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Overview | Why You Need Help | Economic Due Diligence | Due Diligence on the Contract and Disclosure Documents | Walking Around, Tire Kicking Due Diligence | The Ultimate Due Diligence
Your company has been acquired or is downsizing to outsource work, or whatever, and you are out. What are you going to do now? The usual route is to look for another job, but there are lines at all those doors already and you aren't getting any younger. You have access to around $500,000 in cash and liquidity if you know how to evaluate where you are in life (i.e., what you have that is cash or convertible to cash through refinancing it, plus your exit compensation), and you can go into your own business. But you have never done that. You are scared to death if you have any sense. You have nowhere to turn for guidance except firms that say that for a fee they will show you what to do. Most of them - almost all of them - are of no practical use to you and are just promoting you. You're on your own. You need a map, a guide to get it done.
Here it is.
Every day there are thousands of businesses or business opportunities for sale. Any attempt to list them would be a waste of effort, because there are so many, in diverse locales, of such varying descriptions, and of such different scales and conditions of health, that you would be simply overwhelmed. We are now at the point at which the process by which you have screened attitudes, aptitudes, capabilities and aspirations has lead you to narrow the scope of your career search. Therefore, we assume here that you have preferences for type of business in which you might be interested, willingness to relocate if the right situation were to present itself, a reasonable appraisal of what you might be able to handle in terms of the size of the investment and your ability to provide liquidity of assets to handle that plus working capital to see you into profitable operations and to cover your living expenses during that working-to-break-even period.
Your choice will be either a brand new start up business, possibly a franchise, in which you are purchasing the right to use somebody's already developed system and name, an up and operating franchised business which the franchisee or the franchisor may own and have for sale, or an up and operating business which may not be a part of any chain of similarly named businesses.
If you are looking at an already up and operating business, you will be expected to assume leases or to buy the site, inventory, equipment and fixtures, plus a premium called 'good will' or 'going concern' value. In a new start up that is franchised, you will be expected to pay for site development, including buying or leasing existing property that may or may not already be built out to some degree of completeness and suitability, modifying an existing facility to accomodate the layout requirements of your new business format, equipping the business with the equipment that is necessary to operate and establishing support services such as insurance, telephone, utilities, and other purchased functional support. In any event, by the time you are at this point, you will have a fairly definite idea of the money requirements and whether you have it in liquid form or are able to arrange for needed additional debt financing. If you have decided to have one or more partners, this discussion assumes that all of you have done this, and the reference to you is a reference to you and your partners. The benefits and very real risks of partnering are not part of this discussion.
Now you are at the point at which something called due diligence comes into play as the essential skill that should reduce risk of failure from conditions present in the buisiness you are thinking of buying. Some risks are obvious. You buy insurance to replace destroyed assets, for example. But anything you buy may have latent defects, not obvious from appearances and from what you are being told about the business by the people who are trying to convince you to buy it. Defects include not just broken equipment or poor contruction, but inaccurate information and imperfect intangeables. Financial statements have to be verified by bank statements and cancelled checks and cash register tapes and sales and income tax returns and daily and weekly sales reports generated for internal use as well as for reporting to landlords and franchisors. People do not, alas, always tell the truth, or they sometimes do not tell the entire truth. That you have to figure out for yourself.
You have various personal, useful traits, an education, and some substantial degree of business experience, possibly working in a corporate environment in some function, maybe management or production or sales or maybe also with more than one company and in more than one industry. In a corporate environment you had access to support functions provided by the company for which you did not have to pay, such as accounting, insurance, law department, advertising, and so on. What you needed from these other disciplines you simply picked up the telephone and arranged for. In a small business environment these support functions are not already in place without cost to you , and you have to go out and find them and pay for them. A franchisor will tell you that's what you get when you buy a franchise, but, in most key areas of needed support, that simply is not so. When your plumbing, electricity and equipment fail, you have to get them fixed at your expense. There is no maintenance department. You are the maintenance department. The franchisor will not fix anything that breaks down, defend you in lawsuits, absorb your uncollectable receivables, resolve any of your labor or environmental pollution or public health and saftey problems, or protect you on the way to the bank. You buy your own insurance, deal with your own claims adjustors, pay your own bills, run your own advertising, and so on.
