CHAPTER 4
Anticipating the Cost of Your Search
The first step in buying a small business is to find companies that are for sale at a reasonable price and that match the characteristics you want. We call this task searching, and much of this book explains how to search effectively.
You’ll discover that searching can be both time-consuming and expensive and that success depends a lot on your judgment and a bit of luck. Searching is difficult because the market for small businesses is opaque and fragmented. Potential sellers are reluctant to announce that their business is for sale, lest customers and employees begin to consider other options. So, you’ll either need to work through fragmented and secretive business brokers or reach out to business owners directly in hopes that they might be interested in selling. Plus, the set of businesses available for purchase keeps changing as some businesses are acquired and other owners decide to sell. As a result, this exploration phase can take as much as one to two years of full-time effort.
As you seek out companies for sale, you will incur costs such as office expenses, communication and internet charges, travel and data expenses, and professional fees for lawyers, accountants, and other experts. But the biggest cost of the search is the need to put your existing career on hold and forgo the compensation you would otherwise receive. This compensation includes your salary, any bonuses you might receive, and your benefits such as health insurance and pension contributions.
The price tag on your search depends how you decide to organize it. As we will describe, the resulting range of costs is very wide, from over $1.0 million to less than $500,000. Some of the costs are out of pocket, like the fees paid to accountants and lawyers, but most of the costs are your forgone salary and benefits. You can get investors to pay some of these expenses, or you can pay for them yourself, sometimes in novel ways, like relying on your spouse’s job to fund living expenses. But before you decide whether to raise funds for your search, you need a better sense of the parameters of your search.
Deciding on the Parameters of Your Search
To determine the cost of your search, you need to make certain decisions about how you will organize it:
Will you search with a partner or alone?
Will you focus your search by geographical location or industry?
Will you primarily use a broker, or will you do your own sourcing?
There is no one best or most efficient way to search for a small business to acquire. We have seen potential entrepreneurs succeed with broad national searches and other people do well with highly focused regional searches. Jay Davis and Jason Pananos, for example, spent over 2½ years and $750,000 searching for a company before successfully completing their acquisition of Vector Disease Control International. At the other end of the time spectrum, it took Jude Tuma only 2 months to find his acquisition, Penn Warranty, and another 3 months to finalize the acquisition. The most frugal entrepreneur that we are aware of is Ari Medoff, who spent less than $25,000 in both search and personal expenses during the 14 months he spent looking for a company on the Southeast coast of the US. Ari successfully acquired a home nursing care business that nicely matched his search criteria, but he and his family spent much of those 14 months living in his in-laws’ basement apartment. Some of these differences are due to luck, but others are related to decisions the people made about the type and scope of their search.
Searching alone or with a partner
Many searchers, especially those who are more inexperienced, decide to search with a partner and are certain that a team approach is best. They argue that the partners provide essential feedback to each other—that two heads are better than one. They also reason that a partnered search will be more than twice as productive as a solo search. And much of these arguments is true: If partners have complementary skills, the person with the most relevant experience can examine each deal: Manufacturing companies can be reviewed by the partner with the operations background; retail opportunities can be assessed by the partner with a marketing background. Ongoing conversations between the partners also sharpen their search skills as they share experiences and refine their focus. We believe the synergy between partners is real and potentially substantial.
But, of course, two heads require two hats. Though a search has some fixed costs such as data acquisition and setting up a website, the inclusion of a partner generally doubles the expense of searching. There are two salaries forgone, two people requiring living expenses and health insurance, a bigger office, twice as much travel, and so on.
Searching with a partner incurs another huge cost: The financial benefits of entrepreneurship are divided in half because two partners now share the upside. The company will also need to support two salaries and two benefits packages—significant ongoing expenses for a small business. It also can be difficult to divide responsibilities: What will the two of you do? Typically, you’ll be buying the company from a single owner. Who will be CEO? What will the other partner do? How will disagreements be resolved?
One way to circumvent some of the challenges of a partnered search is to look for a larger company to acquire—one big enough to have sufficient financial rewards and complex managerial challenges for two partners. But we believe bigger small companies tend to trade at higher prices relative to their profitability and cash flows, so even with this approach, the economics of being a successful entrepreneur through acquisition are far more challenging in a partnered search.
However, most people who search as partners don’t choose a partnership for economic reasons. Instead, we think they expect that their partner will help smooth the emotional ups and downs of a difficult process. Searching can be lonely and full of daily disappointments; of course it helps to have somebody with whom to share these troubles. But as you make your decision, be careful that you aren’t using a cost-benefit analysis to rationalize taking on a partner just because you want the emotional support. A partnership is very expensive; your search will cost twice as much, and your benefits will be cut in half.
