Purchasing a business can be one of the riskiest undertakings imaginable. The wrong decision can cost you your money and time trying to rescue it, not to mention your home, even your friends and marriage. A serious prospective purchaser should ask themselves the following questions:
Why should I buy an existing business?
The best entrepreneurs will say that you should buy a good business, at the right price, and then make it great by focusing on building the business as opposed to establishing a start-up where everything begins at point zero.
Buying an established business can be a big commitment of time, money and energy. A big advantage of buying an existing business, versus starting a new business, is that an existing business typically has an existing regular cash flow, infrastructure, established customer and vendor relationships, trained employees, and market-proven products and services, a reputation to capitalize on which may reduce the risk of establishing or building a business from scratch. The business may also have a proven financial track record which could make getting a loan easier.
Buying an already successful business lets you take control of your destiny with very low risk and very high rewards. However, it is important that it is the right business—one that your skills, energy, ability, creativity, passion and ideas can take to the next level. The best business is one you will enjoy—one where the day-to-day effort you put in will be fun. Don’t be like most new purchasers, who are more focused on the cash flows of a particular business over the type of business as they are senior level executives who are attempting to buy a business to replace lost income.
It is also often possible to negotiate a transition period as a condition of sale, whereby the previous owner/ manager remains to teach you the ropes and to ensure a smooth hand-over. Finance institutions often look more favorably on supporting the purchase of an existing business, with a proven track record than financing a start-up with no proven cash flows.
Where should I look to buy a business?
You can find businesses in the papers, in for sale magazines, on the internet, or if you are already in business, you can talk to competitors, suppliers, customers or your professional advisors such as your accountants and lawyers. But the chance that the business you are looking for, in your price range, experience range and area will be for sale at the time you happen to be looking, is slim.
Some reputable business brokers offer a ‘Buyer’s Advocacy Service’, where you can retain the business consultant to search for businesses that fit your criteria. This means that you pay commission instead of the vendor, but the business consultant is now legally obliged to work FOR you rather than AGAINST you, and most importantly, you have someone with appropriate insurance you can sue if it all goes wrong. A business broker is an ideal source to tap into to help you find what you are looking for given their wealth of experience in the industry and their extensive database of past and current vendors.
What are the key areas of financial due diligence for a purchaser?
You should study the financial statements – balance sheet, profit and loss and tax returns as this is critical in your assessment of whether or not to buy the business. We recommend obtaining the financial statements of the last 3 financial years (if they are available) for analysis – you should consider reasonableness tests, checking whether items such as rent match up to the lease, what are the major costs of the business, analyse the net profit margin, whether there is seasonal performance, and whether the performance over time is improving/deteriorating and the reasons for the trend etc.
A prospective purchaser should also consider whether the seller’s claims are reasonable. Be wary of claims that cash has been taken out of the business. You should ensure that only add-backs that are counted are ones that can be traced through the books. If there is significant cash element, you should consider a trial period to satisfy yourself of this claim. Use a good solicitor who specializes in business conveyancing to prepare the contract, and a reputable Accountant to conduct Due Diligence prior to completion.
Where the businesses offers a face-to-face customer service, one built on trust, for example, accountants, hairdressers, and dentists, a change of ownership has to be handled very carefully to retain that trust, maintain the customer relationship, and preserve the value of the goodwill.
What’s the business really worth?
With a working knowledge of the financial statements in mind, it’s critical to value the business according to well-known valuation methods, which may include:
- Asset valuation (where the business is asset intensive. Usually valued at their current market value, not the replacement or liquidation value). Professional industry appraisers can be appointed to undertake this process. Consider whether there are any leasehold improvements that need to be also accounted for in the valuation – such as additions, modifications, and upgrades to the physical property and then add in the the seller’s discretionary cash flow, working capital and inventory.
- Capitalisation of Income: This method places no value on fixed assets, because you assume their only value is to produce income for the business. This method works well for non-asset-intensive businesses like service firms. A multiple is usually applied to an Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) figure as that earnings amount offers a fairly reliable estimate of the kind of cash a business generates to pay down debt, pay taxes and offer a return to investors.
- Rules of thumb: This tends to be used by many for its simplicity in determining an acceptable price.
- Discounted cash flow analysis which generally is a method used for medium to large businesses.
The methods described above are described in general terms and it is highly recommended that you speak with a business consultant as well as your accountant who can guide you through the valuation process – it is also important to bear in mind is that historical performance is no indication of future performance. At the end of the day, the purchase price is determined by market forces. The business may in fact be more valuable to one prospective purchaser than another prospective purchaser in which case they are prepared to pay a premium for it.
