5 Frequent Mistakes When Buying A Small Business

Business schools have always turned out a steady stream of budding entrepreneurs, and from the Bay Area to Boston to Brussels that stream turned into a torrent in recent years. For every new graduate who hankered for a job in investment banking or strategy consultancy there would be others looking to become the next Bezos, Blakely or Branson. Get to the entrepreneurship electives early, because you’re likely you’ll find it is ‘standing room only’ in the classroom.

The problem with setting up your own business is that it’s nowhere near as glamorous as you might think. Getting going and getting through the development phase to the point where you finally start to make some real money can be a hard slog, as anyone who has actually done it will be only too pleased to tell you.

But is it really necessary? If you have the skills and know-how to change the business world, do you really have to squander them for years in your back bedroom or garage? Wouldn’t it make more sense instead to do a Martin Sorrell or Bernard Arnaud by buying a business that is already up and running and then stamping your mark upon it as the first step to world domination?

Many people underestimate how complex and challenging buying a business can be. Just ask AOL and Time Warner.  The Vlerick Business School in Belgium has created a Center for Mergers, Acquisitions and Buyouts to help companies and individuals navigate each step of the process, ranging from deal origination to completion, and from financing to integration.

Two of the school’s expert professors, Hans Vanoorbeek and Miguel Meuleman, have shared five of the ten frequent mistakes that people make when buying a business.

1. Assuming that finding a high-potential business for sale is a part-time job

Finding a company for sale can take 12 to 24 months. Statistics show that before finally signing the share purchase agreement, you will have looked into over 100 teasers, done preliminary due diligence on 15 targets, and signed 2 to 4 letters of intent.

Finding a company is an emotional rollercoaster and many potential entrepreneurs quit the search because :

1. They did not ask the fundamental personal questions: Do I really want to do this? Does my partner support me?  Do I want to take the financial risk?

2. They did not devote sufficient time to the search as they were still focused on their previous / current job

3. They never clearly specified what type of business would t their personal pro le and, therefore, did not end up on the radar of brokers

Potential entrepreneurs wanting to buy a company become impatient. Watch out for the ‘entrepreneur in heat’: after a long search process, you tend to become biased and neglect some warning signs when evaluating a business for sale.

It’s better to have no deal than a bad deal!

2. Failing to understand the motivation and emotions of the seller

Business owners have strong emotional attachments to the companies they have built, and will generally be concerned about the future of a company under new ownership. When first meeting sellers, show respect for their achievements.

When meeting the seller for the first time listen 80% of the time to understand the motivation to sell, to learn about the fundamentals of the business, to know the concerns of the seller, and to identify blind spots.

Be humble! Do not be arrogant and tell the owner what you would change and what you think you can do better. The owner generally knows the business better than you do. Show respect and schmoose!

Connect with the seller in terms of your business values and the language you speak (e.g. a McKinsey consultant versus someone who started a business without a higher education). Be authentic.

Always ask yourself, ‘why does the seller want to sell?’

3. Failing to understand the fundamental drivers of the business’ profit engine

It’s not always easy to understand why a business generates a (hopefully) healthy profit margin. The seller and the broker will try to make the business look amazing and frequently the owner will have done earnings management to make the business look attractive. Always question why profit margins might be higher than the industry average or why they have been increasing recently.

Go deep into the financials to understand what happened. Make sure to also grasp the broader industry picture and how it relates to the financials of the business.

Conduct a proper financial and commercial due diligence to

1. Understand the cash flow characteristics to discover anomalies (e.g. fraud, earnings management)
2. Understand why a business has a competitive advantage (e.g. identify unique assets, capabilities, USP, etc.)
3. Draft your ‘first 100-days implementation plan’

In some cases, the success of the business has been built on the personal network and reputation of the original owner and is the only reason why the business has been alive. Many buy-in entrepreneurs fail to see this!

4. Doing due diligence from behind your desk

When you conduct due diligence, you should act as a real investigator and collect information using different data sources including financial accounts, annual reports, (former) employees, industry experts, suppliers, (former) customers, investors, and competitors. It’s clear you will need to get out into the field to collect this data to confirm or reject your assumptions (e.g. Sustainability of the profit margin).

Going out into the field is necessary to obtain intangible data on e.g. Positioning of the products in a store, company image, company culture, quality of the inventory, loyalty of customers, customer satisfaction, customers’ perceptions of how the company compares to competitors, etc.

In many small companies, financial data is not easily retrievable because of a lack of it systems. The speed at which you get information says something about the company. Go into the raw data to understand trends in margins, discounts, revenue, etc.

No numbers, no deal!

Don’t believe (too strongly) in due diligence checklists. Each company has its own specific issues!

Don’t be stingy on advisors. “Penny wise, pound foolish”. If needed, ask specific advice for specific issues (e.g. environment, pension, insurance, permits, etc.).

If the shoe doesn’t fit at the store, it’s unlikely to fit when you come home. Follow your instinct when things don’t feel right!

5. Overestimating the value of the business

“Valuation is not a science; it is an art.” It’s one thing to run the financial models behind valuation, it’s another thing to apply common sense and to know what parameters to plug in. Always be conservative when forecasting future cash flows – watch out for the hockey stick forecast!

When running your financial models, always focus on the bottom-line free cash flow. Many entrepreneurs and investors underestimate future capital expenses including it investments, machinery and equipment, maintenance and working capital needs.

Normalize the numbers when performing the valuation including the revenue and cost statement, the cash flow statement and certain balance sheet items. Take contingent liabilities into account.

When conducting the valuation of the business, don’t forget to include your own (market-based) salary and the salary of other people you might need to hire to replace or complement the management, as company expenses.

Owners are fairly often unrealistic when setting the acquisition price. Use benchmarks (e.g. Multiples) to provide objective evidence. (The M&A monitor, an annual study by Vlerick Business School, investigates the average prices for SMEs in the national market.)

Better to pay too much for a good business, than to pay too little for a bad business.

Vanoorbeek and Meuleman are members of the Vlerick Business School faculty  who run an Entrepreneurial Buyout Academy to prepare individuals for this important step. They have put together a white paper, ‘Why Start From Scratch When You Can Buy Your Own Company,’ with more great advice on buying a business, including insights on financing the deal, developing a good negotiation strategy, the importance of understanding a company culture, overestimating your own abilities and underestimating the time it takes to change things.