In this find a business to buy project, you are also on your own, and no matter what you did before, you don't have the skills to do the due diligence for this project. Even if you were in some corporate merger and acquisition department, you were most certainly not buying one small, single store operation, but a substantial, legitimate company with easily examined corroborating documentation, suppliers and major customers you could go to for verification of the quality of their relationships with your target company. In the small business setting, however, it is a completely different ballgame. Because people who buy small businesses usually lack sophistication, sellers make outrageous representations and try to hide documentation that would allow you to learn the truth if you knew what you were looking at and what it meant. Some will ask you to pay 'good faith' money to look at financial data, an outrageous ploy. Some will show you unverifiable, incomplete data and tell you that is all you need to see to know what you want to know, and will resist complete disclosure. Many will ask a price which the business' historical financial performance could never justify or pay for. You won't know how many times the seller has already sold the business to some inwitting buyer, only to have to take it back and now be trying to sell it to you . Ask if the business has been sold and been taken back before and what the selling price was-get the answer in writing. Find out who the previous buyer was and go talk to that person. You may be thinking this is too insane, that rational people do not behave this way. You are wrong. People have no qualms about asking hundreds of thousands of dollars for businesses that have never broken even and that have never produced enough cash flow to cover the cost of operations, much less debt service and some income to the owner. People buy these because they are told that all it needs is the right operator who is willing to work hard and has some imagination, or that there really is more cash than the financial records show, because there is cash that the IRS does not know about. And people believe this nonsense, only to learn through investment tragedy that it just aint so.
You will need an accountant and a lawyer. They need to be introduced to each other and to be told to talk with one another and work together on this assignment, so that you receive the best of their combined talents and experience. If each is working alone with no communication between them, you are missing out on a large part of the benefits for which you hired them in the first place. You have to budget their fees in your business plan. In all likelihood, your accountant and your lawyer will have little or no experience in due diligence assistance to someone buying a samll business, franchised or not. They both need to read this part of this course material to enhance their ability to provide the level of assistance you need from them. Give them each a copy. You paid for it and you should get the full benefit of it.
There are few professionals with training or experience in analysing a franchise opportunity. Until lately there was no formal education in franchising, and what there is now is superficial and biased toward franchisors because of grants to educational institutions by franchisor associations and franchisors. The lawyer or accountant that you used for your real estate or estate planning projects probably has no background in franchising. The accountant who prepares your taxes can explain how a franchisor's financial statements are structured, but that tells you very little of what you need to know. And in fact, there are some questions you should ask your accountant to look into. Remind the accountant that franchise companies use the accrual basis for their financial accounting, not the cash basis. This means that income that was supposed to come in during an accounting period is accounted for as if it did, whether in fact it did or not. You have to look elsewhere in the financial statements to see whether there are yearly growing accounts receivable or notes receivable that are the product of a serious non payment of royalties problem that the company is hiding by taking notes for past due royalties. If this is the pattern over a three year period, that's a big danger sign. The notes to the financial statements have to answer these questions. If they don't, ask for more information. If they won't give you the information, that refusal is a form of telling you that what you want to know is what they want to hide. Don't buy the franchise. Never buy from an employee owned franchise company. If the stock were worth having and if anyone with any sophistication believed that, there would have been a market for the stock and it would be publicly held. The fact is that a non publicly held employee owned company probably has no future. In most towns and cities there is no one who has ever dealt with a franchise opportunity in their whole life. You have to share this material with your advisors so they can help you better to understand what you're looking at.