It is probably safer to pay more for a solid business with a good track record and prospects, than to pay a bargain price for a shaky business (unless you really know what you are doing and can see the value proposition in improving or turning the business around).
What are some general contractual conditions/criteria purchasers can consider when negotiating the purchase of a business?
The concept of ‘buyer beware’ applies at law – you should make sure to appoint a lawyer familiar in the area of corporate business law and all possible concerns you may have are addressed as conditions in the contract and alleviated before handing over your money. Some of the general matters that a business contract can cover include:
- parties to the contract;
- date of the contract;
- purchase price and settlement date;
- subject to finance provisions;
- subject to due diligence provisions;
- subject to landlord and franchisor consent provisions (if applicable);
- trial period provisions;
- restraint of trade provisions;
- transfer of intellectual property and material contracts;
- interest on late payments;
- insurance provisions;
- guarantee and indemnity provisions;
- GST, taxation and stamp duty consequences;
- termination dates of the contract;
- damages for breach of contract;
- termination conditions; and
- special conditions.
In business it is particularly important to get the right advice before entering into a contract of sale, or you could face significant and far-reaching consequences.
Legal advice will ensure your rights are protected and favorable terms are negotiated on your behalf – terms that better suit your business and allow you to trade profitably, which means the likelihood of costly disputes in the future is reduced.
What information do I need to provide in order to learn more about a particular business?
The information you will be required to provide in order to obtain detailed information on a business for sale will vary depending on the size of the business, the complexity and competitiveness of the industry, the disposition of the seller and other factors.
As a result, each and every prospective purchaser must provide the following items (at minimum) before receiving additional information on a business that interests them:
- Confidential Business Purchaser Profile: This document will help our business consultant evaluate business opportunities that best suit your background, experience, financial and lifestyle goals.
- Personal Financial Statements: In conjunction with the Purchaser Profile above, our business consultants will require this document to determine business opportunities that suit your personal financial circumstances. This information will also be necessary to structure purchase offers and obtain financing when buying a business.
- Confidentiality Agreement / Non-Disclosure Agreement (CA): These documents identify your responsibilities and obligations as a prospective purchaser concerning any confidential information disclosed about a business for sale by the vendor or its advisors.
- Credit Check Authorization or Recently Obtained Credit Profile: Sellers frequently require an up-to-date credit profile as a prequalification to disclosing confidential information to a prospective purchaser. Furthermore, if the vendor has not required it, it will be required as part of an offer to purchase that involves any sort of financing or lease agreement as the Lender will require it.
Should I sign a Confidentiality Agreement / Non Disclosure Agreement (CA) when buying a business?
There are some steps in the business for sale process that benefit both the seller and you, the purchaser. These steps protect the seller from ‘time-wasting’ purchasers, and the purchaser from acquiring lemons.
One of the most important questions when buying a business is ‘can I see your financial statements?’ Numbers provide vital information to help a prospective purchaser decide if they should buy a business. Even if a seller has placed the business on the market, he or she remains reluctant to share highly confidential and sensitive records to any prospective purchaser. If the seller thinks you are a credible prospective purchaser, they will usually require a CA be signed and returned to the business consultant before the vendor’s proprietary information will be provided to you. If a business consultant has provided you commercially sensitive or confidential information to you prior to have a CA it should raise alarm bells as to their professionalism and experience.
A CA is a legal agreement presented by the seller to the purchaser to protect the vendor’s business if a potential sales deal falls through. This agreement gives both parties room for an open and honest atmosphere that may lead to a successful sale of the business. Without a CA, anyone, particularly a competitor, may use the information such as pricing, strategies and projections, employees’ data, etc. to his or her benefit. The seller does not want private business information to fall into the hands of those who may cause damage to the company.
The prospective purchaser cannot discuss the business with anyone, except to the parties included in the CA, use gathered information, steal customers and employees of the business, nor use the information for commercial advantage. If the agreement is breached it can result in a law suit and damages being payable by the prospective purchaser for lost profit and harm incurred by the business. This allows the seller can control the flow of information and protect its confidentiality.
A prospective purchaser is encouraged to sign a CA so that they can study the business, review its financial performance, assess the purchase opportunity and what the future holds for it. You can also determine if the seller’s asking price for the business is reasonable. The prospective purchaser who refuses to sign the CA is considered a difficult or non-serious purchaser and time and effort should be avoided in discussions with them about the opportunity. If a prospective purchaser is serious about buying business they should be willing and ready to sign and return a CA.