Shopping for an enterprise.

Buying an existing business may be more lucrative than starting one from scratch. Here's how to tell what might work for you.

BUYING AN EXISTING COMPANY CAN PUT a neophyte business-type on the fast track to success. Those who opt for secondhand entrepreneurship generally have greater success than those who start a company from scratch. The greatest advantage to buying an existing business is that there is far less risk involved, since any company you're seriously considering should have proven its ability to attract customers and compete in the marketplace. That track record also makes the purchase more appealing to banks and other investors.

But, there is a downside. The buying process can be a long and winding road. And because the prospect of owning an established business is so exhilarating, many entrepreneurs miss warning signals and stop signs along the way. It's very easy to forget that once you sign on that dotted line, you've bought not only the company's success, but its failures as well. "You become burdened with the company's past," says Chicago investment banker Chester Gougis of Duff & Phelps. "That's why it's important to do your homework."

Preparation is the key to a successful acquisition. You must analyze your strengths and skills, find good advisors, develop a strong business plan and do "due diligence" in evaluating a company's business and financial history to make your enterprise shopping excursion a successful buy.

MAP OUT YOUR COURSE

Take a good look at yourself, advises Carlos Sandoval, an acquisitions attorney in Waldorf, Maryland. "Before you begin your search, make an honest appraisal of what you bring to the table: Is it other business relationships that will bring in new business? Is it a new way of doing business in a stale market? Do you have a way to use current technology to exploit another market?"

Horace McClerklin, an Alexandria, Virginia-based attorney who specializes in corporate and business law, also believes this is the time you should decide whether you're the best person--based on your skills--to run a company. "I sometimes have the unenviable task of looking my clients in the eye and saying, `One of the biggest problems with your company is you have the wrong person running it.'"

If you're considering an established company, it may be tempting to learn a new industry. But first-time entrepreneurs should stick to their areas of expertise. You should have a thorough understanding of your market. Know not only who your competition would be, but how and where you would go to get clients.

"The only way someone's going to back you in a business, whether it be a bank or a private investor, is if you demonstrate you have some knowledge about the business that will allow you to succeed," says Gougis. If, however, you are determined to do something new, he suggests taking a job in that industry before going into business to show at least limited experience.

BEGINNING YOUR SEARCH

The opportunity to buy a business can present itself in a number of ways, from word-of-mouth to the World Wide Web. If you're unsure where to look for potential acquisitions or how to negotiate a deal, you may want to consider hiring a broker or an investment banker. The Corporate Finance Directory, which can be found in public and business school libraries, lists brokers and investment bankers. The Web is another good source because you can tailor your search to brokers who specialize in certain industries or geographical areas. Industry associations may also be able to offer suggestions.

"Typically, brokers or bankers may ask for a small up-front fee, but the bulk of it will be contingent on whether you successfully buy a business," says Gougis. "Fees can range anywhere from 5% to 10% for smaller businesses, down to 1% of the sale price for multimillion-dollar deals."

If you decide to hire a broker, write a business plan outlining your vision that can be used to find businesses fitting your criteria. It should explain why you'd do a good job running a company and what goals you have set. "Once you get that kind of general plan, you can speak to brokers and investment groups interested in that area," adds Gougis.

It may be difficult to find someone willing to take on the assignment, however, particularly if you don't have any industry expertise. "Buying a business can be a very long, hard process, and brokers get paid only if they're successful. If I think the person doesn't have a chance, then I'm not really interested," adds Gougis. He suggests looking at the business section of newspapers and talking to industry insiders to learn what might be available or approaching the owner of a company that interests you.

Sometimes an opportunity just drops in your lap. That's what happened to Vern Crosby. He was the head of marketing for a Maryland-based company that provided facilities, janitorial and grounds-maintenance services, primarily to military bases around the country. When he came on board in 1991, sales were approximately $1 million. But thanks to Crosby's marketing skills, annual revenues soared to an average of $8.5 million; in 1996 they were as high as $15 million. Then the principal owners, who were experiencing personal differences, suddenly announced they wanted to pack it in and offered Crosby the right of first refusal to buy the company. It was no secret that he'd always wanted a piece of the action: He knew the company and the market. It was a dream come true; what could go wrong?

Plenty, as Crosby soon found out. Because he was so eager, he encountered problems a more objective buyer might have avoided. He had to learn some difficult lessons before he went on to successfully buy two other companies.