Another problem is that it's not just a matter of reading a contract for what it says. It's a matter of knowing how what the contract says impacts upon the actual operation and future value of the franchise you are thinking of buying. Also, there is the issue of what the contract does not say, that it should have said, that only an advisor with substantial industry experience can get you through.
What this means is that you need to have a guide to give to your lawyer, a tutorial that will help the lawyer understand how to help you. That is what this material tries to do - bring you and your local advisor up to a higher level.
Economic due diligence starts with arithmetic. The arithmetics of your franchise opportunity start with the section of a franchisor's disclosure document (called a UFOC) which sets out, in Items IV and V, the fees required by the franchise agreement. The royalty rates, advertising rates and the initial franchise fee can be compared with those of competing franchise offerings and by referring to industry publications, such as The Franchise Annual, published by Info Franchise News, Inc. If you can't find it in the bookstore, call them at 716-754-4669. But be aware that not all the information in any publication is accurate. For example, the total initial investment stated by most franchisors is rarely accurate (Item VII of the UFOC), and the statement of working capital required rarely includes at least enough money for you to live for a year if it takes that long for the business you buy to break even. So add one year's living expenses to any statement of total initial investment required. You have to know whether you can afford to do this, and it involves more that just the checks you have to write to the franchisor and others. To have any idea of whether the total initial investment stated by any franchisor is reasonable, compare what competing franchisors say the total initial investment in their franchise is, but more importantly, ask at least 50 franchisees of the franchise you are considering how much money they needed to hit break even, including living expenses.
Look at how long the franchisor has been franchising. If it's only a couple of years, they have no idea what total initial investment, including working capital, really is - they're guessing, and you have to check even more carefully with franchisees and competitors. A new franchisor can be a bargain if the initial fees, royalties and advertising fund payments are lower than competing franchises, but the lower cost suggests higher risk in some cases. A new franchisor is also somebody you have to bargain with over fees, length of term, renewal rights, first refusals on new stores in areas adjecent to you , eliminating the covenant not to comepete and many other items. Don't be shy about negotiating. Thay have to get franchisees to be believable. They need you more than you need them, no matter what they say. Bargain over everything with a new franchisor, especially if you are willing to buy an area development franchise where you agree to establish several stores according to a schedule. If you are financially qualified to do that, you are in the driver's seat with a recent franchisor.
The length of time a company has been in franchising is most useful in light of the tenure of their competition and in a comparison of the number of franchisees they have versus the number of franchisees their competitors in business a similar period of time have. If four companies have been franchising for around 8 to 10 years, and three of them have over 200 franchisees while the other has, say, 85, that tells you the low number franchisor is out of touch with the market. You don't want that franchise. Hundreds have comparison shopped it and found it to be less worthy.
The UFOC is supposed to explain to you what the contract terms mean - but it often doesn't hit all the bases. So, you can't rely on just studying the UFOC to know what the contract really says. Sometimes it's tricky. For example, a post termination or post expiration covenant not to compete is per se illegal in California. Most California based franchisors' contracts provide for the application of California law as the law under which the contract is to be interpreted and enforced, except for the law relating to the covenant not to compete. As to that section, they pick a choice of law of the franchisee's state so there may be a chance of enforcement of the covenant. But they don't tell you that under California law that covenant would be unenforceable, and most lawyers and all accountants don't know that. The UFOC doesn't explain that - it just says that, as to the covenant, the law of the franchisee's state applies.The same applies on renewals, because most franchise agreements today provide that on renewal you must sign whatever agreement they are using on new franchisees, no matter what the differences may be.So, in a five year franchise, you can easily find that the value of your investment is seriously eroded when you go to renew, because the renewal is not of your original contract, but of a contract that may have higher royalties and/or advertising fee requirements, less or no territorial protection, a right for the franchisor to buy your business for only the book value of your mostly written off assets rather that for its going concern value.You don't have any way of knowing what you'll have to sign to renew your franchise at the time when you are buying the franchise in the first place, so don't buy short term franchises unless you want to assume that risk. Otherwise, at just the time when you have really built up some 'sweat equity', it can get pulled out from under you on renewal. That same 'new contract' maneuver may also be in the contract if you sell your business. If your buyer has to sign the 'new franchisee' contract, which will definitely have different economics in it, the impact of that difference will be deducted from the sale price by an intelligent buyer. In a one million dollar gross sale business with 15% profit and a 5% royalty, the royalty is 1/3 of the profit. If in a new contract the royalty goes to 7%, for example, the royalty becomes almost half the profit, and the value of the business under the new contract goes down accordingly. Analysis of these documents requires much more than just the ability to read.
