Important Considerations when Buying a Bay Area Business

Purchasing a small business can be the fulfillment of an entrepreneurial dream. In Silicon Valley, the tech industry has given rise to numerous service and support businesses that have seen tremendous growth in recent years. Buying into one of those businesses can be a great investment, but before you put your hard-earned dollars at risk in a new venture, it is important to perform your due diligence.

There are several key areas to consider before buying into a Silicon Valley business, here are 6 of them:

Business Valuation

When looking at a new business purchase, it is easy to let your emotions cloud your judgment, especially if you find a business that is in a growth industry you are passionate about. However, it is important not to pay more than you should, otherwise, you may start out in a hole that will be difficult to climb out of.

There are numerous ways a business valuation is performed. In most cases, it comes down to three essential factors:

• Asset Value: The overall value of the company’s assets and liabilities, such as real estate, vehicles, equipment, etc.
• Income: The annual net income for the most recent years the company has been in business; this figure should be verified by a CPA.
• Market: The recent sale price of comparable businesses in the Bay Area.

Typically, a business appraiser will weigh these and other factors, giving more weight to one factor over the other depending on the type of business and industry. For example, if the business deals mainly with commercial real estate in Silicon Valley, then asset value will be the primary valuation factor. However, if you are purchasing a professional practice (such as a dental office or accounting firm), there may be enough similar practices that have sold recently to use a market-based valuation method. The annual net income of the target business will always be a very important factor since that is a pretty reliable indicator of the value flowing on an annual basis from that business and some multiple of that annual number (depending on the specific type of business) will often be applied as at least one measure of the overall value of the business.

Fixed and Variable Expenses

The overall expenses of a business should be closely examined to determine your break-even point, and to identify any potential cost increases or opportunities to save money. For example, if the company has a long-term lease on commercial office in San Jose that is going to expire next year, it is important to know what you can expect to pay when the lease renews, based on the current rate for comparable commercial leases in the area.

On the other hand, there may be areas of the business where you can reduce costs; such as phone and Internet bills, insurance rates, copier leases, etc. With continual technological improvements, it is always a good idea to investigate areas in which you can optimize operational efficiency.

Employees

Employees are the backbone of your business; if you treat them well and manage them properly, you are in a far greater position to succeed. Before closing on a sale, it is important to fully understand your obligations to the employees you will inherit. Ask to see all employee records, HR documents, employee manuals, non- disclosure/confidentiality agreements, and any related documentation and have them thoroughly reviewed by your business attorney.

Tax and Legal Compliance Issues

There are several important issues to consider in the area of taxes and legal compliance. Examples include employee payroll tax compliance, state and local sales taxes, licenses, permits, existing contracts with vendors, insurance requirements, and many others. Be sure the seller is currently in compliance with all applicable federal, state and local laws and regulations, and they are doing everything possible to minimize the potential for future litigation.

Competition/Growth Potential

The current valuation, sales, and profitability of the business you are considering are definitely important, but equally important is the potential of the business to maintain and build market share in the future. A close examination of the sales figures should show if the company is on an upward or downward growth trajectory. In addition, you will want to take a close look at the level of competition and the industry as a whole. What are the prospects for future growth in the market? Has the business peaked, or is there a realistic opportunity to grow in the coming years? No business or industry remains static; before investing, it is critical that you fully understand the current state of the industry and the local market you are entering.

Along these same lines, another important issue is the potential for the seller to negatively impact sales by competing directly in the same market. If that is the case, then a non-compete agreement should be negotiated. Non-compete agreements are closely scrutinized under California law, however, so make sure you have the agreement drafted, or at the very least thoroughly reviewed, by your attorney.

Business Entity Structure

Entity structure is one of the most critical issues, because each business entity has its own set of legal and tax obligations. Consider whether or not the current legal entity the business operates under is appropriate for where you want to take it both in the short-term and long-term. For example, if you are purchasing an S Corp but you want to attract investors from Silicon Valley to raise additional capital, it may be necessary to convert the entity over to a C Corp so you will have greater flexibility to issue stock. Speak with your business attorney about the advantages and disadvantages of each entity, so you can decide which structure is best for your new business.

Jeffrey Miller is a Palo Alto business attorney and member of the Palo Alto Area Bar Association (PAABA). He provides skilled guidance on the purchase and sale of Bay Area businesses and all other corporate legal matters. To schedule a consultation, call attorney Jeff Miller today at (650) 321-0410 or email him at jeff@jeffmillerlaw.com.