GET GOOD HELP

By whatever means you find a business, it is critical to surround yourself with competent advisors including an accountant, an attorney and a banker. These advisors should be experienced in acquisitions and/or the industry you're considering, so they know where to look for potential problems. "Many people think that if they go to the biggest [firm], they'll get the best, but often it's the opposite," says Sandoval. "Many attorneys have never run a business and have no business sense. You want someone who has worked as an in-house counsel at a company or who has run a company, because that's where you get the practical experience." Your accountant should also have prior acquisitions and due diligence experience.

You can also gain useful insights if you take your time, look carefully and take advantage of outside advisors. When Wahday Washington, now president and CEO of Johnny Lats Gym in New York, first got the entrepreneurial bug, he considered starting a gym from scratch. While looking at both new and existing properties with the owner of the gym he eventually bought, he picked up important pointers about location, space and other requirements that proved useful when he eventually negotiated the deal to buy his gym.

TAKE A GOOD LOOK BEFORE YOU LEAP 

Once you find a business that interests you, learn as much as possible about both the owner(s) and the company's financial and performance track record. "One of the first things you want to know is why they're bailing out," says McClerklin. It could be personal differences between the principals or the death or retirement of an owner whose relatives are not interested in taking over. But be wary of someone who wants to act too quickly. "That should be a signal that there's an existing or potential problem," warns McClerkin.

It may be worthwhile to invest a few hundred dollars in a background check on the owner. There are security companies around the country that perform this service strictly for business transactions. The information they come up with will give you an independent assessment of the owner's motive for selling, such as bankruptcy, poor credit or criminal activity.

In some cases, such as small service businesses, haste may not matter. When Bill Lawrence decided to buy a hair salon in the trendy Adams Morgan neighborhood of Washington, D.C., he was referred to a shop that was up for sale. Although it wasn't doing well, "I knew I could come in and make a difference," says Lawrence, who already had a reputation as an award-winning stylist.

Although the seller will have determined a sales price, McClerklin believes potential buyers should have a business appraised before agreeing to any amount. "Unless you know its true value, you don't know whether you're getting a good deal," he says.

An appraiser can be found by contacting the American Society of Appraisers (800-272-8258) or the Institute of Business Appraisers (561-732-3202). Fees vary based on the amount of time and research involved. According to Barry Goodman, an appraiser with Advanced Valuation Analytics in Washington, D.C., appraisers charge about $200-$300 an hour. Depending on the complexity of the business, the time required can be a few hours to several weeks. If the seller has already had the business appraised, you should check the appraiser's references or have someone take an independent look at the appraisal.

As a longtime employee of the company he wanted to buy, Crosby thought he knew everything he needed to know about the firm. So, he did the appraisal himself, with input from his accountant and an executive at a major Defense Department contractor he'd lined up as a mentor and financial backer. Initially, he acted without the benefit of legal counsel. "I probably would have seen problems a lot sooner if I'd had an outsider value the company."

In his first attempt at ownership, Crosby and the sellers agreed to a purchase price of $2 million, which seemed reasonable for a company he believed was full of untapped potential. It included a value of $600,000 plus $1.2 million in debt. (Buyer beware: you assume a company's liabilities as well as its assets when making a stock purchase.)

By contrast, Bill Lawrence only bought his hair salon's assets, which included taking over the lease and assuming ownership of the equipment, Using his industry experience, he was able to easily negotiate a bargain price of $25,000, and didn't need much up-front capital, other than fees for licenses and stock. He already had an extensive client list, and the owner agreed to continue working at the salon.

STAKE YOUR CLAIM

When you're ready to buy the business and have agreed on the basic terms of the deal, both parties must sign a "letter of intent." Drawn up by an attorney, this written transaction states that you agree to purchase the business subject to certain conditions and prohibits the seller from entertaining other offers. "Very often, conditions outlined in the letter of intent include getting financing and doing due diligence, which is the process whereby the buyer checks out everything the seller has said," explains Gougis.

You should also "make sure that those who purport to have title to the assets of the company and the authority to enter into the transaction, in fact have that authority," adds McClerklin. Where the company has a board of directors, the secretary of that board will provide a certificate confirming this information and authorizing the transaction. When there is no board, you must verify authority through third parties, such as the owner's attorney and other outside counselors.

