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How to Avoid Getting Burned When Buying a Business


Friday, December 14, 2007
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Mary Mkisii is a citizen of Liberia who has lived in the United States under a Temporary Protected Status (TPS) since 1993. During her stay in Minnesota, she has earned a nursing degree, bought a home and raised three beautiful daughters. A friend approaches her with a business proposal: an auto repair garage across the street is on sale for a “bargain $200,000.” Would she like to buy it?

The garage’s current owners are reportedly selling the business because they are moving out of state. The garage is registered as a Minnesota S-Corporation for federal
income tax purposes. The friend insists that unless they close soon, “someone else may grab it.” Though hesitant at first, Mary is considering the offer after the owners
showed her QuickBooks reports with $500,000 in annual sales. She is tempted to dip into her 401k Plan and savings to raise the 25 percent down-payment.

Understandable Dilemma

Right off the bat, Mary is well advised to consult a competent and knowledgeable business attorney and certified public accountant (CPA). While buying an existing business appears like a great alternative to starting from scratch, many dangers abound. Even for experienced entrepreneurs, this can be tricky, let alone the nightmare it is for novices like Mary.

Her dilemma is perfectly understandable: by buying the garage as quoted, would she be making a catastrophic mistake or giving herself a shot at untold
wealth through entrepreneurship?

Small business owners often pay too much or even worse, buy nothing. It’s painful watching your life savings disappear into a bottomless pit that you did not dig. When it comes to buying a business, question, doubt and verify. Mary has 200,000 reasons for wanting to know what she is getting into.

Ask Basic Questions

To avoid potential disappointment, potential buyers of businesses should, at a minimum, ask the following basic questions:
 What is she buying? Mary has to figure out exactly what is for sale – is it the entity itself or just the assets of the garage or both? There are different ramifications
for depending on the answer to this question. Put simply, buying from a sole proprietor is not the same as buying the assets of a limited liability company (LLC) or
acquiring stock of a corporation. As this can be convoluted, engendering significant tax and legal implications, be sure to consult an attorney.

 Why is the business on sale? Mary should investigate independently if possible, why the owners are selling the business. The real reason may differ from what they are telling her. Always remember that anyone would be unwilling to get rid of a source of income unless they had to. Dig deeper to find out why they are doing it.

 Is there a business? It is critical for Mary to determine if the garage is worth the asking price or anything at all. Look at all financial and other data to determine if
indeed, there is a business. A good business would generally be well run and managed, show a growth trend, have a profit motive as well as documentation to back these up. At a minimum, buyers should demand to review audited financial statements for at least 3 years or tax returns filed with IRS. If you need help analyzing
the viability of the enterprise, contact a knowledgeable professional. The fee will be well worth it. Mary should not be content with the financial information furnished
by the current owners.

Valuing the Business

Valuing a business is not a guessing game, it is a semi-science complete with empirical data, knowledge of market trends and financial projections. Do not pay the purchase price just because the owner asks. To arrive at the value for instance, Mary needs to determine the fair market value (FMV) of inventory, current sales, expenses, assets and liabilities and the expected profitability of thenew venture. It is not uncommon for a seller to paint a misleadingly rosy picture of the business just before the FOR SALE sign goes up.

Even for successful businesses, it may be that the owner’s charm, family or experience was responsible for the success. Unless you have similar personal attributes, your purchase may go up in flames. Pay even closer attention to owners purporting to tack so-called “goodwill” to the purchase price. This is a complicated intangible that seldom applies to small, struggling businesses. Mary should be careful if the garage owners attempt to collect more than the verified value of the business.

To obtain professional business valuation services, contact the American Society of Appraisers (www.appraisers.org) 1-800-ASA-VALU or a reputable CPA firm.

 Is the business a good fit for her goals, professional or otherwise? Often overlooked is the reason why the buyer is interested in the particular venture. Is auto business her passion or is it just because the garage is a couple of blocks from her house? Since she is trained as a nurse, what career adjustments would be necessary to profitably run the new venture? This would be an apt time for Mary to review her business plan with regard to operations and management of the garage after purchase.

Beware of Hidden “Timebombs”

 What hidden pitfalls should she belooking out for? We always advise our clients to assume that there are problems even before they see any. Some businesses
on sale are potential minefields, sure fast tracks to bankruptcy or financial ruin. With due diligence, one should be able to determine if a business has undisclosed
outstanding liabilities such as rent, wages or benefits or pending lawsuits or claims. Be certain that some disgruntled employee or customer is not readying
themselves for a lawsuit as you sign the Purchase Agreement.

 Other Legal Issues: Buying a new business raises numerous tax and legal issues. For instance, as a non-resident alien, Mary cannot become a shareholder in an S-Corporation per US federal tax law. Ownership of S-Corporations is restricted to US citizens or residents. She cannot buy stock in the garage. An option for Mary would be to just purchase the assets and then transfer them to an entity that she sets up. Additionally, buyers should investigate the businesses’ patents and copyrights,
any long-term contracts, licenses or zoning requirements.

At the end of the day, buying a business is no different from buying a used automobile. You would not cough out the sticker price without looking under the hood, examining the odometer or even having a mechanic check it out, or would you?

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About Henry Ongeri

Henry Ongeri is a Kenyan-American lawyer and Managing Partner of H.M. ONGERI & ASSOCIATES, a transatlantic law firm with offices in Africa and the United States. He is a regular commentator on global issues for Mshale.

One Response to How to Avoid Getting Burned When Buying a Business

  1. Anonymous

    December 17, 2007 at 5:20 PM

    Relates to my needs.

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