Making an Offer to Purchase a Business

Finding your dream business and securing the necessary funding are two major steps in the right direction. However, before you approach the owner with a formal offer to buy the business, there are some important things you should consider.

Let’s look at the key aspects you should consider before making an offer on a small business that may be difficult to retract.

Evaluate the Business Owner’s Asking Price

Setting a price tag on a business is complicated, and it helps to have a qualified business brokers at your side who can help you understand business valuation. The seller’s asking price and final selling price of a business are different. Through the process of negotiation, buyers and sellers reach an agreed upon sale price before moving ahead with the sale.

The asking price is what the seller proposes you – the buyer – to pay. Often seen as a starting point, the asking price is negotiated amongst all parties involved to get to the sale price. The sale price is the final price that both you and the seller agree upon, as the value to be paid to acquire the business.

Sometimes sellers can overprice their businesses. It is important to understand the rationale behind the asking price. If you feel that the seller has used an incorrect methodology for business valuation, you need to tell them. Often, deals fall apart because the buyer and seller do not agree on the price.

There are three general approaches to valuing a business:

1. Earnings Approach

The earnings approach is best used when buying an existing business that is already profitable or has a positive income forecast. This approach uses the historical, present, and future profit projections to value a business.

If a business has a stable history of being profitable, you can use the historical data to anticipate the earnings in the future. This process can also be employed without a steady history of profits. In that case, you will need to predict the profit the business may earn in the coming years.

The downside to this approach is that it relies on future profits maintaining the same or higher trajectory as now, which may not always be possible.

2. Asset Approach

The assets approach is best used for businesses that have not yet broken even or those that are capital-intensive. This approach takes into account the tangible and intangible assets of a business minus any debts or liabilities. Property and equipment fall under tangible assets, while software, trademark, and patents are intangible assets.

You have to consider the present fair market value of the assets as well as any ROI that the owner may earn from these assets in the future.

3. Market Approach

The market approach used in combination with any of the other two approaches can confirm the business value while taking into account local factors. This approach determines the value of a business based on the selling price of other similar businesses in the industry. It also considers local factors such as the business location, which can have a significant impact on business valuation.

All of the above approaches can be used to determine a fair price for the business you want to buy. However, the final price would be the one that you and the seller agree upon. 

Understand the Business’s Profitability

How do you know if the business that you intend to buy is profitable? Collect all the necessary documents possible so that you can understand if the business that you want to buy is a financial risk or not.

The three key financial statements that show how well the business is performing are the balance sheet, cash flow statement, and income statement. The income statement, otherwise known as the profit and loss statement, shows you whether the business is losing money or not.

1. Net profit margin

When you deduct expenses from revenue, you get profit. If the resultant number is positive, the business is profitable, and if it is negative, the business is incurring losses. Don’t just look at annual profits but also monthly to give you a better idea of the business’s profitability.

2. Gross profit margin

Sales revenue minus the cost of goods sold gives you the gross profit. Gross profit divided by sales revenue gives you the gross profit margin.

A higher percentage means that the business is making a lot of profit compared to the cost of the product. A lower percentage could be fine if the sale volume is high.

3. Operating expenses

The cost that is incurred to carry out your day-to-day operations is called operating expenses. Low automation and higher dependence on manual labor can often increase your operating expenses.

4. Profit per client

Profitability from each client varies based on order type, order size, and trade contracts. It is not necessarily always the big clients that are profitable. Sometimes, smaller clients can be more profitable because they have a smaller revenue to expenses ratio.

5. New projects

Ideally, profits should be spread evenly all around the year. However, that may not always be the case. Business owners should consider taking various measures such as implement new marketing campaigns to attract new business to keep profits coming in throughout the year.

The cash flow statement shows the money flowing in and out of the business within a given time. It also shows you whether the business has enough cash on hand to pay its bills. Lack of cash on hand is one of the biggest reasons why businesses fail.

The balance sheet shows a business’s net worth at a given point in time. It reflects its assets, liabilities, and owner’s equity. It can also be used as to track the growth (or decline) of a business over time.

Other Factors

Productivity

If you can increase your sales or your production output without incurring extra expenses, it can be more profitable for your business. However, doing so may mean that you would need to upgrade to better equipment or offer a higher commission or bonus for increased sales.

Size

The size of your business can directly impact profitability. Expanding your business could amp up your productivity, thereby increasing your profitability. However, your business would only be profitable provided your output is in sync with the demand. If your output exceeds the demand, you could incur losses.

Demand

The demand for your product or services is a big factor in determining the profitability of your business. Different niches may have different demands in the same industry. For instance, when we consider the commercial real estate industry, there are buyers who want office premises and those who require industrial plants. They both are involved in business but the preference for the type of property they require is different.

