We come across many instances where people are looking to purchase a business. Sometimes they have a business, know what they are looking for, what they should be paying, and the areas they need to focus on for due diligence. Other times we have first time business buying queries. These are often focused around uncertainty on the price should be, the process of the transaction, and what exactly due diligence involves. This article is focused on the latter, just in terms of some guidance on some of the things to think about.
What is the process?
Usually an opportunity to purchase a business comes about for first time business purchasers through a business broker. The initial information will be scant with an overview of the business and some summarised financial information, and sometimes a value. Other times the approach may be informal through acquaintances, and the information initially provided will vary.
Initial considerations by the purchaser are often as follows:
- Is the industry suitable to me, and do I have the skills to run this business? Or alternatively, is this industry of interest to me and is there management in place to run this business passively?
- Are the hours suitable?
- Is the location suitable?
- Can I afford to finance the purchase (based on indicated price range)?
- Does the business look profitable (based on information provided)?
- What should I pay / is the price right?
If the purchaser is interested at this point, there is usually a formal arrangement for due diligence with a timeframe, and usually a price subject to due diligence (this may be in the form of a conditional sale and purchase contract or a heads of agreement). We highly recommend that you come to some level of agreement with the vendor on price prior to commencing due diligence as there is no point wasting time and money if there is no prospect of agreement on price.
We are approached prior to due diligence to provide an opinion on value or an opinion on whether to proceed to due diligence based on the numbers. It is here that we need to ask for more information on all the other points above plus some more. The numbers need to be considered in reference to other considerations, and vice versa.
What else should you consider?
What are the outcomes you hope for from this purchase? Are you looking to grow and scale this business, are you looking for consistent income, or are you looking to buy a job?
If you are looking for growth and scalability, is there capacity for it without further investment? For example, if you buy a motel there are only a certain number of rooms – the only variables are occupancy and rates, and even those have a maximum. In other businesses, further investment in capex and labour required for growth and scale objectives need to be considered and factored in.
What are your ownership timeframes, i.e. short term, long term?
Another important factor is whether you own or are licensing the product or service in the business you are purchasing, and factoring in vulnerabilities in this, i.e. licensing fee levels, risks in the license itself. Other examples of vulnerabilities are customer and / or supplier concentration. These risks are able to be mitigated, however identification of these risks is critical to assessment of value.
What are the trends in the industry or regulatory environment that may add risk or present opportunities? What competition exists in your target market, and what is it based on (price, reputation, quality)? What strengths and weaknesses exist in the business in reference to these? Essentially – undertake a SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis.
What are your other options (jobs, investments, other businesses) and assess the pros and cons as the risk profiles of these options are different. For example if you can get a job with less salary, is it worth the extra risk for the extra money and independence, and why? Part of the value or the price you are willing to pay will be based on life choices that cannot be valued.
What other vulnerabilities exist within the numbers?
Often in small businesses, the lease expense or rent is to a related party and may not reflect market therefore may need adjustment. Even if it is a third party lease, you should understand the lease terms.
You should check that the labour expense is reflective of the staff employed, i.e. this may be understated due to non PAYE remuneration, and also ask questions about staff turnover. There may be key employees in the business, i.e. managers, chefs, etc., who are key to ongoing success.
Often the financials provided may not factor in owner remuneration for the time the previous owner spent in the business. This question should be asked, and you should factor into the financials provided the level of effort you wish to spend in the business, i.e. run / work in the business full time, work part time, oversight only. If you are giving up a job to run a business full time; that cost should be accounted for when you are looking at the business’s financials. Or alternatively if a business has had owners working full time in it and this is not reflected in the numbers, you will need to factor in additional remuneration.
Often the financials provided may exclude interest costs as value or sale price often ignore the financing structure. If you are financing the business with debt, you should factor in interest costs, tax and any required capital expenditure to ensure the cash return is enough, that you are able to have the standard of living you are expecting, and also in calculating what your effective ‘payback’ period is. Payback period is when you have made received in cash profits the purchase price of the business.
How can we help you?
We can assist with financial due diligence and analyse the business and the financials in the context of all the considerations above including your objectives. There are standard due diligence checklists for financial due diligence, however an analysis of the business (such as a SWOT) and an understanding of what you hope to achieve will identify the areas that should be focussed on. We can also assist with cash flow forecasting and provide opinions on value. Any opinions on value will be based on an appropriate valuation methodology, however as mentioned above, there are certain drivers of a decision to purchase a business which are of different value to different people (independence, freedom, lifestyle). The value opinion provided should be viewed based on what you are willing to pay for these additional attributes, and on what you can afford based on the lifestyle you wish to achieve.