How to Buy a Small Business Without Getting Taken

It's a great time to buy a business. So says Dan Steppe, a serial entrepreneur who now directs the University of Houston's Wolff Center for Entrepreneurship at the Bauer College of Business. For the last six or seven years, private equity firms have been buying mid-market companies (those valued between $10 million and $30 million) and flipping them, adding debt to these businesses each time they roll over. Now, many of those companies are having trouble repaying their debt and they're selling pieces of their businesses to stay afloat. Investors looking for larger deals should look to these so-called "distressed businesses" for bargains, Steppe says.

But it's also a great time for acquiring smaller companies because of the coming wave of retiring entrepreneurs. "I tell the kids at school...you will soon be talking to a 67-year-old guy who is a little bit tired of what he's doing, who's already talked to his son and his daughter, and the family options don't exist," he says. "The seller will enable the buyer to buy his company fairly inexpensively. You can buy a $10 million company for maybe $2 million and the seller will finance the other $8 million."

Like sellers, buyers need to know what they're doing. Experts advise:

1) Know the fair-market valuation for a healthy business of the type you're buying in that particular geographic location.

2) Do your due diligence: Scrutinize the seller's financials and tax returns. Understand clearly what it costs to run the business: Ask for supplier contracts and invoices for significant expenses, like advertising and rent, for instance.

3) When you're further along in the process, the seller should introduce you to her most important customers and recommend that they stay with you when you purchase the company.

4) Are there any hidden liabilities? Don't hesitate to ask if there's any pending litigation, regulation, and necessary capital improvements.