The seller must agree in the letter to give you or your agent reasonable access to the company and its records during this time. According to McClerklin, the seller should also be required to agree that the company will continue to operate on its normal course until the time of closing. In other words, the seller must deliver m you a company that was just as viable as it was when you entered into the agreement. This prevents the seller from taking on any extraordinary debt or promising employees large bonuses. It is also wise to include a "noncompete" clause so that after you close, you don't find yourself in competition with the seller for business or clients you assumed were part of the deal.

DILIGENCE IS DUE

Due diligence is by far the most important stage in the buying process. "Every business has some problems," Sandoval warns. At this point, you'll have to figure out whether you can solve them. While the amount of diligence required may vary, there is some basic information a buyer must get.

Besides financial information, a buyer must find out whether there is any existing or pending litigation or liens against the company. "Go to a court to search for any suits that may have been filed against the company or any grievances filed before state or federal commissions," says Gougis. The local Better Business Bureau may also be able to provide information about past or current complaints.

"You want to measure the company's overall financial health," he adds. Take a detailed look at all of the company's financial records to determine a trend in revenues. Have sales grown, stagnated or declined? If they are declining, find out why. It may be that the company's products are obsolete, or there is some new technology or product that is taking away its market share. Also look at costs to see if profit margins are increasing, stable or declining. They may be getting squeezed because the company is facing greater competition, so determine if this is an obstacle you can overcome.

Tax records for the past five to seven years should also be carefully reviewed. "Often, small businesses don't have audited financial statements, signed by an accountant," warns Gougis. "Tax returns are often one of the best things to look at because it's a lot tougher to lie."

When Washington looked at buying an established gym in Brooklyn, New York, for sale because the owner was retiring, he found that the owner's handwritten books and tax returns did not justify the asking price of $375,000. "We had to approach a bank for financing and needed to bring them something to justify that amount, so that just wouldn't work," says Washington. "He'd been in business for 20 years, which is great for a gym, but I decided it was too risky."

Talk to the company's customers to ensure that it is delivering satisfactory service and review all contracts. "You have to know where your sales will come from," cautions Crosby. You must also talk to creditors and vendors to find out if costs have been accurately reported and whether accounts are current or in arrears. "You don't want to have a problem getting support from your suppliers later on because your predecessors did not have a good credit record," says McClerklin.

Crosby found that his company was not paying vendors on time. Although the owners blamed delays on late payments from government contracts, it was a signal to him to dig deeper. He also had a difficult time following the flow of cash and warns others to find out exactly where money is being spent. He discovered the owners were disbursing cash into a variety of ventures in unsuccessful attempts to diversify. "There was so much commingling of dollars, robbing Peter to pay Paul," he laments. "It was a nightmare once you got into it."

Despite these problems and warnings from his advisors, Crosby was still anxious to go ahead with the sale. He had met with the company's clients and obtained several memorandums of understanding and teaming agreements with other contractors. "I had on my Lee Iacocca hat, and just knew I could turn this company around," remembers Crosby. But when the banks he'd lined up for financing checked the company's books, they found that the tax debt was much higher than originally stated. Instead of $250,000, it was more than $1 million with late fees and penalties. That put an end to the deal.

When Washington began his due diligence to purchase Johnnie Lats, he used information he'd picked up while looking at other gyms to renegotiate the sale price. He learned, for example, that the gym did not have the requisite certificate of occupancy or $50,000 bond that protects members if the gym is forced to close. This time, the financial records were in order and the income the owner claimed it generated each year was indeed verifiable. But because there was no certificate or bond, Washington negotiated the price down from $250,000 to $175,000.

Throughout the due diligence process, a buyer is also looking for financing. Since banks are more willing to finance the acquisition of an existing company than a start-up, the amount financed depends on the business, its assets and the buyer's level of industry expertise. A person with a lot of experience may be able to get half of the money from a bank and the rest from private equity groups. These groups, as well as banks, will look at the buyer's personal assets and will typically require that the buyer demonstrate a commitment to the investment by, for example, taking a second home mortgage.

Sometimes a seller will actually help finance the sale of the business. At the owner's suggestion, Washington gave the seller a $50,000 down payment on the gym, consisting of $30,000 of his own money plus $20,000 in loans from relatives and friends. After making five $10,000 interest-free balloon payments over a year, Washington is now paying the balance off monthly and will own the business free and clear by April 1999.