In perhaps only this instance, we think Gordon Gekko in the movie Wall Street offered some sage advice: “If you need a friend, get a dog.” A dog is much cheaper and will give you unconditional love even if you don’t find and close a deal quickly.
The scope of your search
You might be tempted to consider every available deal when you are looking for a small business to buy. You might think that limiting yourself to a particular geographical area or industry at the outset would curtail your choices, perhaps leading you to miss an outstanding acquisition because you didn’t even know about it. But a national search across dozens of industries is time-consuming and expensive. You would have to evaluate thousands of potential deals nationwide in a wide range of industries to identify those that are worth a closer look. And there is the time and expense of traveling to distant parts of the country to learn more about promising opportunities.
Sometimes, searchers limit their scope to a particular location because they have strong preferences about where they live. Entrepreneurs need to live near their businesses because they will work long hours and be deeply involved in every aspect of the business for a decade or more. Absentee owners, especially with newly purchased companies, are asking for trouble. If you and your family cannot happily live in the surrounding community, you will probably be miserable at home, less effective at managing your business, and less successful overall. If you are unwilling to live where a potential business opportunity is located, then there is no sense searching for businesses there.
An industry focus lets you take advantage of your background in a particular business. We often see acquisitions in a “business next door,” that is, a business that is similar to one that you’ve worked in previously. You’ll know where opportunities are likely to be present and where there are unmet customer needs. You might even know a willing seller of a business that interests you or have a network of industry contacts that can help guide you to a potential target. An industry focus will also take you less time and effort to understand the target business and to see in a potential target the value that others might not see at all.
How you’ll source prospects
Your search begins with finding small businesses that are available for purchase—a task we call sourcing. Your approach to sourcing, like the decisions to have a partner or focus your search on a particular location or industry, will have a big impact on the costs of your search. There are two approaches people typically take to source potential deals; we will describe these approaches in detail later in chapter 8, “Sourcing Prospects Using Brokers,” and chapter 9, “Sourcing Directly.” In this section, we just sketch the approach and outline the associated costs.
The most common and straightforward approach to sourcing is through brokers. Owners—most of whom have never sold a company before—retain brokers to help sell their company. Brokers help sellers through each step of the sale. From the searchers’ perspective, brokers help to identify committed sellers and make it easier to learn about the prospect. If the prospect seems to be a company you would like to buy, the broker can help get the deal completed, which is especially helpful when the owner is a first-time seller. If a prospect is offered by a broker, it indicates the seriousness of the owner’s intention to sell—an important factor in the efficiency of the search.
Many searchers rely exclusively on brokers as they look for a company to buy. If you don’t source through brokers, you’ll need to contact business owners directly about potential sales. The upside of direct sourcing is potentially better deals on better firms—because these firms generally won’t have been available to other searchers on the open market—but the downside is that direct sourcing is far more expensive. You’ll need to try different outreach methods, from individual cold calls to mass-produced messages to personalized letters following significant research into individual companies and their owners. The vast majority of these outreach efforts go nowhere, largely because most owners are not interested in selling their businesses. The least personal of approaches gets about a 1% response rate; targeted, personalized efforts do better but, of course, take much more time.
Direct sourcing is a manufacturing effort of sorts. You will need to hire two or three people to work full time to help with the volume of outreach, and while these positions can be minimal-cost internship opportunities, the scale of the operation still requires a larger office with more telephones, computers, and other infrastructure. A direct approach also requires the purchase of company data to help identify potential targets and professional-grade databases to track the large volume of outreach and responses.
On its face, using brokers is much more economical than direct sourcing. Moreover, it is critical that you minimize the time and expense devoted to simply identifying prospects. However, some smart, successful people do source directly. Many of these pursue a hybrid approach that combines both brokered and direct sourcing. With such an approach, you first learn a lot about the big picture by looking at brokered deals: for example, identifying interesting market niches. Focusing on those niches can then make direct sourcing more productive since you’ll be more familiar with the industry and, consequently, better at evaluating prospects. You can use your network within the industry to connect with potential sellers, and you’ll come across as a more credible buyer.
Coordinating your choices
Some search structures make more sense than others. The two most common combinations that we have seen are (a) a directly sourced search with a partner, without a focus on a single industry or geographical location and (b) a broker-sourced search by one person who is focused on a particular part of the country. Other combinations, of course, can work, and we have seen that almost every combination can be successful.
Budgeting for Your Search
Once you have decided on the parameters of your search, you can begin to estimate your search budget. To keep it simple, we will look at the two common combinations just mentioned: a fully funded, partnered search that uses direct sourcing and a more frugal, self-funded individual conducting a regional search through a network and brokers. From these two extremes, you’ll be able to base a budget for your own search on the parameters you have chosen. Table 4-1 totals the two-year costs for these two types of searches we are using as bookends. The costs for other combinations, of course, will fall somewhere in the middle.