Compare competing franchise offerings also for the terms of succession should you die. What are the rights of your heirs to assume ownership and operation of the franchised business, or do they have to sell it. Does the spouse of the franchisee have to sign the contract. If so, then see whether the spouse is considered an heir or a co-franchisee for purposes of the 'death of the franchisee' clause - sometimes it's different. Gender bias is still in a lot of agreements. Some slick franchisors make the spouse sign so they can claim against the spouse to enforce the agreement, but then treat the spouse as a non party if the principal franchisee dies.If the spouse doesn't sign, then the heirs may be able simply to tell the franchisor to hit the road and operate under another name with no obligation to the franchisor - not even under the covenant not to compete. Some franchisors, to undercut this danger, put in a clause allowing the franchisor to buy out the business for the written down book value of the assets upon death without contract assumption by the heirs. That means the surviving spouse may have to sign, probably the 'new franchisee' agreement, and lose part of the value of the business or sell to a buyer who will have to sign the 'new contract' and lose part of the business' value that way. If you can spot these traps before you buy the franchise in the first place, you may want to consider the ultimate due diligence at the end of this discussion.
What does the franchise contract say about limitations upon your ability to purchase supplies and equipment? Does the franchisor claim to have 'proprietary' products you can only buy from them? Many product franchises, like pizza shops, doughnut and pastry shops, soft serve froaen or refrigerated dessert shops, have a secret product formula that is the heart of the franchise, and you will be required to buy the mix or sauce or dough for those products from the franchisor or the franchisor's designated supplier, and they will make a profit. That's normal, so don't bother trying to negotiate on that. Eventually you will learn that these 'secret formula' products are really generic in the sense that a perfectably marketable equivalent is available on the market for less money. But you will still be required to buy the franchisor's product for more money, so just get used to it and don't whine. If others using cheaper equivalent products are out there competing with you and price cutting, that's just too bad. Again, see the Ultimate Due Diligence section of this paper for the way to avoid that.
Does the franchisor you are looking to maybe buy from require you to buy from designated suppliers other supplies and equipment (including leasing equipment), or can you buy on price, quality and service like non-franchised business people do? If you are limited, what does the franchisor say about whether they derive income on account of those purchases by their franchisees. The facts of life are that a supplier is not going to provide free advertising or promotional services to a franchisor unless the supplier gets to be relatively immune from competition in selling to you and can get a higher price from you than they get selling in the open market at competitive prices, where people can buy from whomever they want. That means that even though the contract gives you the right to seek approval of alternative suppliers, the franchisor probably won't approve them, or will make the approval process so cumbersome as to be unworkable. If the franchisor approves many suppliers, the designated supplier will have to compete on price, quality and service, which is what he doesn't want to do and won't give benefits to the franchisor if he has to face it. Also, if the suppliers are tight with the franchisor, they may not treat you well, and the franchisor probably won't help you because the franchisor doesn't want to risk losing the supplier's allowances and promotional free goods, favorable pricing for the franchisor's company owned stores, or other promotional assistance. You are told that you are in business for yourself, but not by yourself, but you will come to see that you are much more by yourself and on your own when problems arise than you thought you were going to be. The franchisor will not be passing those allowances and promotional benefits along to you. They are for the franchisor's bottom line only. In some cases a franchisor will see that advertising and promotional allowances go into the advertising fund, but don't count on that. And be aware that the franchisor is charging the advertising fund for many expenses of administration of the fund, plus a profit, including attorney fees when delinquent franchisees have to be sued and advertising that is not to sell your product or service to the public, but to sell more franchises (business opportunity advertising). Additionally, there is usually no requirement that the franchisor spend advertising money in your territory or region in any proportion to the inflow of advertising dollars from your territory or region. Also, you have to see whether, in addition to your advertising fund payments, you still have to do your own local advertising, as in the yellow pages, local flyers and newspaper ads and the like. Frequently what you get from the advertising fund is formatted ad copy that you then get to pay for yourself to run in your local market.
