HBR Guide to Buying a Small Business

1. Entrepreneurship through acquisition: A unique path to business ownership

You can buy an existing small business, right now, and run it as CEO.

A new entrepreneurial avenue. Entrepreneurship through acquisition offers a compelling alternative to traditional corporate careers or risky startups. This path allows professionals to become CEOs of established businesses, leveraging their management skills and experience. The opportunity is vast, with an estimated 200,000 suitable businesses in the United States alone.

Financial and lifestyle benefits. Acquiring a small business can provide significant financial rewards and lifestyle flexibility. Owners often structure deals to retain a meaningful economic stake, potentially earning substantial returns on investment. Additionally, running your own company offers greater control over work-life balance and the ability to make impactful decisions.

Key advantages:

• Immediate leadership role
• Potential for high financial returns
• Flexibility in work-life balance
• Opportunity to apply general management skills

2. Identifying the right small business to buy: Enduring profitability is key

The essential characteristic of enduringly profitable businesses is recurring customers.

Focus on stability. The ideal acquisition target is an established business with a history of consistent profitability and slow, steady growth. These "dull" businesses often provide the best opportunities for long-term success and reduced risk.

Characteristics of enduringly profitable businesses:

• Recurring customers
• Strong reputation
• Limited competition
• Essential but relatively small part of customers' costs
• Integration with customers' operations

Avoid high-growth, technology-driven, or cyclical businesses, as they often come with increased risk and higher purchase prices. Instead, look for companies with stable cash flows and a proven business model that you have the skills to manage effectively.

3. Financing your acquisition: Balancing debt, equity, and seller financing

Buyers typically pay for their acquisition of a smaller firm by borrowing about two-thirds of the purchase price.

Typical financing structure:

• 30-50% senior debt (bank loans)
• 20-25% seller financing
• Remaining portion from equity investors

Leveraging multiple sources. Successful acquisitions often involve a combination of debt and equity financing. Senior loans from banks or the Small Business Administration (SBA) can provide a significant portion of the purchase price at favorable terms. Seller financing demonstrates the seller's confidence in the business and aligns their interests with yours post-acquisition.

Equity considerations. Raising equity from investors is crucial for completing the acquisition. Investors typically expect annual returns of around 25% for the risks associated with private equity investments in small businesses. Structure your deal to provide attractive returns while retaining sufficient ownership for yourself.

4. Sourcing potential acquisitions: Leveraging brokers and direct outreach

Sourcing through brokers is the most successful approach to overcome the problems presented by uncommitted first-time sellers.

Broker advantages. Working with business brokers can streamline the acquisition process. Brokers provide organized information about companies for sale, help manage seller expectations, and facilitate communication between buyers and sellers.

Direct sourcing approach. Alternatively, reaching out directly to business owners can uncover off-market opportunities and potentially lead to better deals. This method requires more effort but can yield unique prospects.

Sourcing strategies:

• Develop relationships with multiple brokers
• Use online platforms like Axial or Dealnexus
• Conduct targeted outreach to business owners in desired industries/regions
• Leverage personal and professional networks

Balance both approaches to maximize your chances of finding the right acquisition target. Be prepared to review hundreds of prospects before identifying a suitable opportunity.

5. Due diligence: Thorough investigation to validate the business opportunity

Due diligence is an iterative process that you guide.

Comprehensive evaluation. Due diligence is critical for validating your understanding of the business and uncovering any potential issues. This process involves both qualitative and quantitative assessments of the company's operations, finances, and market position.

Key areas of focus:

• Financial performance and accounting practices
• Customer relationships and satisfaction
• Legal and regulatory compliance
• Operational efficiency
• Management team capabilities
• Industry trends and competitive landscape

Engage professional advisors (accountants, lawyers) to assist with specialized aspects of due diligence, but remain actively involved in the process. Use the findings to refine your financial projections and acquisition strategy.

6. Negotiating the deal: Crafting a win-win letter of intent (LOI)

The LOI is a handshake and it allows both parties to proceed with reasonable confidence.

Framework for negotiations. The letter of intent (LOI) serves as a roadmap for the acquisition, outlining key terms such as purchase price, financing structure, and post-acquisition commitments. While non-binding, it sets expectations and demonstrates commitment from both parties.

Key components of an LOI:

• Purchase price and payment structure
• Financing details (including seller financing)
• Due diligence period and exclusivity
• Key employee retention plans
• Post-closing transition arrangements

Negotiate terms that protect your interests while remaining fair to the seller. Be prepared to adjust based on findings during due diligence, but avoid reopening settled issues unless absolutely necessary.

7. Closing the acquisition: Navigating legal complexities and finalizing agreements

You are now moving toward your acquisition on three separate fronts: you are completing your confirmatory due diligence, working with your lender to complete their due diligence and negotiate a loan agreement, and finalizing the shareholders' agreement with your equity investors.

Coordinating multiple workstreams. The final stages of an acquisition involve simultaneous efforts to complete due diligence, secure financing, and finalize legal agreements. This process requires careful coordination and attention to detail.

Key closing considerations:

• Purchase agreement negotiation
• Financing documentation (bank loans, seller notes)
• Equity investment agreements
• Employment and non-compete agreements
• Regulatory approvals (if applicable)

Work closely with your legal counsel to ensure all necessary documents are properly prepared and executed. Be prepared for last-minute issues and remain flexible in finding solutions. Remember that the closing is not the end, but the beginning of your journey as a business owner.

Last updated: August 30, 2024