By Reed Richardson.

 

It’s a tempting premise: rather than suffer through building a new business from the ground up, why not scoop up an existing one that’s struggling and turn it around? For prospective entrepreneurs long on ideas and short on patience, this strategy has long held a certain appeal. But is jump-starting a career in small business ownership, especially in the current economic climate, really as easy as buying someone else’s failure and turning it into a success?

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To be sure, buying a struggling business often has some distinct advantages, explains Stephen I. Butler, who owns his own financial and business brokerage firm, Butler Bank Consulting. Thanks to common features such as readymade staff, turnkey inventory and infrastructure, and an established customer base, acquiring an existing business can be an effective way to end run the sometimes laborious start-up process. Still, Butler says it’s worth pointing out that what is really being sold is someone else’s problems.

 

Diamonds in the rough are hard to find

At any one time, roughly 10 percent of the country’s six million small businesses are in the process of being closed, sold, or transferred, according to a 2011 “State of Small Business Report.” While that translates into well over half a million small businesses undergoing some kind of transition, the active marketplace for small businesses being bought and sold is actually far less than that. (The two major online business-for-sale marketplaces, BizBuySell and BizQuest, claim just less than 100,000 combined active listings for companies of all sizes.) And of those, only a small minority will be businesses in distress or in the process of closing.

However, after witnessing the glut of undervalued real estate properties now available, many budding small business owners may think there are similar diamonds in the rough to be had in the business market. But Marc Gudema, a business broker from outside of Boston, says the analogy just doesn’t hold. “What I hear a lot from prospective buyers is, ‘I just want a decent business at a really cheap price,’” Gudema explains. “But I have to tell them those kinds of great deals are all gone.”

In fact, a recent BizBuySell Insight report from earlier this spring suggests that the business market bottomed out over a year ago and is now slowly rebounding. “It is evident from the increasing median cash flow and median revenue of closed transactions that small businesses are showing stronger financials coming out of the recession,” the report concluded. “Therefore, there will likely be an influx of businesses on the market from owners who were hesitant to sell until their business performance strengthened.”

Buying a business is complicated; consider hiring a guide

The prospect of an even larger marketplace that, simultaneously, features fewer good turnaround candidates makes navigating the business-for-sale waters even trickier. So, to avoid getting swept up into an unwise or even shady deal, prospective buyers might want to strongly consider hiring a professional to help them chart the waters.  

Real estate agents and CPAs are sometimes used to broker small business deals when the transactions are heavily real estate or location dependent, such as the sales of gas stations or restaurants. But selling businesses is not what they do for a living every day, notes Steve Wain, who runs the New Jersey-based business brokerage firm Calder Associates. “Business brokers, on the other hand, have to be educated in transition law, insurance, due diligence, and financial lending,” he says. “But if they’re not certified by the International Business Brokers Association (IBBA), you really don’t know who you’re dealing with.”

 

In about three out of every four brokered business sales the broker is hired by and paid by the seller rather than the buyer. Still, seller-hired brokers often give free advice to prospective buyers on things like compiling their financial portfolio and drafting a proper offer sheet. The process of matching a buyer with a business being sold typically takes anywhere from six months to a whole year, depending on the size, type, and complexity of the company and its assets. Although sales of failed or distressed companies sometimes can be executed much more quickly than that, there’s no guarantee, since the financial and logistical problems commonly plaguing a struggling business may take months to thoroughly untangle.

 

As a result of this complexity, standard business broker fees usually range from 10 to 15 percent of the cash portion of the deal. “Anything significantly above that, you should run for the hills, no matter what kind of promises they’re making,” Wain cautions. He also emphasizes that the cash price—and therefore the brokerage fee—is commonly much less than the total amount the business is sold for, since that latter figure often includes loans and other types of long-term payout compensation. “And if it’s a fairly straightforward deal for a fairly small business,” Wain adds, “it’s possible to negotiate a flat fee instead.”

 

“It’s not like you’re going to Home Depot to pick out a company”

“Almost 90 percent of the time, buyers first come to us saying, ‘I want a business that will bring in x amount of income a month,” Wain explains. “That’s a dangerous attitude, because it’s not like you’re going to Home Depot to pick out a company.” Wain says most reputable brokers will regularly turn away these entrepreneurial-curious types, because they’re simply looking to collect an easy paycheck rather than put in the hard work necessary to revive a business that’s currently on life support.