Look into what happens if you fail to perform any obligation of yours under the franchise contract. Some defaults subject you to being terminated without an opportunity to cure the default, and some provide a notice of default with an opportunity to cure, within a stated number of days. Compare that program with the default-cure system in competitors' franchise agreements, which you can get the same way you got this one. You should get the contracts and disclosure materials, as well as the sales and marketing messages they send out, from every franchisor in the field you are looking at. You have the time and you had better take the time to comparison shop everything. Anybody who presses you for a decision should be stricken off your list.You have no way of knowing whether the franchisor you are looking at is on some kind of mission to sell, sell, sell, regardless of anything, either out of an ego trip, or to be able to make a loan payment, or whatever. Remember that on default that is uncured within the cure period, all the termination rights of the franchisor are triggered, including termination of all other agreements that you signed in connection with the franchise purchase, takeover of your business at written down value of assets cost only, cancellation or takeover of your premises lease if that is in your franchise agreement or lease or sublease, an attempt to enforce the covenant against competition so you can't go into the same business under another name and acceleration of any promissory note you signed, or notice to your lender who may have acceleration rights if you lose your franchise. These are strong ropes that you need to be aware of and make a conscious decision about if you decide to buy a franchise.
One thing you must not take seriously in the sales pitch is the idea that you are joining a family that will be there for you when you are not performing. The risk of success or failure is yours, not theirs, just as it would be if you were independent. You pay or else - that's it - no family! When your equipment breaks down and you can't operate, it is you that has to get it fixed. When the fire marshal or health department comes around and finds some expensive things that need to be done, it is you who will do them, not anybody else.Don't go getting all fluffy over the sales pitch. This is at best an arms length commercial transaction - at its best that's what it is and no more. Carefully compare the marketing and sales information they send you, and the things they say orally (of which you had better make and keep careful notes) against what the contract says. No matter what is said in the sales presentation, if that is not in the contract, it isn't part of the deal. For example, the 'we give you on-going expert support to make you successful' in the sales pitch, becomes 'the company shall, from time to time, at its sole discretion, provide additional training as it may deem appropriate.' You have to learn to separate fact from fantasy.
If the franchisor is publicly held, it is filing reports with the Securities Exchange Commission, which are public information. Get and read those reports and note any differences between what the comnpany says about its business and prospects in the SEC filings and what it says in the franchise materials. As an example, you could find in the franchise sales materials a statement that this franchise is in an industry (broadly described as home improvement, for example) that has grown at a steady 15% rate for the last 40 years. But in the SEC filing you could well find the statement that while the overall industry seems to have performed well in the past, it is now in a decline which may adversely affect future growth. That's the way this goes on more frequently than you could imagine. Be doubtful. Check out information in the library in trade papers that are focused of this franchisor's type of business, whether Nations Restaurant News or any other industry specific trade journal.Go talk to this companies' franchisees, its competitors' franchisees, independent retailares in the business who are not franchisees, and find out what they think has been happening in the business you are thinking of investing in. And if you're too lazy to do this kind of homework, you can bet you're too lazy to make it in business anyway. It's hard work. If you are coming out of a big company, you're used to being able to go get help in your own organization. You had your own advertising department, your own legal department, your own real estate department, a human resources manager, a company motor pool, and on and on. Not any more, baby. If you're not mentally prepared to have to re-create all these corporate assists on your own, maybe you need to seriously consider the ULTIMATE DUE DILIGENCE at the end of this paper.
