Lessons Learned from Searching for a Small Business to Buy

I am currently in the process of  finding a small business to purchase. I have not yet completed an acquisition, but I have already learned a lot in the few months I have been looking. I will write follow up articles as the process progresses. If you know anyone who is selling a business in the Los Angeles area or that can be managed remotely, let me know.

Everyone is lying about their earnings

When a small business is for sale, they typically have a “teaser” listing that shows how much they are selling the business for, the amount down they want or the amount of the deal they want in cash, and the cash flow or “sellers discretionary earnings” (SDE). The SDE is always inflated. Either they want to be paid on an average that includes past years and revenue/profits have since fallen, are adding back expenses that are inappropriate to add back, or they are temporarily reducing expenses/investment in a way that artificially temporarily increases cash flow and earnings.

“Parallel books” are common

Many small businesspeople and most of humanity are not huge fans of paying taxes. When you inquire about some businesses their broker will politely notify you that if you look at the financials they won’t necessarily match what they reported to the IRS. This is problematic for the seller if you are on the up and up because the IRS may wonder why a business all of a sudden the business is making more money. As most small businesses are asset sales you will not be liable for past misdeeds, but it can still cause issues.

Verifying cash is tough for some small businesses

When you talk to people about buying a small business they invariably will bring up laundromats and car washes. The problem with the former and to a lesser extent the latter and businesses like them is that because they are largely cash businesses, it can be difficult to ascertain exactly what the company is earning. Laundromats in particular are great for money launderers because you can always inflate the cash receipts to “wash” money  (the irony here is hilarious). As someone who actually wants to generate real profits this is problematic as you can’t get a baseline of true profitability as you cannot prove where the cash originated.

Brokers level of involvement varies considerably

There is a huge difference between a good and a bad business broker. Most business brokers will serve as an intermediary between you and the seller. They will put together a confidential information memorandum (CIM) and usually make sure the financials are somewhat intelligible. A good business broker will do initial intake calls with buyers to make sure they are legitimate and facilitate more detailed due diligence. A bad business broker will require multiple inquiries before providing any information, fail to draft a CIM, and will do little more than post a listing on a major business website such as BizbuySell.

There is a ton of room for improvement

Most small businesses are not well run and constrained by a lack of capital. They lack the systems and processes that are the norm in larger companies. In some cases, the physical location may actually be dirty and customer service may be poor or non-existent. If you ask the business owner why they don’t do certain things they may simply reply that they did not want to do the work or lacked the funds to invest in a new opportunity.  A lot of businesses can be made more profitable through simple blocking and tackling.

Businesses with employees are more expensive

A business that you largely have to run yourself, “buying a job” are far cheaper than businesses with employees that do not require the owner’s full-time oversight, so called absentee ownership. Usually multiples are 1-2x SDE for an owner operator business vs 3-4x for businesses that can be run by absentee owners. Taking a business that is owner operated and building it into one that is not can theoretically increase value significantly through the expansion of the multiple the company can sell for.

Multiples are really low

Businesses that make less than $1m a year and are relatively stable sell for 1-4x SDE. Usually a substantial portion 10-50% of a deal price is seller’s equity so the actually check you need to buy a business is not significant. 

Aggregators save time

Sites that aggregate hundreds of brokers such as Kumo save a ton of time in the search process.