Guide To Buying a Business

Financial Criteria

Buying a business is risky. Financial returns from any investment should reflect the level of risk of that investment. Generally small to mid-sized businesses are priced to produce a pre-tax return of between 20% (for a business bought at a multiple of 5) to 100%(for a business bought at a multiple of 1). Most businesses are priced with a return on investment of 25 to 30%. The expected rate of return varies based on industry, business location, growth rate, and other factors. Determining what a reasonable multiple is for a specific business is discussed in detail in the section on valuation (which is not written yet but you can visit our companion website www.guidetosellingabusiness.com and read the valuation section there). In some industries (especially technology related industries) it is not uncommon to see multiples as high in the 5 to 7 range, especially in transaction in the $5 to $10 million range.

To understand why businesses have such a high expected rate of return think of it this way. You can buy a basket of small capitalization value stocks for a P/E of about 10 times trailing earnings (or an expected return if past performance is indicative of future results of 10%). If you buy that basket of stocks, you have both geographic diversification and industry diversification that make the stocks less risky than any individual small business. Since you can sell the stocks at any time, in a matter of minutes, you have a great deal of liquidity, whereas with a small business it may takes months or years to sell. When buying a business the seller knows more about the business than you do, but you may know as much about the company as the seller of a publicly traded stock. Many of the disclosure requirements that exist for public companies do not apply in buy/sell transactions of companies that are not publicly traded. Finally, a basket of publicly traded stocks requires little of your time and attention, whereas a small to mid-sized business will require a great deal of time and attention. For all of these reasons, you should expect a far greater return on investment when buying a company in a private transaction.

There are a large number of approaches to valuing a business that are discussed in detail on our companion website Guide To Selling a Business. You can also use the Free Valuations Online calculator to help you determine an appropriate price to offer for a business. Keep in mind, when using the calculator or any of the methods explained on the website that these calculations give a price based on a 100% cash price at closing. If the owner is going to be taking back paper, there is an earn-out or other contingent payments as part of the offer, or the owner is retaining stock in the company the price should be adjusted to account for the increased risk to the seller.

Specific Goals For Individuals Acquiring A Company

As an individual you need to know why you are acquiring a company, beyond just as a way of making money, in order to decide what type of acquisition target to search for. Are you a hands on person, who enjoys building things yourself or a manager who enjoys supervising others as they do the work. I, for example, sold my programming business when it got to the point that I spent the vast majority of my time supervising others and almost none actually designing software. So, if I were going to buy a business I'd want to buy a smaller one.

You need to determine what industries you know well enough to properly evaluate an acquisition target and which industries you would enjoy working in. For example, even if you believe that pharmaceutical research and development is fascinating, unless you have a background in the industry, buying a business is not a good way to get into the field. Entering even a simple field, like landscaping, by buying a business is ill advised. You don't want to find after you've closed a deal that baking in the hot sun is not the life for you.

You need to do some self examination to determine what kind of a job and what kind of business will make you happy. If you don't have a good grasp on it, one of the most respected books on the subject is "What Color is Your Parachute?" (link at left).

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