Now let's get back to the documents. We aren't through yet. Lets talk about what happens if you have a dispute with the franchisor. Your franchisor's contract and UFOC may have provisions concerning choice of law (what state's law will govern the contract), venue selection (if there's a lawsuit or arbitration, where will it have to take place?), and an alternate dispute resolution requirement that probits your suing them. The Federal Arbitration Act provides that if you sign an arbitration agreement, you are bound to its terms. If it says all disputes go to arbitration, you cannot get out of it, even if the franchise agreement in which the provision is included was induced by fraud. That is a unanimous holding everywhere in the United States, whether in state court or in federal court. It is a docket clearing statute, designed to lower the congestion of litigation. If you go to court after signing an arbitration agreement, even one buried in a franchise agreement, you will be summarily thrown out. Many franchisors have gone beyond simply choosing arbitration as a means of dispute resolution. They are now including statements in arbitration clauses that provide for you to waive not only the procedural right to go to court, but also such substantive rights as lost profit damages, emotional suffering (as when you lose everything and have been cheated), punitive damages (as when the wrong done to you was intentional, not merely negligent). It may also require you to go to non-binding mediation in some far off place before you can even start an arbitration proceeding. All this is to make any redress of wrongdoing you may have suffered difficult or impossible for you to pursue.If you see this kind of approach in your franchise agreement, don't buy it. Refuse to buy the franchise unless all that dilution of your rights is removed and you can go to court, and demand jury trial and seek vindication. An honest franchisor doesn't have to go to such extremes, and this approach is a good indicator of what kind of people you are dealing with. All the talk about lawsuit abuse should be ignored, because that simply isn't true, and it isn't the reason why that language is in there anyway.
Franchise companies are really having a bad time of it as we enter the new millenium. They will never admit this, but you need to know what they are doing and how it will affect any franchise you decide to buy. The latest craze in the franchise industry today is encroachment and overcrowding of territory with new franchisee stores, new company owned stores and, especially, with e-commerce. And, worst of all, franchisors whose franchisees sell products instead of services are finding that the franchisors are putting these products in discount outlets, supermarkets and any other channel of trade that will buy from them. What you thought was going to be something exclusively identified to your franchised business is now being sold everywhere, many of which outlets are more convenient to shop at than your store. These are also being used by the big stores as traffic builders, and the price cutting is really fierce. What your gross margins might have been a few years ago simply are evaporating in the heat of the price competition. You will see in the contract that the franchisor has either reserved to himself the right to sell through any other channel of trade, that you are restricted to selling at your store, and/or that there is no restriction on the franchisor's right to dump the products through other channels. This market flooding is destroying franchisees' investments all over the USA, and you need to know that and not listen to any protestations of loyalty to franchisees or any other boloney sales pitch about "our great family". Go into any supermarket today and you see Hickory Farms products that were once exclusive to its franchisees. The same can be said for any vitamin or nutritional product. Many others are going the same way. Any franchisor having a web site is enabling on-line sales directly to your potential customer, and maybe the franchisees get some pittance of a share of the sale and maybe not at all. With this awfully destructive practice, you owe it to yourself to keep your money in your bank account while you do the "Ultimate Due Diligence" recommended in the last section of this article.
If you're looking at an existing business, franchised or not, there's more to do than just read documents. Everybody has baggage. Some of it may be Gucci type baggage, but some of it maybe be a bit battered. You need to know the mix and evaluate your ability to deal with it.
