Blog

By Purple Fox Legal

December 21, 2022

An entrepreneur may prefer to buy a business, invest in it, and sell it instead of creating a business from scratch, which is generally riskier and entails a longer and more nuanced process. The main advantage to buying versus building a business lies in the fact that one can avoid a long, painful and expensive process. However, a key pitfall is losing creative control and the experience of being the founder of the business. 

Determining Fair Market Value

The fair market value of a small business is typically determined through a business valuation process, which involves analyzing various factors to determine the business’s value. This can include factors such as the business’s financial performance, the value of its assets and liabilities, the value of its intellectual property, the value of its customer base, and any potential synergies with the acquiring company.

In some cases, a business valuation may be performed by a professional appraiser who has expertise in valuing small businesses. In other cases, the parties involved in the acquisition may agree to use a specific method or set of methods to determine the fair market value of the business.

Ultimately, the fair market value of a small business is determined through a combination of objective factors, such as the business’s financial performance and assets, and subjective factors, such as the acquiring company’s willingness to pay for the business.

Only 30% of businesses put up for sale actually sell, which means it is extremely important to know how to price your business before going to market. If the price is too low, you risk leaving money on the table, and if it is too high, you risk not transacting at all or engaging in a prolonged marketing process. 

There are various valuation methods that are typically used to arrive at an estimate of fair value for a business, including the market approach (using comparable transactions as a guide), the multiplier approach (based on cash flow), the asset approach, and the adjusted net income approach.

Once a business owner has acquired a new company and carried out the business plan to add value to existing operations while growing the company, it may be time to sell it and reap the rewards.

Best Practices When Buying a Small Business

• Ensure the company is generating cash flow.
• Search for a company that is relatively undervalued in terms of cash flow.
• Look for a company with poor marketing, as that leaves room for improvement for a new buyer.
• Prioritize opportunities where you can run a business with low skills as opposed to needing to install a highly specialized (and expensive) team.
• Aim to improve the business by growing revenue and reducing expenses.
• Use seller financing when possible and use it to negotiate better terms and raise extra funds to pay for the balance of the transaction price and operations. Pay off seller financing and debt early, if possible, using revenues generated from the business.
• Ensure the business plan allows you to take a salary for running the business yourself or to cover the cost of installing a general manager to run it for you.

The Selling Process

The process of selling a small business can be tedious and may take nine months to complete. Transition and separation typically take three months more. The process entails the following steps:

1. A seller works with a broker/financial advisor to create a business valuations and marketing package, including a brief teaser. 

2. Buyers read the teaser, sign an NDA (non-disclosure agreement) and review a business summary of the business. Some brokers ask for proof of funds before the NDA & summary can be released. 

3. The buyer has to decide if they to pursue the deal. A seller interview is arranged. At this point, a buyer will have to send in an LOI (letter of intent). An LOI may be binding (requiring buyers to create an escrow) or non-binding. 

4. Buyers make arrangements for funding and due diligence, which is typically planned for 30-60 days. If a lender is involved, the deal is underwritten while the official and final purchase agreement is drafted by the buyer’s legal counsel.

5. Once the purchase agreement is agreed upon by all parties, a closing date is set. The funds are escrowed at one of the attorneys (generally the seller’s attorney), and at closing, the signatures are sent to the buyer, and funds are remitted to the seller’s bank.

6. Transition is planned. Normally there is a free period of roughly two months where the seller transitions the business to the buyer. Training may be involved. Finally, the seller officially “separates” from the business.

Legal Issues to Consider When Buying and Selling a Small Business

One of the first legal challenges that must be addressed when buying or selling a small business is the issue of due diligence. Due diligence refers to the process of carefully investigating and verifying the accuracy of the financial and legal information provided by the seller. This process is essential for ensuring that the buyer is fully aware of the business’s financial condition and any potential liabilities that may be associated with the purchase.

One of the challenges of due diligence for small business transactions is the limited resources and expertise available to thoroughly evaluate the financial and operational status of the business. Small businesses may not have the same level of financial reporting and documentation as larger companies, making it difficult to assess their financial health and potential risks. Additionally, small businesses may not have the same legal and financial advisors available to assist with the due diligence process, requiring the buyer to perform a more comprehensive review on their own. This can be time-consuming, and costly, and may require specialized knowledge and expertise to accurately assess the business.

Another legal challenge that must be addressed when buying or selling a small business is the issue of contract law. The terms of the sale must be clearly outlined in a legally-binding contract, which must be signed by both parties. This contract should include detailed provisions outlining the rights and obligations of each party, as well as any warranties or guarantees that are being provided.

In addition to these issues, there are also a number of tax considerations that must be taken into account when buying or selling a small business. Depending on the specifics of the transaction, the buyer and seller may be subject to different tax liabilities. It is important to consult with a tax professional in order to ensure that all applicable taxes are properly accounted for and paid.

Furthermore, there may also be regulatory issues that must be considered when buying or selling a small business. Depending on the industry in which the business operates, there may be specific laws and regulations that must be complied with in order to complete the sale. It is important to carefully review these regulations and ensure that the business is in compliance before proceeding with the sale.

Overall, the process of buying or selling a small business can be complex and challenging. By carefully considering the legal challenges involved and taking the necessary steps to address them, it is possible to successfully navigate the process and complete a successful sale. 

Get Legal Advice Before Purchase and Sale Transactions

If you have questions about the process of buying or selling a small business, you should consider hiring a business attorney to help you navigate the various stages involved in a business transaction. 

There are several advantages to hiring a law firm before acquiring a small business. Here are a few:

• A law firm can help you conduct due diligence on the business to ensure that it is a good fit for your goals and that there are no potential liabilities or issues that could arise after the acquisition.
• They can help you negotiate the terms of the acquisition, including the purchase price and any contingencies, to ensure that your interests are protected.
• A law firm can help you draft and review the legal documents related to the acquisition, such as the purchase agreement and any financing documents, to make sure that they are in line with your goals and interests.
• They can provide guidance on any legal issues that may arise during the acquisition process, such as compliance with relevant laws and regulations.

Overall, hiring a law firm before acquiring a small business can help ensure that the process goes smoothly and that your interests are protected throughout.