Recently, a friend contacted me about a business that was for sale. They wanted to know if the asking price was fair and how to calculate a CAP rate. A CAP Rate (asking price divided by the NOI) is the rate of return for the year being evaluated. The NOI is the net operating income which is gross income minus operating expenses. While a CAP rate is a good place to start when looking at a business that is for sale, it should not be the sole piece of information used to determine if the asking price is good. Knowing this, I began to ask a lot of questions such as the following:
· What type of business is for sale?
· What is included in the sale? Land; buildings; furniture, fixtures, and equipment (FF&E); brand name; website; phone number; customer list; inventory, etc.
· Do you have a copy of the business’ signed tax returns for the past three years?
· Have you received a copy of the year-to-date (YTD) profit and loss (P&L) statements?
The information obtained from the questions was as follows: The seller was not including any assets. None. Essentially, they worked as a contracted laborer for EXA Company* providing equipment repair services. They did not have a contract with EXA, who outsourced equipment repairs to them. There was no guarantee of work. The seller recently created a company name but did not register the business with the state where the business is located. The income was very attractive. The seller was busy enough that they hired a person to assist them with meeting the demand. The terms of the sale were attractive with an offer of owner financing requiring a substantial down payment, no interest, and a fixed monthly payment for five years.
The information gathered cause me to quickly realize that the seller was selling a job, not a business or business opportunity. A business that is for sale will include real estate or a building. When the sale includes a building, but not the real estate it sits upon, there is usually a land lease between the landowner and the owner of the building. Many well-known companies’ set up their businesses in this manner. When one of these businesses are for sale, it is not considered a business opportunity.
A business opportunity is when a business is for sale that does not include real estate or a building, but it does include assets. An example of a business opportunity could be a chiropractic office that is renting office space and selling everything related to the business: brand name; website; phone number; FF&E such as desks, chairs, chiropractic tables, filing cabinets, etc.; customer list; and, inventory such as products sold to patients; etc.
What determines whether a business for sale is only a job that is for sale? The items included in the sale. In my friend’s situation, there were no assets and no contract between the seller and EXA who they provided service to. In other words, my friend could purchase the what the person had for sale, and EXA could enlist someone else to do the repairs leaving my friend without any income and a loan that had to pay.
If a contract had existed between the seller and EXA that could be assigned to the buyer, the sale would have been a business opportunity worth a look. My friend dodged potential frustration by performing due diligence to understand the opportunity. Always dissect any opportunity to buy a business. If you do not know the answers, find someone who does. Also, run any potential business purchase by your attorney and accountant. They can guide you through the due diligence phase and protect you from a potentially disastrous situation.
*Company name changed to EXA to protect those in the story.