Look at the location as though you were inspecting a room. Is the parking area dirty or in need of repair. If there's a dumpster, is it full and smelly, or can you tell if it's being maintained properly and emptied regularly. It is extremely important that you hire an engineer that is familiar with inspecting the kind of business that you are considering, who will perform a detailed inspection. This includes structural, electrical, plumbing, equipment condition and functionality, safety, code compliance and the whole kit and caboodle. Expect to pay several hundred dollars for this inspection. You cannot afford to do without it. If it's a food service operation, are there containers littering the area. Walk around the block and see if their cups, bottles and napkins are on the ground. You're trying to see if the seller has been a good neighbor-it says a lot about the seller. Drop into other businesses around the area and just browse. Strike up conversations with the owners or managers and get around to talking about how's business and what's happening in the area. Talk to clerks, waiters, errand people, old people hanging around. Old people hanging around do that every day and know exactly what's in everybody's dirty linen, and they do talk. Before you meet anybody at the location you're thinking of, shop it as a customer. Come around at different times to see the variations in slow and busy periods and how much or little confusion there is when they're busy. Do the same thing on every day of the week. If the business is seasonal, take a while and see if you can spot the pattern. Look at weekly sales reports and you'll see the seasonality. If it is extreme, you need to do your cash budgets to account for seasonality. Pay more when there is higher cash flow and less when it's the slow season. Rent can be made to fluctuate with seasonality. Loan repayment schedules can be negotiated to reflect seasonality. Regularized payments that can't be negotiated for seasonality can be overpaid in high cash flow periods so there is a credit balance you can use during the slow periods. The employees of any business, when they're on a break and you are not acting like a cop, will tell you just about anything you want to know. Pretend there is a problem with something, anything minor, and go talk to the manager about it. See how they handle customers.
Go to city hall and to the county building. Check the fire marshall's inspection reports on the building you might become the owner or tenant in. Do the same with the health department, especially if it has anything to do with food. Try to check out the police track record of trouble calls in the area and at that particular location. They may give you information and they may not, but try. Go talk to the city or county engineer and find out what kind of public works may be in the works for the area, so you can see if that might impact the business. Freeway construction that may not have an exit ramp around your intented area could be the reason the business is for sale, and only the locals know it.
Every business has vendors or suppliers. Get a list from the seller of the top ten suppliers and go talk to them about the quality of the relationship, and about what arrangements would exist between them and you if you took over the business. Never offer to assume any debts of the seller unless it's just the mortgage on the purchase of the property and the interest is low enough so that it isn't worth refinancing yourself. Get a credit report. If you can't, your banker, lawyer, insurance broker or accountant knows how to get one. Get one of them to do you a favor. If there's a credit problem anywhere, go talk to the creditor and see how you might be affected by that if you were the new owner. Check the county recorder's lein office and the secretary of state's lein office for lein and security interest filings on the seller and the seller's assumed and corporate names. If any part of what you are buying is subject to any security interest or lein (such as a tax lein or a bank debt that is secured), you will not receive good title to that or those assets unless the lein or security interest holder releases the encumbrance. Without the release, you will have to pay off the lein or security interest holder even though you paid the full price to your seller for that or those assets. Many security or lein filings provide for coverage under the lein of all accounts receivable and all after acquired property. This means that everything your seller bought after the lein is automatically subject to the lein. Many business buyers get caught in this problem. Your lawyer has to know about this and know to check it out before closing. But you have to know about it to be sure that you have checked out your lawyer's diligence. You want a clean deal, not a malpractice suit because your titles are not clear.
Get the seller to introduce you to his insurance broker and get a claims history from him. That could tell you a lot about where the hot spots of potential trouble are. Have an engineer inspect the premises for everything-structural, electrical, plumbing, heating and air conditioning, compliance with building and safety codes and with E.P.A. and A.D.A statutes. Have your own insurer who will issue your policy send a loss control person to the property to inspect it. That might catch something the engineer missed, and there's no charge for that. It's part of the underwriting process for your policy. See what it's going to cost to come into compliance and factor that into your purchase price.
