How to buy a business
Buying a business is undoubtedly one of the most daunting investment prospects you can possibly undertake - possibly even riskier than getting married!
The safest and most cost-effective way to approach the actual purchase of a business is to look at it as a long process of elimination, involving a number of steps, like concentric rings, each reaching deeper towards the core. Each step should be taken only after successful completion of the previous step.
The important thing is to allow sufficient time to complete each stage of the investigative process comprehensively.
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In order to have a reasonable chance of success, and before you even begin looking, you need to know the answers to a number of important questions:
- Why do I want to buy a business?
- What do I expect from the business?
- What can I contribute to the business?
- How much capital can I raise?
- What are my (truthfully, now!) business strengths, weaknesses and experience?
- Where do I want the business ideally to be located
- As a result of the above answers, what kind of business am I best suited to run?
We can't help you with the answers to the above questions, but once you are satisfied with the answers you have come up with, the next most important question is: where to begin looking for a business? There are a number of possibilities:
- Private sale. You could look in the Businesses for sale section of various newspapers and magazines, or be referred by someone "in the know" for businesses for private sale, and, if you are very lucky, you could save yourself agents' fees by buying privately. However, the major drawback here is that you are subject to "Caveat Emptor" - "Let the buyer beware!", if things turn out to be not as you hoped they might be. Certainly you have an Accountant and a Solicitor to help you, but so does the Vendor!
- Through a Real Estate Agent advertising a business for sale. This does not involve you in any direct costs, as the Agents' Fees are paid by the Vendor. These people are generally licensed, and subject to Department of Consumer Affairs supervision and a strict code of conduct, and carry Professional Indemnity Insurance. But they generally have little specialist knowledge of business, and in any case, they are actually committed to their client, the Vendor, who is the party paying their costs, and are duty bound to obtain the best possible deal for them.
- Through a Business Broker advertising a business for sale. At least here, you are dealing with a specialist, and would expect someone with a deeper understanding of the business he is offering on behalf of his client. Otherwise, the same comments apply as for a Real Estate Agent.
- Through an Accountant. Here you would have a professional who understands business, carries Professional Insurance, and is not a salesman. But he may not be subject to the same Department of Consumer Affairs Licensing requirements, is generally acting on behalf of his Client, and has access only to a limited number of businesses belonging to his Clients.
- Through a Business Broker acting as your Buying Agent. This involves you paying the Agents' Fees directly, rather than indirectly, as when the Broker is acting on behalf of the Vendor. The advantage for you is that now, the Broker is acting FOR you, rather than against you. His legal duty of care, as well as his self interest, are working on your behalf. By law, he may only act for the one party in any transaction. And, as your Agent, if he does not have exactly what you are looking for, he can go and seek it out on your behalf.
Some of these pointers might sound obvious, but there have been many triumphs of optimism over basic common sense, resulting in financial ruin for the people concerned.
- Choose a business where you have an advantage by way of qualifications, or experience. Business these days is generally highly competitive, and you need to be at least as good as your opposition, to stay in business.
- Choose an occupation that you enjoy. Small business often involves long hours, and requires great enthusiasm to motivate staff, and deal successfully with clients. This can become very tedious if you are not happy at it.
- Check the Vendor's reason for selling. There are many legitimate reasons for selling a perfectly good business, such as retirement, marriage or partnership difficulties, deceased estates, other business interests, or even just simple "burn-out". But sometimes, there can be a more sinister reason, such as impending problems with a lease, technology changes, new competition, demographic or infrastructure changes, obsolescence, impending major capital outlays..., the list is infinite. This is where it could be advantageous to have someone experienced working on your side. Every business has its problems; the trick is to know what they are, and have a strategy for dealing with them.
- Understand clearly the nature of the business, and how much capital is required to run it. As well as the cost of purchasing the business, you need to have sufficient capital to finance stock, Debtors and overheads. The working capital requirements are clearly different as between a retail business, a wholesaling business, a manufacturing business, and an importing business.
- Understand the cash flow characteristics of the business, and any seasonality. Just because there is a profit shown at the end of the yearly accounts, does not necessarily mean that there will be cash available at critical times to meet necessary costs, such as interest, taxes, and your living expenses.
- Be pessimistic. The business will probably experience a bit of a downturn until you "get up to speed" with it. The current boom might end the day you take over. This is not to say you should not go ahead and purchase the business, just that you should have contingency plans and leave some reserves, just in case.
- Ensure that you have the means to purchase, and operate the business, and fund any planned growth or development of the business.
- Try to get to know the Vendor, to gauge whether you can successfully "fit into their shoes", and run the business at least as well as they did.
- Try to meet the key employees, to make sure they intend to stay, and that there will be no major personality clashes. In many cases, Vendors won't want you to talk to the staff until negotiations are at a fairly advanced stage, and in such a case, you can insert appropriate provisions in the purchase agreement.
- Don't plan any major changes to the business in the changeover period, unless you are very sure of what you are doing. A smooth transition with minimum customer impact is the usual road to success.
- Be prepared to follow the previous owner's tried and proven methods, once again unless you are very sure of what you are doing. This often constitutes a significant part of the purchase price, and it would seem a shame to throw it away.
This means that, in order to determine the true return to an owner of a business, we need to "add-back" certain allowable deductions in respect of financing costs and proprietorship issues not directly related to the operation of the business, to determine EBIT (Earnings Before Interest and Tax). These "add-backs" could include:
- Interest charges and financing costs. These are a matter arising out of the financial circumstances of the owner of the business. You would need to factor in your own projected financing costs to determine the viability of your ownership of the business.
