Buying an existing business is a lot less work than starting one from scratch. It’s also a bigger up-front investment, though, and while it’s often easier to get financing, you don’t want to take on six-figure loans unless you’re sure you can be successful.
The biggest reason new business owners fail because they don’t ask the right questions before they take the leap. While no business venture is ever a sure thing, you can minimize your risk and increase your odds of success with the right planning.
Some of the red flags of a risky business venture are obvious but others are harder to spot, especially for new entrepreneurs. Let’s take a look at the most common mistakes people make when buying a business—and, more importantly, how you can avoid them.
Mistake #1: Taking profit and loss figures at face value.
In a perfect world, you could trust that someone selling a business is being honest about its yearly revenues, profit margins, and other financial figures. Unfortunately, the reality is you can’t always count on someone selling a business to give you the complete picture up-front.
Take time to thoroughly review all documents available and come up with your own operational budget and sales projections based on those figures. Among the things you should verify are whether the building and equipment are owned or leased, the terms of the mortgage or rental agreement, and the average monthly expenses for utilities, insurance, payroll, and inventory.
Gathering this information can be time-consuming but it lets you reach your own conclusions about the potential profitability of the company rather than taking the seller’s word for it. If you can’t find the information you need to assess the long-term viability of the business, that’s a red flag the seller may be covering up some less than savory statistics.
If you’re a new business owner and don’t know how to gather or make sense of this information, consider hiring an independent auditor. Auditors are experts who know how to assess the value of a business and explain it in layman’s terms. They can tell you whether the selling price is fair and point out any hidden problems you’ve missed.
Mistake #2: Not having cash reserves for unexpected expenses.
You’ll sometimes hear new homeowners described as being “house poor” when they’ve bought a house above their means. Because they spent their entire savings on the down payment and closing costs, they can’t afford repairs and maintenance for the house they purchased.
Inexperienced entrepreneurs can end up similarly “business poor”. They’ve invested everything they have into buying the business and getting it ready to open. When something goes wrong (as it inevitably will), they’re forced to choose between going deeper into debt or resorting to half-fixes that cost more in the long run and can impact their ability to turn a profit.
The importance for business owners to plan ahead has never been so apparent as it is in 2020, but it doesn’t take something as catastrophic as a pandemic to send many new businesses to the brink. From road construction to water main breaks, there will always be things you can’t control affecting your ability to turn a profit.
Don’t only consider the stated costs of purchasing a business when you’re deciding if you can afford it. Plan out how much you’ll need to keep it operating for the first 6-12 months and include that in the amount you need to finance your new business. This extra cushion will keep you afloat during the transition period and ensure you’re able to cover surprises and emergencies.
Mistake #3: Failing to consider your lifestyle and interests.
Obviously you need some expertise in the industry if you intend to be an owner/operator. Even if you plan to take a relatively hands-off approach to the day-to-day business operations, though, a new business is going to require a lot of time and attention, at least during the ownership transition. Picking a business that fits your expertise and interests will make it a lot easier to devote yourself to its success.
Lifestyle is a big factor here, too. If you’re a night owl and hate waking up in the morning, don’t buy a business like a bakery or café that could require you to be on-site at 5AM. That doesn’t mean they’re a bad idea for everyone, though—that schedule might be perfect for parents since it keeps your evening free for family time.
How a business is managed will always impact its profits. Give yourself the best chance at success by picking an industry you have experience with or passion for.
Mistake #4: Seeing the potential over the reality.
Sellers sometimes encourage this behavior by setting the value of their business based on how much money it could make rather than the profits it actually brings in. Even without this push, though, entrepreneurs tend to have an aspirational outlook. This is a strength when it lets them spot opportunities other people miss, but it can also lead to problems.
It’s easiest to see this when you look at businesses where occupancy percentages have a direct link to profits. Consider the example of a hotel. The aspirational viewpoint sees the potential profits if you can fill every room every night, even though that’s realistically not going to happen in even the best-run hotel. A better approach is to look at the actual occupancy rates over the past year or two and extrapolate the value based on those figures—in other words, look at the performance, not the potential.
You absolutely want to plan for how you’ll improve a business when you buy it, but shouldn’t pay for those improvements before you’ve made them. How much you pay for a business should be based on current profit and sales figures, not what it could be worth in an ideal world.
Mistake #5: Ignoring the history of the location.
Let’s say the business is closed when you buy it and you plan to rebrand it completely. You’re starting with a blank slate—so why does the past matter? First of all, it can help you avoid a bad investment. A recent drop in profits could be the result of mis-management, but it could also indicate a long-term drop in the location’s viability. Maybe a new store down the street has pulled away customers, or shifts in traffic patterns have reduced the amount of street traffic in the area. Learning this context will help you avoid boarding a sinking ship.
You also need to consider the impression potential customers have when they look at your shop. If the name changes but you’re doing the same thing, you’ll still bear the reputation established by your predecessor—for better or worse. It’s possible to turn this perception around, but you’ll want to know before you buy so you can best focus your marketing and outreach efforts.
One other thing many first-time business buyers forget is to check up on the legal history of the business. Liens or legal matters attached to the business license or property won’t just magically disappear when the business changes hands.
Mistake #6: Taking on personal liability for the business.
If you take out loans or sign contracts in your own name, that makes you personally responsible for whatever happens. Should you default on those loans, your personal property and assets can be seized to repay them. Similarly, you’ll be the target of any law suits or other legal action that may be brought against the business in the future.
Obviously, your goal is to succeed and not get sued. But as a business owner, you have to plan for what you’ll do in the worst case scenario, even while you’re taking steps to prevent them from happening.
The best way to protect yourself is to establish an LLC or corporation. This entity then owns the business and is the responsible party on any loans you take out. While this does add some extra paperwork, research, and fees, they’re worth it for the extra layer of protection.
Mistake #7: Signing an un-favorable contract.
Once you’ve signed the purchase contract, you can’t back out of or change whatever terms you’ve agreed to. You owe it to yourself to read the contract thoroughly and make sure it matches the price and conditions you’ve discussed with the seller.
The sales contract doesn’t just establish you as the new owner of the business. It should also outline details like the assets connected to the business, any intellectual property connected to the business, and exactly how and when responsibility will transfer from the current owner to you.
If you don’t have a lot of experience with contracts, it’s a smart idea to consult a lawyer with experience in business negotiations. They’ll be able to point out issues you might not notice on your own.
What’s the Bottom Line?
Buying an existing small business can be a great investment or a huge money sink, depending on the state of the business and how well you’re able to run and manage it. It’s important to take the time and do your research before you jump on any offer. That will help you to avoid the mistakes described above.
Don’t forget that there are lots of resources out there to help potential business owners learn about contracts, neighborhoods, and other useful information. At the very least, make sure you reach out to your local SCORE chapter of Small Business Development Center (both affiliated with the U.S. Small Business Administration) before you start looking for businesses to buy. The more knowledge you have, the better you’ll be able to decide if buying a business is the right choice for you.