 

Many of these merely curious potential buyers do have the sufficient means to buy a company, notes central New Jersey-based business broker Rick Fulton, but they are often underqualified and overconfident, a deadly combination. (A common source of first-time buyer funding these days is a cashed-in 401(k) from a former job, he says.) “I’d say 100 out of 100 times, the buyer of a failed or distressed business thinks they can do better than the seller,” Fulton says. “But 90 out of those 100 will never make it.”

 

There’s a reason, in other words, that every town seems to have at least one storefront or restaurant spot that is always either “under new management” or “going out of business” and it likely isn’t the owner’s fault. Fulton too, has encountered the same business site being pitched to him for sales help multiple times, as different entrepreneurs cycle through what is an inherently flawed business model or location. “They fall in love with it and overlook the realities, and then they’re surprised when they’re out of business within a year.”

 

The key to staying emotionally detached during a business transaction, most brokers say, involves due diligence. Steven Butler always tells his buyer clients to get as much information as possible about the business and then get a second opinion. “Get a look at three years of past balance sheets, if possible, as well as any audits by accountants, past tax returns, and reports dealing with the business’s accounts receivable. Then, take all that data and have it analyzed by someone with relative expertise in finances.” (For a more complete list of disclosure documents a buyer should see before purchasing, see the sidebar.)

 

But don’t stop there, Butler says. It’s also important to take a hard look at the struggling company’s reputation as well. Why? “Because many times, distressed or failed companies have burned all their bridges of good will with their customers, suppliers, and financiers, by failing to deliver on their promises, pay for inventories, or make loan payments,” he explains. And despite the presence of new ownership, this past behavior can often haunt an ongoing business undergoing a turnaround, forcing it into onerous circumstances, like operating by C.O.D. payment or having to seek out entirely new sources of capital.

 

Starting over vs. starting fresh

Though fast-forwarding into entrepreneurship may be the primary driver behind purchasing a distressed business, it’s nonetheless important to take things slow both before and after the purchase. Not taking the time to understand what makes the business tick, many experts say, is a common mistake first-time business buyers make. And for someone buying a distressed business, in particular, it’s imperative to find out what once made the company successful and what has since changed to make it fail.

 

“I call it figuring out the ‘secret sauce’ and every business has it,” Wain says. Even if a prospective buyer has all the financial data and has talked with the sellers extensively, there’s still no substitute for actually experiencing how the company runs on a day-to-day basis, he says. “It’s like trying to explain to someone else how to ride a bicycle, they just can’t understand it until they do it themselves. That’s why I tell all buyers to check their egos at the door.”

 

As a cautionary tale, Wain cites a recent business transaction in central New Jersey where a buyer bought an established Italian restaurant and, within six months of purchasing it, changed its menu and theme to that of a Japanese restaurant. Soon after, the business began struggling and ultimately failed. “You have to remember you’re not only buying the assets, you’re buying the customer’s goodwill too,” he says. “In that case, the new owner didn’t grasp that, and he squandered that goodwill with an unexpected change.”

 

According to many business brokers, the most successful buyers of businesses—distressed or otherwise—are people who currently own another business or have experience running a business in the past. First-time buyers, they say, usually have a difficult time learning how to both run a business and resurrect someone else’s business at the same time. That’s why Butler often advises first-timers to take a hard look at the advantages and disadvantages of buying versus starting fresh. “In the end, I usually advise potential buyers that it’s probably better to start from scratch than to try and buy an existing firm, especially one that’s failing.” 

 

And although it might sound obvious, if a buyer considering the purchase of a struggling business can’t find any track record of success at all, there’s really no point in worrying about the “secret sauce” or future customer goodwill because neither are likely to exist. “Don’t bother buying a business that was never successful,” Wain says bluntly, “you’d be better off just starting your own business.”

 

 


 

Resources you should know about.

To locate a nearby business broker, use the IBBA’s “Find a Broker” tool.

 

Want to know the four biggest misconceptions about buying a business? Check out the IBBA website to “Avoid These Business Sale Myths.”

 

What are the eight sets of documents every prospective buyer should get from the seller before purchasing a business? To find out, go to the New York TimesGuide to Selling a Small Business. Look under “Prepare Your Business for Sale (Now!)”

 

Need a handy checklist of questions to ask during a business sale? Check out Inc. magazine’s “What to Look for in a Seller.”

 

What are the characteristics that make a prospective buyer an attractive and successful candidate for purchasing a business? Read broker Marc Gudema’s blog posting to find out “What Business Brokers Look for in a Buyer.”