- Accelerated depreciation. Often the effective working life of equipment far exceeds the time over which it is allowable to depreciate the equipment (for example, a machine with an effective life of 10 years may be depreciated over 3 years). In this case, the proportion of accelerated depreciation could be treated as an "add-back". Unless there is a real need to replace the equipment within the foreseeable future, depreciation is only a book entry. The tax deduction allows you to repay some principal from your loan out of pre-tax income, so the bigger this deduction, the better.
- Expenditure of a private nature, such as the personal use of luxury cars, generous superannuation contributions, and other "perks" not directly related to the operation of the business.
- Salaries paid for the purpose of income splitting, to nominal or non-working Directors.
- Owner's income, in the case of owner-operated businesses. This is a controversial issue; many writers claim that owners' income should not be considered as an "add-back". We say that the amount of income an owner draws is a personal matter, depending on the circumstances of the owner. However, the fact that the owner's income is included in the "return to Owner" figure, should be reflected in a lower multiple to be applied in valuing the business.
- Stock write-backs. Many businesses use a deliberate undervaluing of their stock, reducing declared profit, and effectively deferring tax liability. You would need to check the physical stock take, however, before accepting this as an "add-back", as it could just as easily be used in the opposite way.
- Capital expenditure. In many cases, small businesses "expense" capital items, to write them off in the year of purchase, rather than depreciating the item over a number of years.
- Non-recurring expenditure, such as research and development costs, tooling, personal travel, and other creative ways of deducting from tax expenditure more for the benefit of the proprietor than the business.
There are many books available on how to value a business. Most of them have masses of theoretical information, with formulae and graphs and reams of calculations. Most have not got the point that a Barber Shop has no value to a Plumber, but may have a lot of value to another barber, who wants to increase his own business.
Basically, the purchase price should be such that the business can allow you to repay your investment in a reasonable time, having regard to the risks and effort involved. This might vary from 4-5 years in the case of, say, a Post Office Agency, down to less than 1 year, in the case of a pizza parlour or video hire shop. Manufacturing, service and wholesale businesses would generally fall somewhere in between, once again depending on the security, and level of assets involved.
In general, it would seem wiser to pay a little more for a sound business, than less for a "bargain" that could send you broke. The total cost of acquiring a business should be taken into account, and can be divided into a number of components, covering both tangible and intangible assets:
- Freehold property (if applicable). This can be valued by comparison with other similar property in the area. Take care that the business is paying rent, or allowing sufficient return to cover imputed rent.
- Plant and equipment. The book (depreciated) value may vary from the auction value, which may vary again from its "going concern";, or current market value. This may occur if it has been subjected to accelerated depreciation, or expensed rather than capitalized. There is also the factor of installation, commissioning and tooling costs. Basically, plant and equipment in a profitable business is worth what you are confident it can earn for you, otherwise it is only worth resale value.
- Stock. You should ensure that you only purchase good and saleable stock, at the Vendor's landed cost. The amount of stockholding should be at a level commensurate with the demonstrated stock-turn of the business, and historical logistics considerations. Excess or obsolescent stock should only be purchased if the terms are favourable.
- Intellectual property. This is the value of licenses, leases, agreements, patents, processes, tooling and know-how, which are necessary to the successful operation of the business. Generally they would have cost time and money to accumulate, and would certainly cost time and money to duplicate. It is generally lumped in with "goodwill".
- Goodwill. This is the difference between the value of the business on a "return-on-investment" basis, and the net value of the tangible and intellectual property assets. A business acquires an element of goodwill if it can demonstrate to your satisfaction a reasonable expectation of future super profits in excess of the value of the other assets, so that the return on the total investment in the business is financially viable.
- Working capital. The amount of money needed to operate and grow the business with reasonable confidence. In each case, it would be necessary to verify these claims, as part of the "due diligence" process, which constitutes the last phase of the purchase process.
- Due diligence, whereby the Vendor allows you and/or your accountant access to all the books and records of the business, to verify all the vendors claims about the profitability and future viability of the business.
- A trial period, whereby you can attend the premised for an agreed time to verify the takings of the business (applicable to cash businesses).
- Finance clause. The Purchase can be subject to your being able to obtain Bank Finance sufficient to purchase the business.
- Special conditions. These can include the granting or assignment of licenses, permits, contracts, agencies, patents, re-zonings, or any other thing or condition necessary for your successful continuation of the business.
- Lease conditions. The contract can be subject to premises leases being granted or assigned on conditions suitable to you.
- Tuition. Generally, the contract will specify a tuition period, being the time the vendor will remain after settlement date, to ensure a smooth handover. The contract can also specify an extended period during which the previous owner will remain available for further assistance.
- Staff retention. In many cases, the contract will be subject to nominated key staff remaining with the new owner for an agreed period.
- Non-competition. The contract will specify a period, usually three years, during which the vendor may not operate in any way in competition with the business being sold.
Each of these conditions would specify a time frame. At the expiration of this time frame, you then have the option to reject the business, in which case your deposit is refunded, or confirm the contract by payment of the balance of deposit (10%). Settlement would then usually take place within 30 days.
The business can be seen as a car. It will only move if you drive it, and it will only avoid the inevitable obstacles that will come your way if you operate the steering wheel and controls accordingly.
I remember an ex Bank Manager who purchased a Fruit Shop. After the first month, he complained that the previous owner had lied about the figures. Even though he had conducted due diligence and a trial to verify the figures, the previous owner "must have faked them", because the business was now doing nowhere near the figures quoted.
I approached the previous owner about this. He told me he had indeed lied about the figures - the real figures were actually 10% better than he had let on.
The problem, he explained to me, was "you must-a sell-a da fruit". Where the new owner was sitting in his office watching and fretting about the figures, the previous owner had been out the front of his shop urging customers to "buy-a the lovely tomatoes".