Buying Into a Business: The 2 KEY Factors
24 January 2022: Buying Into a Business – The 2 KEY Factors
Faithful readers: If you missed last week post, it is because there was none – the first such instance in years and one noted by several of you.
Well, there’s good reason for that first-ever omission. For the last ten days or so I’ve been laid low by a vicious virus that just kicked my butt.
But I’m well on the way to recovery, so let’s get down to bidness!
Like most businesses, we get regular reports on the traffic to the various areas of our website. Given the current pace of businesses coming to market – the oft-mentioned Silver Tsunami; the “Baby Boomer Business Sell-off” – this blog gets a fair amount of traffic and judging by the topics visitors search for and the titles that get the most readers, our audience has primarily been business owners seeking guidance on selling and individuals – often Realtors – looking for information on how to value and sell businesses – how to get in the game.
Recently, however, we’ve noticed an increasing trend of readers searching for information about buying into a business; that is, buying a portion of one. Though we’ve posted before on this topic, it was relatively general information. And though many of the steps and issues that must be considered when buying part of a business are the same as if the buyer was buying the whole enchilada, the biggest difference is that the buyer of a partial interest in a business may not have much control over the business after the buy-in.
Though the issue of control is generally a function of negotiation and what, if anything, the buyer will contribute besides capital, there are two primary factors that anyone buying into a business must address before anything else. Let’s look at them both.
Who Owns the Business?
Needless to say, when buying into a business, knowing who owns it – and I mean every bit of it – and who has the right to sell whatever part you’re buying would be pretty important information to have.
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We’ve been helping business owners sell their businesses for more than 20 years and during that period we have occasionally discovered “silent partners” – owners of some portion of the business that we’d been hired to sell – some of whom were unaware that we had even been contacted.
For us, not knowing exactly who owns the business – and who has the authority to sell it – can result in a last minute collapse of the deal – or worse, a buyer receiving a legal notice a year or more after the sale from a lawyer representing some long-lost nephew of the previous owner who claims to own 30% of the company.
For someone buying part of a business, though there are similar concerns, an additional one is that you may not realize how many partners you’ll have or whether you’ll be able to get along with them.
If you are considering buying into a business, realize that hiring a business attorney is the surest way to reduce unpleasant surprises, But you can save yourself some time and legal costs by requesting some basic legal documents from the owners of the business before you hire that attorney. What you want to see are the business’ organizational/corporate documents – the documents that describe how the business entity is structured and how it is owned.
What these documents are called varies depending on the jurisdiction the business is in but in the U.S., there are two general categories: businesses formed and operating as corporations and those formed and operating as so-called “pass-throughs”, which include limited liability companies (LLCs), partnerships and sole proprietorships.
What you need for you analysis of each is similar but not the same.
For businesses formed and operating as corporations, you’ll want the following:
- Articles of Incorporation
- Certificate of Good Standing from the appropriate state agency (generally the State C0rporation Commission) showing that the business is properly registered and current in its registration
- Shareholders Agreement, which all shareholders must sign, and which shows, among other things, how stock in the company can be sold/awarded. The shareholders agreement also describes the rights and responsibilities of the shareholders.
For businesses formed and operating as pass-throughs, you’ll want the following:
- Articles of Organization
- Certificate of Good Standing from the appropriate state agency (generally the State C0rporation Commission) showing that the business is properly registered and current in its registration.
- Operating Agreement
- Membership Agreement, if there are multiple members (owners). If the business exists as a single-member entity, the Articles of Organization will state a much. The Membership Agreement will show, among other things, how membership interests in the company can be sold/awarded as well as describing the rights and responsibilities of the shareholders. If you are buying into a single-member LLC, it will no longer be a single-member LLC and a Membership Agreement must be created.
These documents are an excellent place to start but they do not take the place of good legal counsel.
For example, how can you be sure that the company, in need of a quick $250,000 a couple of years ago, didn’t carve out an ownership position for the provider of that capital but neglect to update its corporate documentation.
Hire a good business lawyer to review all the documents and other information you collect to be certain that you understand the ownership structure of the business you’re considering buying in to. Granted, there may be just one owner – your friend of college roommate. But this is no time to take chances.
What’s the Chunk You’re Buying Worth?
Just as important as knowing who owns the business is knowing what the business is worth.
The quick and easy answer to this question is to just get a valuation done. If you’re buying 25% of the ownership of the business, if would stand to reason that you would pay 25% of it’s value. But additional consideration must be given to what your participation will be.
Will you be a partner in the sense that you are going to contribute only capital and leave the operation of the business to others? How will they be compensated for their time and effort running the business?
Will you also be contributing talent or labor? If so, is some or all of your compensation in the equity you’re acquiring or will you receive additional compensation for your talent, as well?
Our course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, teaches you how to value and sell businesses.
Become a Professional Business Broker…
A professional business broker can tell you what the business is worth. If the current owner(s) of the business – a portion of which shares or membership units you will be buying – are recruiting you, it would be realistic for them to pay for the valuation – to prove that the business is worth what they say it is; i.e., what they want for it. However, we often see that parties split the cost of the valuation
The Bottom Line
This post is not meant as a thorough tutorial on buying into a business. For a more in-depth discussion, including some examples, check out this post from four years ago.
There are many ways to structure the sale of a portion of a business. The ownership can be sliced and diced – and even morph over time, if equity is based on performance.
But as important as all of that may be to the deal, it all follows the first two major questions: who owns what (and has the authority to sell) and what is the value of the portion you’re being offered.
The answers to both require the advice of professionals, both legal and transactional. Make sure you work with an attorney who understands and has experience with business transfers. And in order to know the value of what you’re considering buying, make sure you work with a business valuation expert or appraiser – someone that values businesses for a living.
If you’d like a referral to either – or just some advice on the process – let me know.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
We have a buyer U.S.- and Canada-based based residential and commercial services – HVAC, plumbing, overhead door, landscaping and tree care businesses – with EBITDA between $2 million and $20 million.
If any of you know of something that might fit, please let me know.