5 risk-reduction steps before buying any business

Do you know what the number one risk is when buying a business?

Nope — it’s not taking out a big loan...

It’s not doing enough research.

You’d be shocked at how many people buy businesses “sight unseen,” and jump headfirst into a bad deal.

This is a huge, but preventable mistake.

Here are the top five due diligence steps you should take before investing into any business acquisition:

1. Calculate the cashflow

We want to find out the total financial benefit that the business is giving to the owner.

This is called the Seller’s Discretionary Earnings, or SDE.

This includes the owner’s salary and distribution costs, plus the personal benefits their business is currently paying for, like vacations and car payments.

2. Look for “Golden Ratio” profit margins

We want businesses between a 15% and 35% profit margin.

Below 15%, you’ll be at risk if a major change happens, like a big customer leaving.

If it’s over 35%, that’s probably because the owner is personally working on the day-to-day parts of the business.

In that case, you’re basically buying yourself a job... which (depending on your goals) may defeat the point of the acquisition!

3. Determine your working capital requirements

Calculate the average of three months’ business expenses, and multiply that by three.

E.g., if every month costs $50,000 in expenses, you’ll want $150k in reserve, sourced through a line of credit or an SBA loan.

This is the minimum amount of working capital you should start with.

Don’t neglect this!

I’ve seen too many businesses play fast and loose with their working capital, leaving them unable to meet payroll when Friday comes around.

4. Assess the management structure

People are your most valuable asset, so make sure this is rock-solid.

Do some digging, and ask:

• How involved is the owner?

• Does the business have a GM (General Manager) running the day-to-day?

• What tasks does everyone do, and for how many hours per week?

• How long on average do the employees stick around for?

If there’s no GM and a high employee turnover, you’ll end up managing the day-to-day yourself, and your staff will be at a high-risk of leaving.

5. Audit their systems

The key questions here are:

• What CRMs and software are they using?

• Are they doing any marketing right now, or is growth coming from referrals?

• What do their day-to-day operating procedures look like?

If you understand how these systems work, you’ll have a better idea of the time and cost required to overhaul those parts of the business, if necessary.

Acquisition entrepreneurship is far from a get-rich-quick scheme.

It takes a strong work ethic, and a willingness to learn.

But if you’ve got that?

The process itself is straightforward, and the time and financial freedom it affords you can be life-changing.

To learn more about how you can start acquiring and investing in profitable businesses:

Fill out our Investor Survey here, and tell us what types of deals you’d like to learn more about.

And check back in every Tuesday and Thursday for more acquisition tips and strategies!