APPLY THE LESSONS YOU'VE LEARNED

Still smitten by the entrepreneurial bug, Crosby realized that buying the company he worked for wasn't feasible; he resigned and began to look elsewhere. As it turned out, the owner's sons also co-owned a smaller facilities management company in Maryland: Excell Management. And since they, too, were battling each other, they were willing to sell.

In addition, Crosby approached the owner of Outsource Inc., a small computer-assisted design company in Virginia, to see if she was interested in selling her business. She wasn't at first, but after mulling over his offer, she contacted him. Excell and Outsource are both small companies that Crosby is buying for $180,000 and $140,000, respectively. He plans to continue running them separately.

Taking the lessons he'd learned, the first thing Crosby did was bring in an attorney right away. He also hired an accountant and an acquisitions attorney to handle the company valuations. And because he was more detached, he was able to look at the companies' financial statements more clearly. The second time around, the due diligence process did not uncover any problems.

Buying a business can be exciting, but that excitement can get in the way. Crosby's advice to potential buyers is to surround yourself with the appropriate counselors who, in addition to providing expert advice, will help you keep your emotions at bay. Once you take ownership, that's when the real excitement begins.

RELATED ARTICLE: Organize Toward a Better Business

These organizations can advise you in your entrepreneurial endeavors:

Association of Small Business Development Centers

3108 Columbia Pike, Suite 300 Arlington, VA 22204 703-271-8700 www.asbdc.us.org.

Counselors at Small Business Development Centers around the country provide information and guidance to entrepreneurs on such issues as business planning, loans and humans resources development.

International Franchise Association

1350 New York Ave. NW, Suite 900 Washington, DC 20005-4709 202-628-8000 www.franchise.org

The IFA provides answers to entrepreneurs' individual queries as well as publications and video and audio cassettes on franchising. In addition, it will refer you to members, experts and consultants for further assistance.

National Black Chamber of Commerce 

2000 L St. NW, Suite 200 Washington, DC 20036 202-416-1622

This organization acts as a liaison for entrepreneurs who need information about the Small Business Administration, lending programs, banks, etc. It can also help you find free technical assistance.

Service Corps of Retired Executives (SCORE)

409 3rd St. SW Washington, DC 20024 800-634-0245 www.score.org

Members of this nonprofit, volunteer association serve as counselors and advise aspiring entrepreneurs and current business owners. They provide insight on how to start, operate and buy or sell a business.

U.S. Chamber of Commerce Small Business Institute

1615 H St. NW Washington, DC 20062-2000 800-835-4730 www.usccsbi.com

The Small Business Institute is a training and educational resource that helps entrepreneurs with business issues from A to Z. It offers individualized training, self-study programs and local conferences.

RELATED ARTICLE: Shopping for a business online

Log onto these Web sites for useful info for buying and selling a business

www.vrbusinessbrokers.com. VR Business Brokers, a national network of independently owned franchises, posts thousands of businesses for sale on its site and has sold more than 30,000 nationwide, including fast food restaurants and auto mechanic shops.

www.cabb.org. This site--sponsored by the California Association of Business Brokers, a professional trade association whose members are involved in buying selling and evaluating business--educates you on the use of professional business brokers.

www.bizbuysell.com. BizBuySell, a site for buyers, sellers and brokers looking to find or sell a business, can help you find a buyer or a broker, give you selling or buying information, and connect you to buyer services.

www.bizquest.com. Through a database of business transfer information, BizQuest will give you access to its services, brokers, M&A advisors and organizations.

RELATED ARTICLE: Reference Books for Buying a Business

These books can guide you to the right path when shopping for a business

Legal Guide for Starting & Running a Small Business, Volume 1 by Attorney Fred S. Steingold (Nolo Press, $24.95). Comprehensive explanation of the practical and legal information you need for business operations.

A Basic Guide for Valuing a Company by Wilbur M. Yegge (John Wiley & Sons, $34.95). Explores the ins and outs of different valuing techniques for small business.

How to Read a Financial Report: Wringing Vital Signs Out of the Numbers by John A. Tracy (John Wiley & Sons, $16.95). Shows you how to cut through the technicalities of a financial report; easy-to-read discussion.