We will walk through the budgets sequentially, that is, in the order that you will incur the expense. That way, you can follow the steps for actually getting started on your search and their associated costs. This will help you form both a budget and a to-do list.
Legal fees
You first need to form a company that you’ll use as a search vehicle, because it broadcasts to brokers and potential sellers that you are serious about your search. It also helps keep search-related expenses organized and keeps the legal and financial aspects of your search separate from your personal life.
In the United States, the company should be organized as a limited liability corporation (LLC). Outside the United States, most countries have an equivalent structure that you should use. These are pass-through entities—that is, the LLC itself does not pay taxes. Instead, the revenues and expenses make their way to your tax return and are taxed there. An LLC is simple to form: You can do it yourself using online resources or through an attorney at a minimal fee. Some law schools sponsor law clinics where aspiring lawyers will form your LLC for you at no cost as practice. You will also need an employer identification number (EIN) (or equivalent) from the Internal Revenue Service (IRS). You can obtain the form yourself and request the number from the IRS.
Before you can form your LLC or get an EIN, you will need to come up with a name for your company. We recommend that you keep it professional so that you can get on with the actual business at hand—finding a company to buy. Skip the stupid or cute names, no ex-lovers, current lovers, or dogs; you are naming a company, not a boat. Of course, some names seem better than others. One of the best examples we have seen is Succession Leadership Capital, which was formed by Randy Shayler, whose sourcing strategy emphasized companies whose owners were nearing retirement. A word of caution: It is easy to invest a lot of time in finding just the right name, but it actually doesn’t matter much. Once you have a name, be sure that it isn’t already registered as a company and that you can get a domain name for your website and email address.
If you are searching alone and are funding the search expenses by yourself, then the name, obtaining an EIN, and setting up the LLC is all you need to do on the legal front. We estimate about $1,000 in legal expenses, less if you do some of it yourself or find others to do it at reduced costs.
If you are planning a partnered search with a national scope, you will also need an operating agreement to govern the relationship between you and your partner. If you plan to get outside investors to fund your search efforts, you will also need a shareholders’ agreement that specifies the rights and responsibilities of the limited partners who are your investors and the general partners who are the two searchers. These agreements can be simple or complex, depending on the nature of the relationship between the general partners and the number of limited partners. Typically, there is a simple agreement among the general partners but a more detailed agreement between the general partners and limited partners. Those agreements can easily consume $25,000 in legal fees.
Office expenses
Solo searchers usually begin by working out of their homes, especially if there are no small children at home. If that’s not possible, you’ll need to get a humble office in which to work. It can be as simple and low cost as you can endure because no outsiders will visit your office. You don’t need a conference room, kitchen, lobby, reception area, and the like. Reliable telephone and internet along with basic utilities are the requirements. A window is a luxury. The office is just for you, and you’ll be paying for it: Be frugal. Imagine a 12-by-12-foot space, an old file cabinet, an older metal desk with a telephone and computer on top, a worn-out chair, and a pull-chain light. Even if your regional search is centered on an expensive city location, your office doesn’t have to be; if you are searching out of New York City, think the far reaches of Brooklyn, not Times Square. In Boston, think Allston, not Copley Square. We are pricing your individual office expense at $6,000 per year.
If you have a partnered search or plan to use interns in a direct search, then you need more space and it has to work for others in addition to yourself. The space will need to be better equipped and more convenient. You might want a small conference room, multiple offices, probably a few windows too. Our guess is that you’ll need 600 square feet of office space and that it will cost four times the simple, dark 12-by-12 space a single searcher would use, say, $24,000 per year.
Communication
You will need a telephone system with conference calling, forwarding, and voicemail capabilities, and if you are doing a partnered search or plan on having coworkers help you with sourcing, you’ll need extensions as well. Don’t just rely on your home phone or everyone’s mobile devices—you and your employees will be on the phone a lot throughout your search, and you need something that is reliable and static-free and has a decent speaker-phone and comfortable headset.
You will also need a website that brokers, potential sellers, and investors can visit to get a sense of your professionalism. You can build a site yourself using a variety of different software aids, or you can hire somebody to do it for you. You should include information about yourself, your search approach, and your investors or advisors; visit websites of other searchers to get a feel for typical standards. As with choosing the company name, there are no rewards from investing heavily in a website—just keep it professional and simple. You’ll also need to have an email address that matches your website; again, keep the email separate from your personal account to signal that you are engaged in a serious, full-time, professional search.
Finally, you’ll need a database system that allows you to keep track of your phone calls, emails, and leads and the companies you have pursued. Simple web-based systems are available for just a few dollars per month through companies like Zoho.com; these are sufficient for a single searcher using brokers to source deals. A bigger search process—such as partnered search or direct sourcing—may require a more powerful system such as Salesforce.com, which will be more expensive, perhaps costing more than $100 a month.