Competition

The more competition you have, the more difficult it will be for your business to be profitable. But competition can also help you justify your asking price, because you can prove that your business offers the buyer additional benefits, compared to other comparable companies on sale.

Direct expenses

Direct expenses vary with productivity. The higher your productivity, the more raw materials you need to purchase as well as workers. Automation could increase productivity at a lower cost. If your business is low-tech, your direct expenses may increase due to the absence of automation. The added expenses, if not kept in check, could very well eat into your profits.

Overhead expenses

All other expenses except direct expenses and material costs are considered overhead expenses. These include advertising, accounting fees, insurance, utilities, taxes, and repairs. Some of these expenses can be necessary. For instance, advertising may increase your costs, but it also creates increased demand, which in turn, can impact profitability.

How Do You Negotiate the Sale of a Business?

Once you determine a fair asking price, you will need to issue a Letter of Intent, often referred to as an LOI. The negotiation process begins with the buyer submitting an offer, including price, terms, and conditions.

If the seller accepts, the LOI is a non-binding agreement between two parties involved in a transaction and clarifies the intentions of both parties as well as the main provisions that they have agreed upon.

The LOI provides detailed information necessary for the buyer and seller to make an educated decision about the deal. It may also give the buyer the “right of first refusal”, which means that the seller cannot sell the business to another buyer before reaching an agreement with you.

The LOI also gives you, the buyer, the opportunity to begin your due diligence. You will be given access to the financial statements and other important company documents, including customer information to verify the information given by the seller.

Here are some useful negotiation tips to help you in your quest of securing a great deal.

Know the industry and market well

Before you get into any kind of business negotiations, you should take the time to learn more about the market and the business that you want to buy. When you research the market, you will get to know all the ups and downs of the industry.

You will also be able to find out pertinent information regarding the sale of similar businesses. Getting to know the market valuations of those businesses can help you arrive at the right price for the business.

Understand why the seller is selling the business

Understanding the reason why the seller is selling the business can help you secure a great deal. If he wants to make a quick sale, then he may not have a lot of time to wait for the optimum buyer. You may be able to buy the business at a lower price than the asking price.

How Do You Write an Offer to Buy a Business?

When putting together your offer (LOI), start by stating the purpose of the document. Clearly identify the buyer and seller in the transaction. Then, give a brief description of the transaction, including purchase price, and any deadlines that should be agreed upon.

Consider how much cash you’ll need to make the purchase. Your offer should include a cash down payment, plus financing. Consider how much cash you can afford to give and still have enough left for working capital to keep the business afloat until you can turn a profit.

If the seller is willing to carry some of the financing, consider monthly payment amounts, when the first payment is due begins, and the duration period.

Your first offer should be conservative. Never start out with a full price offer. You can always raise if the seller doesn’t accept it. Your rule of thumb is to not start out with the maximum amount you are willing to pay. Also, be mindful of any issue that may come up during final due diligence.

Make the offer contingent

The purchase price should always be contingent on the final due diligence, including your review and approval of the following: business financial statements, lease terms, condition of equipment, inventory. Your offer should also be contingent on any buyer/seller non-compete agreements, buyer/seller transition and training period, and any financing can be obtained under acceptable terms.

The structure of the LOI will differ depending on the type of business deal. You should get it reviewed by your attorney before presenting it to the buyer. Also, your offer should include a refundable good faith deposit. This could be $1,000 or more. This money can be held in escrow by a business broker until the deal is finalized and signed by all parties.

As this is your initial offer to buy the business, expect the seller to respond with a counteroffer. They may even offer incentives to sweeten the deal in a positive direction. Be prepared to be flexible, but also know your limits ahead of time.

Final due diligence

Once the buyer and seller reach a workable agreement, the buyer should set a deadline for the process of due diligence to be completed. This is an extensive review and verification of all aspects of the business. Your accountant and attorney should be involved in this process and confirm that there are no red flags or discrepancies.

Engage a business broker

You can negotiate on your own, but if you are unsure of your negotiation skills, then the best thing to do is seek expert help. A broker is a person or a firm that arranges transactions between buyers and sellers.

If you want to secure a phenomenal deal, a broker could prove extremely helpful in finding you the right type of business that matches your interest and budget. Brokers are generally involved in a wide range of business sales. They can provide excellent advice and guidance during the buying process.

They can use their experience to compare prices in a particular industry across regions. Hence, they can easily determine if the asking price of the seller is fair or overpriced.

To find a broker, see Bizquest's Business Broker Directory.

Conclusion

If you want to secure the best business deal, you will need to be open-minded and creative at the same time. Don’t let your ego come in the way of your negotiations. When you prepare an offer to buy the business, make sure to include all tangible and intangible assets that would be transferred to you. You should also have your broker or an attorney review your purchase offer before you offer it to the business owner.