How to buy a small business, step by step
Buying a business that already has customers, staff and cash flow can be faster than starting from zero, but you inherit its problems along with its profits. Each step below is designed to surface those problems while you can still walk away or change the price.
Set your criteria
Decide what you are looking for before you look. Write down the industries you understand, the range of earnings you can afford to buy, how far you will commute or relocate, and the role you want, whether that is running daily operations or overseeing a manager.
Be honest about your skills and appetite for risk. A business that depends on a licensed trade, one key employee or the owner’s personal relationships is harder to take over than one with documented systems and a team in place.
Find deals
Most buyers combine three sources. Business brokers list companies for sale but usually represent and are paid by the seller. Online marketplaces show many listings at once, though good ones can sell quickly, and direct outreach to owners who haven’t advertised takes longer but faces less competition.
Expect to sign a nondisclosure agreement before you see financials, and to review many businesses for each one worth pursuing. Track every lead in one place, with the asking price, earnings and your reason for passing.
Value the business and sign a letter of intent
Small owner-run businesses are usually valued on seller’s discretionary earnings, or SDE: pre-tax profit plus the owner’s salary and perks, interest, depreciation, amortization and one-time expenses. Larger companies with management in place are valued on EBITDA, which treats a market-rate manager’s salary as an expense. Price is a multiple of those earnings, and multiples vary by industry, size and risk.
For example, a business with $400,000 of SDE priced at a 3x multiple would ask $1.2 million; that multiple is an illustration, not a benchmark. Test every add-back the seller claims against receipts and records.
A letter of intent sets out the price, structure, financing, diligence period and exclusivity. It is mostly non-binding, except for terms such as confidentiality and exclusivity, the seller’s promise not to negotiate with other buyers for a set period.
Do your due diligence
Diligence confirms that the business is what the seller says it is. Compare several years of tax returns with the profit and loss statements and bank deposits, because gaps between them are where problems hide. On larger deals, a quality of earnings report from an accounting firm tests whether profits are accurate and repeatable. Then check what the numbers don’t show.
- Customer concentration: how much revenue depends on the largest few customers, and whether contracts bind them.
- Leases, contracts and licenses that need consent to transfer to a new owner.
- Employees: key staff, pay practices and whether contractors are properly classified.
- Liens, lawsuits and unpaid sales or payroll taxes.
- Equipment condition, inventory counts and deferred maintenance.
Structure the deal
Many small business sales are asset purchases: you buy the equipment, inventory, customer lists and goodwill, and most liabilities stay with the seller. A stock purchase transfers the whole company, history included, and is sometimes needed to keep contracts or licenses that can’t be assigned. Sellers often prefer stock sales for tax reasons, which makes structure a negotiating point.
In an asset deal, buyer and seller each report the price allocation to the IRS on Form 8594, so settle it in the purchase agreement. A seller note, where the seller finances part of the price, keeps the seller invested in your success. An earnout ties part of the price to future results, so define the metric and the accounting precisely.
Agree on the working capital, such as inventory and receivables, that stays with the business at closing, so you aren’t funding payroll from your own pocket in the first month.
Line up financing
SBA 7(a) loans, made by banks and other lenders and partly guaranteed by the SBA, are commonly used to buy small businesses. They require a buyer equity injection, meaning cash of your own in the deal, with a minimum set by SBA rules that have changed over time.
Expect to personally guarantee the loan if you will own 20 percent or more of the business, and to pledge collateral where available. A seller note in an SBA deal may have to sit on standby, with payments delayed, and SBA rules bar seller earnouts, so confirm current requirements with an experienced SBA lender early.
Close and manage the transition
At closing you sign the purchase agreement, bill of sale, lease assignment and any seller note, and funds usually move through escrow. Some states require a buyer to notify the tax department before buying a business’s assets, or the buyer can become liable for the seller’s unpaid sales taxes.
Negotiate a training period in which the seller introduces you to staff, customers and suppliers. A non-compete keeps the seller from opening a rival business nearby, and courts in most states enforce one tied to a business sale more readily than an employee’s, as long as its length, geography and scope are reasonable.