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Research and Due Diligence
This answer is provided by Hanwei Cheng, senior Counsel of Ed Lee Law Group PC in Los Angeles, California. This answer is based on a telephone interview with Mr. Cheng. Click here to listen to the full telephone interview and get advice on other common questions that entrepreneurs have when buying and selling businesses.
There are so many benefits to doing your research before you buy or sell a business. I will start this answer off with an example that many make you a bit hungry. Let’s say you own an ice cream shop: we will call it “Sprinkles.” You have this small company and you are ready to sell it. The first thing you want to do is determine how much you would like to sell it for. So, you go out there and see what other ice cream businesses there are in your area. You also see what ice cream shops sold for in the past and what kind of valuations they have. Let’s be honest, nowadays the Internet provides so much information for both buyers and sellers. The more information you bring to the negotiation table, the better. But, there is a plethora of information out there; it’s overwhelming.
The first thing you want to do is determine how much you would like to sell it for. So, you go out there and see what other ice cream businesses there are in your area.
If you are buying a business, you can easily do some research and see what red flags there might be, whether or not the seller is running their business properly, whether it is efficient or not, what kind of records they keep, and what kind of employees they have, and so on. More than ever, buyers are able to enter negotiations with an abundance of information. It is like buying a car; you are not going to walk into a car dealership and say, "hey I like that car because it is yellow, how much is it?” Nowadays, everybody uses the internet - you go to cars.com or another website and you research the car, you research every type of car, you look at reviews, you see everything about the car before you step foot in that dealership. It’s the same with buying a business. As a buyer looking to buy an ice cream shop, you are going to Google “Sprinkles” Ice cream shop and see reviews, look at their health code rating, find out how many employees they have, and get an idea beforehand if this is a business you want any part of.
Research is important for more than just buying or selling a business though.
Research is important for more than just buying or selling a business though. I had a client once who was part of an LLC with three or four members. This actually went to litigation because there was a member who wanted to be bought out of the business but they could not arrive at a certain price to buy them out on. So, they went through litigation and we went into a settlement mediation conference to discuss what the price would be. At the mediation conference, the litigation attorneys were trying to agree on a value and it became an intense discussion on the correct way to value this member’s buy out price. With a four member LLC, does the member just get 25% of the company? How do you value that company? There are so many methods that you can use to value a company based on just the revenue: you can value to goodwill at a certain amount, you can valuate trademark and whatever intellectual property they have in order to increase valuation. This is where due diligence and research comes into play. The more you research and answers these questions, the better prepared you will be, and the better price you can get! If you are curious, we went with a simple revenue valuation for last couple of years, although the last couple of years they were not doing very well, so we eventually decided on 25% of the value of the business and it came out to be a reasonable number for all parties.
A business attorney is someone that specializes in this line of work, would be able to tell you the ins and outs
The last point I want to make is that it is really important to obtain an attorney if you are considering buying or selling a business. I mean, without an attorney, how you are going to know the terms and conditions, especially if you are a startup, you've never sold a business, or you have never bought a business before? The process is a lot more daunting than most people ever realize. A business attorney is someone that specializes in this line of work, would be able to tell you the ins and outs and, because there are so many attorneys nowadays, you can usually get a free 30 minute consultation, which is something my firm provides. We will give you a little consultation if that is something you want, then obviously we explore it a little more to see how we can help you. You can avoid so many issues if you seek out an attorney to help you with due diligence, help you research the business, negotiate the deal, draft the contract or review a contract, and so much more. The earlier you retain an attorney, the better off you will be because there is a very good chance that the other side will be retaining an attorney as well.
Hanwei Cheng, Esq.
Adli Law Group P.C.
444 South Flower Street Suite 1750 Los Angeles, CA 90071