of 5 years old, if not 10+ years or more. This reduces your risk of failing by 65%.

Earnings Generated by the Business

My second item is the amount of earnings the business generates. Typically, when you are searching for a business to acquire, they will have their advertised earnings available. Whether they categorize it as EBITDA, SDE, and in some cases Cash Flow, depending on your purchase power, you want to set a minimum amount of earnings the business makes. For individual investors, I always recommend looking for businesses that produced a minimum of $100,000 in bottom-line earnings. We are here to make a return, aren’t we?

This number is obviously subjective to each individual, but my point around setting a minimum is because we want to make sure the business produces a good amount of cash, and we also want to make sure that specific amount can service our debt payments. Yes, we are looking for a business that can pay back our loan and then put some in our pocket as well. Therefore, we need to set a decent minimum earnings, and those businesses are out there.

If we want to get into the nitty-gritty of it, most SBA lenders look for a minimum debt service of around 1.15-1.25. This means they want to see the business earn at least 15% to 25% more than your debt payments. In other words, service the debt. The higher that debt service number, the better for both you and the lender.

In conclusion, look for a business that generates a minimum of $100,000 in earnings and adjust this number up if needed/wanted/can, but I wouldn’t advise adjusting down. My reason for that is because any business earning less than that typically means you might be buying a job or will be heavily owner operated.

Customer Concentration

For my third piece of search criteria, I think it is crucial to look for businesses with a customer concentration below 15%-20%. This means no one customer or client makes up more than 20% of the revenue. I think a lot of individuals might overlook this, but it is incredibly important. There are plenty of businesses that do well with a high customer concentration, especially in the small to middle market, but most times, this is connected to long-standing relationships with the client and the owner. Remember, if you buy a business, you are removing the owner from the equation, which means you’re removing the relationship from the equation as well. Therefore, all it takes is that one customer to take their business elsewhere, and you lose a major chunk of revenue immediately.

This is something you most likely won’t find out until you sign an NDA to take a closer look at the business, but it should be one of the first things you look for. Even if those numbers on the Profit and Loss statement look good and the customer concentration is high, run.

Owner Dependency

This leads me to my next point regarding owner dependency. Now, this may vary depending on the type of buyer, but you do not want a business that is highly dependent on the owner. For many reasons, but to piggyback off number three above, you do not want to acquire a business where all the sales are a direct reflection of the relationship the owner has with the customers or clients. Again, you will be removing the owner from the equation, so what happens when you do that? You need to look towards the future of what could be the possibilities if the owner or owners are gone?

Is there a large portion of revenue-generating activities tied to the owner(s)? Is the owner or owners heavily involved in operations? Meaning, are they going out to job sites themselves? Are they performing the actual services? If so, you need to take a minute to reflect on that. Do you have someone who can replace their operational duties, which means hiring someone, which means cutting into your cash flow? (Which is fine, as long as you are aware).

The safest businesses, in my opinion, are ones where the owner does not have all the connections to the customers or clients, and they are not putting 40 hours a week into operational duties of the business. You want to look for businesses where the owners are doing duties that you yourself can/want to replace. For example, maybe the owner has a strong organizational chart in place, and they just work on the backend sales or the backend marketing or even the books. Unless you are looking for a business you have experience in and plan to take over the operational duties, then this isn’t as big of an issue.

So, keep an eye on owner dependency. We want to find out how many hours the owner works and what they are specifically doing in the business. Then, we want to assess if this is a role we can fill ourselves, or do we have someone we can replace them with knowing it will cut into cash flow. Ideally, we would love to find a business where the owner is a little removed or an owner absentee business, working on business development or something other than day-to-day revenue-generating activities.

Industry Safety

This next piece of initial search criteria may seem obvious. We want to stick to industries that are “safe” or recession-proof. I like to look at it from the angle of what services people always need, which leads into the “service” industry. Not the restaurant service industry, but home services. Think plumbing, HVAC, roofing, etc. Businesses that provide a service people NEED. If you go one step below that, I think it is smart to look for services that are re-occurring. Maybe not necessarily contracted services, but if I cut your grass this week, you are going to need it cut again in two weeks.

I have never been a fan of businesses that seem “fun,” such as entertainment-type businesses, bars, or restaurants. I think it is safer looking for businesses that can operate during a down market, their services or products are always needed, and even better, contracts in place for their services.

Lastly, you want to search for businesses that are in industries that may be a little difficult to start. Essentially a barrier to entry. Is it hard for the everyday person to get up and decide to start a business in this industry? Does this industry require a license or some sort of qualifications? If yes, then that is good. You want to find something safe during market downturns or recessions, a business that provides a needed service or at least a re-occurring service, and lastly, a business that is in an industry that has some sort of barrier to entry.

Financial Performance

This now brings me to the numbers. When you are looking to buy a business, you can buy for profit, opportunity, location, or all of the above. Most acquisitions are geared around profit.

This means you are buying based on the past performance of the business while simultaneously identifying further growth opportunities. How you buy based on past performance is by looking at the previous three years of profit and loss statements along with the business’s tax returns.

Typically, you look back three years and, in some cases, five. The number one thing I like to look for and advise on is that the statements should reflect a positive trend over the previous three years with no irregularities. If a business takes a dip in one of those three years, it isn’t necessarily the end of the world, but you have to understand that inconsistency is a possibility moving forward. Of course, we cannot predict the future, but we want stabilization and consistency as much as possible. Simply put, reducing our risk even more.

As you can imagine, this allows the seller to ask for a higher purchase price because they are “selling while high,” but I believe in the saying from Steven Schwarzman: “The returns to successful ownership will often be much higher than the returns on winning a one-off battle over price.”

When you find a business that checks all the above boxes and you have confidence you can continue the trend of the business, then you have found a good deal to pursue.

The hardest part is removing emotions from the decision-making process, and that is when it is critical to lean on your deal team: your consultant/advisor/broker, attorney, and CPA. Let your deal team lay out the facts in front of you, and if they all check those criteria boxes and you are still having a difficult time making a decision, it is most likely you are allowing emotions to boil to the surface.

Never make an emotional decision, but rather let the facts speak to you.