Briefing: HBR Guide to Buying a Small Business | The Smart Way

Small-business acquisition and management is not without its challenges. That’s why you need to approach your search, deal negotiation, and transition to leadership in a systematic way. In the highly-regarded HBR Guide to Buying a Small Business, Harvard Business School professors Richard Ruback and Royce Yudkoff provide expert guidance.

Through Rick and Royce’s extensive research on companies and their buyers, they’ve developed a road map for tackling all of these steps. Here’s a quick summary.

The Search

The search begins by sourcing and assessing potential businesses.  They recommend focusing on companies with annual revenues of $5 million to $15 million and annual cash flows of $750,000 to $3 million. In this range, there are high-quality small businesses available for prices low enough that you and your investors can earn an excellent return even if the business grows only slowly. Forget rapidly evolving startups and risky turnaround opportunities; you should look for steady (often unglamorous) enterprises that are profitable year after year and likely to remain so—what they call enduringly profitable. While these are strong businesses, you can still add a lot of value by applying best management practices that the current owners might not know about or have the energy to pursue.

In a typical search you’ll encounter acquisition prospects every day—through referrals from your network or brokers or through your own direct outreach to business owners.You will need to dismiss most of them very quickly. They recommend that you evaluate each using five criteria:

• Is it profitable?
• Is it an established business?
• Are its revenues and cash flows in the desired range?
• Do you have the skills to manage it?
• Does it suit your lifestyle (location, hours, need for travel, and so on)?

If you answer yes to these questions, move on to two additional questions that take a bit more time to investigate:

• How enduringly profitable is the business?
• Is the owner genuinely interested in selling?

Markers of enduring profitability include a steady, loyal customer base; a strong reputation; deep integration with customers’ systems; large switching costs; and few or no competitors. Examine the financials carefully and look for strong margins and low customer churn.

If the business owner is working with a broker, this typically indicates a serious intent to sell. But it’s not uncommon for people to back out at the last minute. To counter this risk, spend time with potential sellers as early as possible to understand their motives. Are they retiring? Have they had a life change that requires them to give up the business? Are they just testing the waters? Consider their expectations: What price do they want? Are they just looking to turn a big profit—or perhaps get rid of a bad apple? Also, make sure you’ve spoken with all co-owners or stakeholders, as their perspectives on selling may differ from the primary contact. 

Even as you dig more deeply into businesses that make it past your initial filters, you should continue to review new prospects in case your desired deal falls through.

Negotiating a Deal

At this stage, if the business still interests you, begin your preliminary due diligence: a focused period of rapid learning in preparation for making an offer. This is when you’ll test the seller’s initial claims and verify the information that has made the business appealing to you. You believe the company has many devoted customers because it reported a low churn rate—but are those customer businesses themselves healthy? You think cash flows are steady—but what did the books look like during the last recession? And how sound are the company’s current business practices (regarding quality control, billing, refunds, pay, and benefits)? Your goal is to uncover any red flags that might make you reconsider the acquisition.

Use the company’s historical financial data to project its future earnings and calculate your return on investment. These calculations will allow you to value the firm as accurately as possible—and thus to arrive at an offer price, typically between three and five times the current EBITDA. Approach your investor and lender network to raise money for the acquisition. You should be prepared to provide information about the business and its industry, details on the due diligence that you’ve done, your financial projections, and the proposed deal terms. This is also the time to persuade the seller that you are the right buyer, especially if you’re competing against other interested parties.

If your offer is accepted—or accepted after negotiations—you’ll enter a period of confirmatory due diligence in which the company’s records will be fully open to you. You will typically have around 90 days to work with your accountant and attorney to check for any inconsistencies and red flags. (It’s a good idea to wait until this stage before bringing in these outside professionals so you don’t incur unnecessary legal or accounting costs in the event the deal falls apart earlier in the process.)

Transitioning into Leadership

After closing the sale, you should focus on four tasks: introducing yourself to all your managers and employees, meeting with external stakeholders, clearly communicating the transition plan to everyone, and taking control of your cash flow.

As you meet your new team, reassure them that they won’t see any immediate changes. Instead, share your vision and goals for the company—for example, excellent customer service, commitment to quality, a satisfying work environment. Also give them an opportunity to ask you questions, but don’t feel as if you should have definitive answers for everything: “I want to learn more about that issue before I make a decision” is a perfectly fine response.

You’ll need to take the same proactive approach with customers, suppliers, and your new community. They will appreciate meeting the new leader, and often have valuable suggestions for improvement. Two acquisition entrepreneurs made a point of visiting every major customer as soon as they could; they explained that all their new product and service ideas in the subsequent months came out of those early meetings.

If the previous owner is staying on temporarily as part of the transition, explain to employees and customers how that arrangement will work. Make it clear how decisions will be made going forward and whom they should approach with concerns or requests.

Along with relationships, cash flow should be a top priority. Many small businesses run into problems due to cash shortages, especially with acquisition debt to pay off. So set up a process whereby you approve all payments before they go out, and review your accounts-receivable balances at least weekly. Establish a 90-day rolling cash flow forecast to stay ahead of any potential issues.

 

Growing pains are inevitable. If you have approached the acquisition process thoughtfully and begun to apply good management, you’ll find stability soon enough. And then you’ll be able to focus on growing your small business into something bigger and better.

 

THE INFORMATION PROVIDED IS NOT INTENDED TO CONSTITUTE LEGAL ADVICE, ACCOUNTING ADVICE OR ANY OTHER ADVICE OF A PROFESSIONAL NATURE. THE CONTENT SHOULD NOT BE USED AS A SUBSTITUTE FOR PROFESSIONAL ADVICE. YOU SHOULD ALWAYS CONSULT YOUR OWN ATTORNEY, ACCOUNTANT OR OTHER APPLICABLE PROFESSIONAL FOR ADVICE BEFORE MAKING IMPORTANT PERSONAL OR PROFESSIONAL DECISIONS.