Company data
There are many associations and networks of business brokers that allow you to easily contact their members to source deals for free. In addition, new online systems that connect searchers and brokers, such as Axialmarket. com or Dealnexus.com, streamline this process even further. Brokers can use the system to look for likely buyers and can send searchers potential deals according to the characteristics the searchers identify. These systems cost about $4,000–$5,000 per year for searchers.
If you will be reaching out to companies directly, you will need a substantial amount of information about thousands of small companies because you won’t know, before you contact them, which owners might be interested in selling. While some searchers try to economize on data by guessing at owners’ email addresses, this is not a good use of your very scarce time. A better approach is to buy data; in addition to saving time, this enables a more personalized search approach with higher response rates.
Travel
With a regional search, travel to a potential acquisition is likely to require just a few hours in your car and, perhaps, some inexpensive motel rooms. It isn’t going to cost much, perhaps $5,000 per year.
In a national search, travel expenses are much larger. As you begin your national search, you will probably visit a potential acquisition once or twice a month. When you find one that interests you, it will usually take several trips to the company as the sale process progresses. These trips are likely to be multiday adventures with plane travel, taxis, dinners, hotels, and the like. While the cost will surely vary by destination and duration, you can easily spend $30,000 on travel annually for each searcher.
Forgone salary and benefits
Searching for a company to acquire will require a full-time commitment to be successful. We understand why searching part time seems appealing, however. It would be so much easier if searching for a business to buy could be a hobby—something you could do on nights and weekends or in your spare time. That way, you could have a steady income from your existing job while you began your search to see if a good opportunity appeared.
The problem is that this approach doesn’t work. There’s simply too much to do. Take the first part of the process—sourcing prospects. If you choose a brokered search, you’ll be contacting (and keeping in touch with) upward of a hundred brokers and looking at the thousands of teasers they send your way. If you source directly, the number of companies you’ll need to contact is significantly higher than that. Even working full time, you’ll feel rushed and overwhelmed—and will find a viable candidate perhaps once a week. Devoting only nights and weekends to this task will mean it will be a long time before you have found even a handful of businesses to research more closely. We know someone who has been doing this part time for years, and the effort has never come to anything.
The problem is not just the volume of work, but when you need to do it. Let’s say you do succeed in finding a business to look into more deeply. As your research progresses and you move closer to a purchase, you need to be available and responsive. The seller needs to be able to meet with you at a convenient time to answer your questions, and you need to keep the process moving forward so he or she doesn’t become frustrated and decide not to sell. You can’t have a conversation with a commercial bank to talk about a small business loan at 7 p.m. And you can’t wait until Saturday to call back a potential investor.
Leaving a full-time job is a big step, but it ensures that you have all the opportunities you can to find the right business and close on the deal on favorable terms. Still, it means that the largest part of your search cost is the salary and benefits you forgo. You know what you make for salary, so this is easy to calculate. Health insurance plus other benefits like pension contributions also need to be included. If you could otherwise earn a salary of $150,000, and assuming a 30% benefit rate, the opportunity cost of the search is about $200,000 per searcher per year. A partnered search would add $400,000 to the costs per year.
Obviously, the sooner you buy a company, the lower these and other costs are. But of course, you don’t know how quickly that will happen. We recommend you conservatively budget for a two-year search. You are likely to close sooner, but budgeting for two years will help you focus on buying a quality company rather than racing against the clock.
Broken-deal costs
Once you find the company you want to buy, you will start incurring costs directly related to the deal—such as fees to lawyers, accountants, and other outside professionals. These costs can total well over $100,000. When you complete the acquisition, they get rolled into the total amount you finance to buy the business. But when a deal falls apart late in the process, you are responsible for the fees incurred by these professionals.
Some estimates suggest that about half the deals for smaller firms fall apart for one reason or another. If you follow the recommendations we make later in the book for staging your use of outside professionals, you can minimize broken-deal costs, but it is unlikely that you’ll avoid all of them. To that end, we recommend budgeting a reserve of $50,000.
An insufficient reserve for broken-deal costs will lead you to become overly conservative so that you only retain professionals when you are completely sure the deal will be completed. At best, requiring that kind of certainty before you hire an attorney and accountant will lengthen the search process; at worst, you’ll avoid potentially great deals because you have some resolvable doubts. Perhaps the biggest cost of not having a reserve for broken deals is that you’ll be tempted to complete an acquisition even though you’ve learned some disturbing information about the company late in the process. You need to have the flexibility to abandon a bad deal throughout the process; no acquisition is far better than a bad one.
Next Steps
Whether you are considering the high end or the low end of these numbers, the totals suggest that the cost of searching for a small business is significant. You are probably wondering how searchers pay for their search. That’s the subject of the next chapter.