If the business has a few very important customers, go talk to them to find out your prospects for a continued relationship. Look at the premises lease with a commercial leasing agent. When does it expire? What, if any, are the renewal terms. If renewal is only a couple of years away, go negotiate the renewal terms before you buy. You will need the landlord's consent to anything, including your tenancy in the first place. Be certain that, before you are obligated on any agreement, no matter how small, that you know every person whose consent or agreement you are going to need to do business, and that you either have those consents in writing before you sign any agreement, or that the agreements you sign are contingent on those consents being obtained. Your lawyer can help you with all this agreement sequencing. If you are buying the prpoperty, be sure to get an owner's (not a lender's) title insurance policy. It's better than a title opinion from a lawyer, because if there is a title problem the insurance company simply has to deal with it. If the lawyer's title opinion is defective, you have to prove the lawyer was negligent to get anything done, and that's always going to be a major problem with any title claim. Title insurance is no more expensive than a title opinion, and even if the opinion is cheaper, it's no bargain. Your lawyer can be sure that the seller has to comply with bulk sales laws having to do with the sale of a buinsess so you don't get stuck with any past debts of the seller. You never buy stock, you buy assets. Your lawyer probably has her own due diligence check list. Go through that as well as what is here. There are always local issues that the local attorneys, accountants, bankers and insurance people know better than any out of towner. Get local help whenever possible. They are going to be your resource group after you buy.
You have, or have access to, from $150,000 to a million or more, and you are looking at the prospect of buying a franchise or a non-franchised business. The greatest risk reducing form of due diligence is to keep your money in your pocket for a year and go to work for someone in that business. You will learn the business. Even if you only make minimuim wage that year, you will be better off than not doing this and risking your liquidity on an investment you know a lot less about because you were in such a hurry. If you miss out on buying a particular business or franchise, so what! There's an investment opportunity available to you every day of the year. Don't be fooled. By the end of a year's work in the business you think you like, you will know enough to decide whether your expectations were realistic. You will know enough to know whether you want to do that with a franchise or as an independent. You will be told that United States Department of Commerce statistics show that there is a much higher success rate among franchised businesses than among non franchised businesses. That is simply untrue. The Department of Commerce did put out those statistics many years ago, but the survey only received a less than 7% response. Later more well responded to surveys, not done by the government, suggest there is no difference in the success rate between franchised and non franchised businesses.
Finally, if you are going to buy any going business, you must get five years tax returns (including amendments). The federal tax return is the most conservative statement of the earning power of any business. Any statement rosier than the tax returns is unreliable. Anyone who says that the tax returns don't really tell the truth is saying they lied under oath. How honest, then, are they going to be with you? If you don't know how to analyse (not just read) financial statements, or where to go to look for points of verification, get a financial analyst to help you. You will also have to have monthly financial statements, daily and weekly sales reports and state sales tax returns. Anything less and you are simply groping in the dark. You will be expected to sign a confidentiality agreement to get that information. It should say you will use it only in connection with deciding whether to invest in the business and may show it only to advisors counselling you in that effort. It should not attempt to bind you to anything at all, and you should never pay or put up any money to see that information, not even as a 'good faith' deposit. If you do you probably will never get your money back. If you are told that the sales information is all you need to see, they are insulting you. Some franchisors and non franchised business sellers will take a failed operation, cut the prices to and into the bone to boost sales and make it look like the business, in the hands of the right person, can grow beautifully. That old trick is called 'pump and dump'. Take a failed operation, cut prices to pump up the sales, then dump it on an idiot who later finds out that, although sales are great, there is not profit without raising prices. There go the customers. This is your biggest investment of money and time and effort. You can't afford to wing it.
Copyright 1997 - 2008 || Richard A. Solomon
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