Buying a Business Part 2--How can you Purchase a business?

Let's say you've found a business that, at first glance, looks like it could be a winner. In my next installment, I'll discuss ways in which you can help determine whether the business you want to buy really is a profitable business. But for now, there's a more pressing concern: How can you pay for this business you want to buy?

Simply put, there are only four ways to buy a businses:

1. Pay cash.
2. Obtain financing from an outside source.
3. Obtain funds through partners/shareholders.
4. Have the owner finance all or a portion of the purchase price.

Often, purchasing a business involves using a combination of the above sources. From a purchaser's standpoint, however, there are advantages and disadvantages to each method, depending on your own personal situation and the details of the business you want to buy.

Let's go through them one at a time:

1. Paying Cash. The main advantage to paying cash for a business is that you'll have an easier time reaching a positive cash flow. After you've bought the business, you'll have to pay taxes, salaries and wages, insurance, lease payments and other costs. Buy cutting out the necessity of a loan payment (and the interest that comes with it) you've reduced your overhead, and made it more likely that you can turn a profit. Often, by paying cash, you've got more bargaining power and can perhaps negotiate a lower purchase price.

There are, of course, some downsides to paying cash for a business. The first is a practical one: as with purchasing a home, many would-be buyers simply don't have the financial wherewithal to pay a lump sum for a going concern.

There are other disadvantages as well. Even if you do have the cash, tying it up in a business reduces your ability to invest your money in other endeavors. You are, as the cliche goes, putting your eggs in one basket. You're also risking a lot. What if your business fails? Then all the cash you've tied up could go with it.

Finally, there's one large disadvantage to paying cash that many would-be purchasers don't consider, but I'll discuss it further down below.

2. Obtain financing from an outside source (such as a bank).

As opposed to tying up a lot of your cash, a bank loan allows you to use less of your own capital, and more of other people's money, to get your business started.

Also, a bank loan, if granted, often comes at a better interest rate than, say, owner financing, discussed more below.

Finally, if you can obtain a bank loan for your purchase, usually some disinterested third party (the loan officer) is in effect giving you a second opinion on the business you're wanting to buy. You will need (as will be shown in further discussions) to do your own due diligence, but having an extra set of eyes look over the business and think it can work will at the very least reduce your chance of failure.

What are the disadvantages?

From a practical perspective, you'll still need to come up with some of you own money, because banks will usually not loan 100 percent of the purchase price on a business. Unlike a piece of real estate, which is dirt, bricks and mortar, a business is the value of something less tangible--the cash flow.

Also, of course, having to make loan payments of principal and interest will reduce your cash flow, making it harder to turn a profit.

Finally, if you borrow money from a bank and fail, you stand a greater risk of financial ruin. If, for example, you paid cash for a business and it failed, you'd at worst lose your cash you invested (though perhaps you'd get some of your money back simply by selling inventory and equipment). If, on the other hand, you borrowed the money and your business failed, you'd have to repay a bank note. If you could note, the bank could potentially repossess and foreclose on your business, and then go further and file a suit for any remaining unpaid money. More than once I've seen a wide-eyed would-be entrepeneur buy a business with bank money hoping to strike it rich, only to fail, and suffer foreclosure, financial ruin and bankruptcy.

3. Bring on partners or shareholders. One way to bypass some of the risks associated with borrowing money for a business venture is to raise your needed cash through partners or shareholders. Basically, each individual contributes money with the understanding that the money isn't a loan, and that there's risk involved, but also with the hope that the money will be a good investment through dividends, profits or perhaps increased equity and a sale in the future. This lowers the risk of a disastrous failure. If the business doesn't make it, at least you won't have put up all the cash (or be subject to foreclosure and repossession).

The down side, however, is that now you owe duties not just to yourself (or yourself and your lender), but to other owners of your business venture. Savvy investors will want a say in how your business is governed, and might even want a guaranteed dividend if the business turns a profit.

Furthermore, though you might have had the vision for the business's success, you've now got to get along with and cooperate with other investors whose visions may differ from your own.

4. Owner Financing. Under this scenario, the business seller finances all or a part of the purchase price by accepting payments, with interest, on the purchase. Some naive purchasers, ready to take the business to the moon, don't like the idea of a continued relationship with the seller after closing. However, I think this option can often provide the best chance of success. Why? Because the owner has a continued stake and interest in your business success!

In all of the other three situations, the owner would successfully be able to "cash out" and walk away from the business. To be sure, the owner couldn't intentionally deceive you about what you were buying, and a good lawyer might recommend that as part of the sale you make the seller sign certain agreements (a non-compete and an employment agreement) to help your success. But nothing will give the seller more incentive to help you succeed than the knowledge that if you fail, he doesn't get paid!

When I represent business sellers, I try if at all possible to discourage sellers from owner financing, because they will remain in essence a business partner for years to come, without the benefit of getting the profits. But from a purchaser's viewpoint, owner financing is very desirable.

Sometimes (though not always), the interest charged might be higher than a bank's rate. On the other hand, sellers often are willing to finance a larger percentage of the purchase than a bank, because the sellers have greater confidence in the business which they're selling.

If your seller has taken his cash and gone, you sometimes run the risk that he will not be around if you have questions, or that, absent an agreement to the contrary (or sometimes in spite of one) he will open up a competing business.

However, when the seller is receiving his sales price month by month, from the fruits of your business success, he has little incentive to not help you, and even less incentive to work against you or compete with you.

If you're looking at purchasing a business, before you sign a contract--or even a non-binding letter of intent--let a business attorney advise you. If you would like to meet with me, please contact me at 704-460-7398 or wldeaton@vnet.net .