How to buy a failing business: opportunity or trap?
Short answer
Buying a failing business can work if you know exactly why it's failing and can fix that specific cause, you pay close to asset value rather than for earnings it no longer has, and you have enough cash to fund losses during the turnaround. Buy assets rather than the entity to leave liabilities behind. Expect limited bank financing, because lenders lend against cash flow the business doesn't have.
Distressed businesses attract buyers who think they can do better than the current owner. Sometimes they can. The trick is being honest about whether the problem is the owner or the business.
Diagnose first
Often fixable
Owner burnout or illness; neglected marketing; poor pricing; bad bookkeeping; a key staff departure that can be replaced; deferred maintenance you can afford.
Often structural
Shrinking demand for the product; a lost anchor customer; a new dominant competitor; an unaffordable lease; regulatory change; a reputation problem online.
What a distressed business's numbers can and can't tell you
In a declining business, historical earnings overstate what you'll get, and asset values often matter more. Look at monthly results for the last 24 months, not annual totals, to see the slope of the decline and whether it's slowing. Rebuild a trailing twelve months. Check receivables (customers who stop paying a struggling business), payables (suppliers it stopped paying), inventory (stock that won't sell) and deferred maintenance. Then estimate what the business earns if your fix works and if it doesn't. A lender will base any loan on the historical numbers, which is why many turnaround purchases are made with cash or seller financing.
Protect yourself
- Buy assets, not stock, and run lien and tax searches. See UCC lien searches.
- Check for unpaid sales and payroll taxes that could follow the business in your state; ask about tax clearance.
- Value equipment realistically. See asset-based valuation.
- Talk to the landlord early: a struggling tenant may be behind on rent.
- Talk to key suppliers: they may be on cash-in-advance terms.
- Budget turnaround cash for losses until the fix works, then add a margin.
Worked example: pricing near asset value, with a turnaround reserve
Illustrative example, not a valuation
A restaurant equipment supplier's revenue fell from $2.4 million to $1.6 million in two years, and it lost $90,000 last year. The seller wants $500,000. An equipment appraiser values the inventory at $180,000 (at what it would bring in an orderly sale, not its book cost) and the trucks and warehouse equipment at $70,000. That's $250,000 of assets. With losses, there are no earnings to pay for. A buyer who thinks the cause is fixable (say, the owner stopped calling on customers after an illness) might offer close to the asset value, perhaps with a small seller note tied to the assets, and keep cash aside: if it takes 12 months to stop the losses, and losses average $8,000 a month in the meantime, the reserve needs at least $96,000, plus a margin. The total cash at risk is the price plus the reserve, which is the number to compare with what success would be worth.
Questions that separate fixable from structural
- Did revenue fall because customers left, or because the business stopped finding new ones?
- Did competitors grow over the same period, or did the whole market shrink?
- Did margins fall because costs rose, or because prices were cut to keep customers?
- What changed in the business when the decline started: an owner illness, a key departure, a new location?
- Would the best customers come back, and what would it take?
If the answers point to the owner, the fix may be yours. If they point to the market, a new owner usually inherits the same decline.
Financing reality
Most lenders, including SBA lenders, finance acquisitions based on historical cash flow. Under SOP 50 10 8.1, projections can be reviewed but can't be used to meet the coverage requirement. Expect to fund a distressed purchase mostly with your own money, seller financing or investors. That's another reason to pay close to asset value.
A 100-day turnaround plan, in outline
- Days 1 to 10: stop the bleeding. Cash forecast by week, pay critical suppliers and staff, freeze non-essential spending, talk to the landlord and lender.
- Days 10 to 30: find the cause. Talk to former customers, staff and suppliers; compare pricing with competitors; check reviews and service quality.
- Days 30 to 60: fix one thing well. The cause you identified: a broken sales process, bad pricing, poor service, a weak manager.
- Days 60 to 100: measure. Weekly revenue, margin, customer wins and losses against the plan; adjust or cut losses.
If after the first month you can't name the cause in one sentence, your reserve is your most important asset. Protect it.
Liabilities that can follow a distressed business
Struggling owners often stop paying what they can: payroll taxes, sales taxes, suppliers, rent. Some of those can follow the business or its assets. Run a UCC lien search for secured creditors, check federal and state tax liens, and search court records (including bankruptcy filings on PACER) for the business and its owners. Unpaid payroll trust fund taxes are a serious matter; the IRS can pursue responsible people personally under 26 U.S.C. 6672. Some states still have bulk sale or successor liability rules for sales taxes when a business sells most of its assets; ask your attorney about your state, and require tax clearance or a holdback where available. An asset purchase helps, but it isn't a complete shield.
Questions to ask the seller of a struggling business
- When did revenue start falling, and what do you think caused it?
- Which customers left, and would they talk to me?
- Are rent, payroll taxes, sales taxes and suppliers current?
- What liens, loans or judgments exist against the business or its assets?
- What would you do differently if you had the energy or capital?
- Have you had other offers, and why didn't they close?
Who you are negotiating with
A distressed seller is often not the only party with a say. Lenders with liens on the assets, landlords owed back rent, and the IRS or state if payroll or sales taxes are unpaid may all need to agree, or be paid, before the assets can pass to you free and clear. Ask early for a list of every creditor and what each is owed, run lien and tax searches, and talk to your attorney about whether the sale needs creditor consent. In some cases the cleanest route is a purchase from a lender after foreclosure on its collateral, or through a court process, each of which has its own rules and timelines. A deal that ignores the creditors can fall apart at closing, or leave you exposed after it.
Set a firm diligence budget before you start, and a date by which you will decide. Distressed deals invite endless investigation because every answer raises another question, and the business may be losing money every week you wait. If the key questions can't be answered by your date, that is itself an answer.
Frequently asked questions
Can I get an SBA loan to buy a failing business?
It's difficult. SBA change-of-ownership loans require historical debt service coverage of at least 1.25 for an initial acquisition and can't rely on projections. A business without earnings usually can't meet that.
How do I price a distressed business?
Usually near the value of its useful assets, plus perhaps a little for location or customer list. Paying for past earnings that no longer exist is the main trap.
Should I buy the stock of a struggling company?
Rarely. Struggling companies often have unpaid taxes, vendor disputes and other liabilities. An asset purchase leaves most of them with the seller's entity.
What makes a turnaround succeed?
A fixable cause (bad management, a neglected marketing channel, poor pricing) rather than a structural one (declining demand, a lost key contract, a bad location), plus enough cash to survive the fix.
Should I buy a failing business out of bankruptcy?
Sometimes buyers can acquire assets through a court-supervised sale, which can provide a clean transfer free of most liens and claims. The process has its own rules, timelines and competition from other bidders, and the court approves the sale. Get a bankruptcy attorney if the seller is in, or near, a bankruptcy filing.
Who buys failing businesses?
Often competitors who can absorb the customers, operators in the same industry who see a specific fixable problem, and buyers looking for assets at a discount. First-time buyers can succeed too, but the risk is higher, financing is harder, and a cash reserve for the turnaround is essential.
Sources
- SBA SOP 50 10 8.1, Appendix 15 (DSC and projections)
- Cornell LII: UCC Article 9 (secured transactions and liens)
- Cornell LII: Bulk sale
- Cornell LII: 26 U.S.C. 6672 (trust fund recovery penalty)
- PACER (federal court records, including bankruptcy)
Related guides
General information, not legal, tax, financial or investment advice. Rules and lender practices change; check the linked sources and talk to your attorney, CPA and lender about your deal. Examples with named numbers are illustrations, not real businesses. OKtoBuy's Deal Check does not value businesses or give price opinions.