The idea of buying a business to grow yours may seem unrealistic but lately it's becoming a lot more practical.
The Great Recession has left a lot of good-quality businesses with depressed financials run by owners who are battered, tired and motivated to leave.
Whenever a market swings too far in one direction, there is opportunity in the air.
Here's a four-step plan to buying a business to grow by acquisition:
Finding a diamond in the rough
The best way to find a good business to buy is to show up at your industry association meetings and meet your peers on neutral territory. Even though socializing may not be your thing, participate in the dinners. After your peers have a couple of drinks, you'll find out who's considering selling.
Valuing your target
For $219, you can query a database like Pratt's Stats for a report, which will show you the average price being paid for businesses in your target industry.
This report will also give you an objective statistic to point to in the negotiation process with a business owner.
Financing the deal
It's a buyer's market, so you can usually get sellers to lend you some of the money to buy their business in a financing agreement called a " vendor take-back." (Get a lawyer to structure the agreement).
Lets' say, for example, that you find a business you think is worth $600,000. You can offer the business owner $400,000 in cash and borrow the other $200,000 from the owner at a competitive interest rate (maybe prime plus three). If you default on the loan, the business owner gets his or her company back.
Getting to yes
Your target is likely going to think their business is worth more than you do. It can help to show them objective data like a Pratt's Stats report, but all of the statistics in the world are not going to help if the business's owners have a number in their head below which they will not budge.
This is where you can use an "earn-out" to bridge the gap.
Let's say the business owner you're negotiating with thinks his or her business is worth $1-million but you think it is worth $600,000. You could make the extra $400,000 available to a business owner if the business reaches a set of goals in the future.
A word of caution about earn-outs: In my opinion, they're a good tool being too heavily relied on by buyers today.
One M&A professional I recently spoke with recently told me her typical deal is now 30 per cent cash up front, with the other 70 per cent available over a five-year earn-out.
I don't think that serves either the buyer or the seller well, since the seller is going to begrudge the length of time he or she needs to stay to get paid.
I would recommend limiting your earn-out to one or two years maximum and – unless there are some very unusual synergies you expect to exploit – no more than 40 per cent of the total price being paid for the business.
A million-dollar business for $400,000
Now let's put all of this together in an example.
Let's say you find a business generating $1-million in revenue, with $200,000 in pre-tax profit after accounting for a market rate salary for the owner.
You figure the business is worth three times pre-tax profit so you offer $600,000. You say you'll pay $400,000 on closing day and you offer to pay the owner an interest rate of prime plus three if he or she loans you the extra $200,000.
You also offer to pay the owner another $400,000 if he or she stays on as CEO and leads the former business to at least $350,000 in pre-tax profits at the end of the second year of a two-year earn-out.
You get what – at least in the seller's mind – is a business worth $1-million, but you put only $400,000 of your capital at risk.
The owner is happy because he or she has some cash in the bank, a better interest rate than he or she would get at the bank on the money he or she lent you, and a realistic path to get to his or her million-dollar valuation in two years.
Special to The Globe and Mail
John Warrillow is a writer, speaker and angel investor in a number of start-up companies. You can download a free chapter of his new book, Built to Sell: Creating a Business That Can Thrive Without You.
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