Just like boat ownership, it is often the case that the happiest two days of a business owners life are they day they buy the business, and the day they sell the business.
With some foresight and planning however, hopefully the days in between can be just as rewarding.
Here are 10 tips to consider when looking at buying that small business.
These tips assume that you already have a good understanding of the industry and high level risks of the business (e.g. location of competitors) and focuses more on the technical considerations of buying a small business.
Tip 1: Understand how to value a small business and don’t overpay
When buying a house, it is fairly easy to get to grips on what a property is worth. Valuing a business however, is much more of a black art.
For most small businesses, the two most important things to consider are (i) what are the normalised maintainable earnings of the business and (ii) what multiple is appropriate to apply to these earnings to establish value.
Some traps to be aware of include:
- Averaging the last 3 years of profits to work out maintainable earnings. This is often a flawed approach. The past is the past and what is really important is the level of profits the business will generate going forward.
- Including owners’ wages as part of the profit return. YOU SHOULD NOT BE PAYING FOR A JOB!!! When working out normalised maintainable earnings, you should first deduct a fair owners’ salary.
- Be cautious about paying additional value for stock. Small business are often sold on the basis of a price (usually based on profits multiplied by a multiple) plus inventory. On the face of it, this is a flawed approach. When determining the value of a business, you need to assume that it comes with a reasonable level of working capital (more on this below). I would not waste energy arguing with sellers on this point but rather you should always work backwards to ensure that the final purchase price (inclusive of stock value and any other adjustments) still implies an earnings multiple which falls within an acceptable range.
- Beware of optimistic earnings normalisations. Sellers will often present an earnings position which adds back expenses that they believe will not be incurred by the business once it is sold to you. In my experience, sellers are overly optimistic in this area and careful consideration should be given to these calculations. When looking at normalised earnings, it is also important to consider what is missing from the earnings (e.g. the cost of extra staff to fill the position of a relative of the seller who is working in the business but is not receiving a wage).
Tip 2: Understand “key person risk”
A lot of the goodwill associated with a small business is likely to be attributed to the owners’ personal goodwill. As such, it is important to understand whether or not the owners’ departure will impact on the financial performance of the target business once you acquire it.
Some question to ask yourself include:
- How dependent are the business’s revenues on the personal efforts of the current owner?
- Does the current owner have any special relationships with customers which may disappear when they sell the business?
- Does the current owner have any special relationships with suppliers and if so, what impact will their exit from the business have on input costs?
- What roles does the current owner fulfill in running the small business and do you have the skill set to step into these roles or will you need to source external help (at additional cost)?
Whilst these questions apply to the owner of the business, you should also consider the level of personal goodwill linked to any other key employees within the business.
Tip 3: Beware of hidden capital expenditure requirements
When deciding what to pay for a small business, it is important to consider any short and medium term capital requirements of the business.
As a general rule, any significant capital expenditure required within 12 months of the purchase date which is essential to maintaining the earnings of the business, should be deducted from the purchase price.
As an example, lets say you are looking at purchasing a cafe which generates profits of $100,000 per year. You have reached an initial agreement to pay $250,000 for the business (i.e. 2.5x annual profits). However, the coffee machine has had its day and you will be required to stump up $20,000 for a new machine within 2 months of acquiring the business. This $20,000 should be deducted from the initial agreed purchase price of $250,000.
Another example is where the business you are looking to acquire undertakes its business within a shopping complex. Leases for these premises often require significant refurbishments so it is important to consider when the next refurbishment is due, how much it will cost, and whether there should be a corresponding adjustment to the purchase price.
Also be on the lookout for any fixed assets which may be under onerous rental or lease arrangements.
Tip 4: Understanding the tax history
This will not apply if you are buying just the assets of a business. However, if you are buying the shares or units of an entity which holds the business, you will need to consider the historical tax history of the entity.
This could include income tax, GST, payroll tax, employee pay-as-you-go withholding and land tax. We would also include employee superannuation into this category.
Taking on a poor tax compliance history can be a very expensive problem for new owners so it is important to look at this carefully.
Tip 5: Understand what employee liabilities you are inheriting
When a business changes ownership, it will usually be a requirement that the buyer recognise past periods of employees’ service. Accordingly, it is important to understand:
- how long employees have been with the business;
- the level of accrued annual leave and long service leave; and
- the likelihood of transferring employees leaving the business post acquisition.
One item which often catches people out is the belief that long service leave only applies for employees with over ten (10) years of service when in fact, in some circumstances, it can apply for employees with as little as five (5) years of service.
Buyers also have a requirement to offer existing employees with employment on the same terms and conditions as they were on with the previous owner.
Getting to grips on the level of these liabilities will be important for determining how they addresses as part of purchase price negotiations.
Tip 6: Understand customer risk
In any acquisition, it is important to gain an understanding of the business’s customer profile. This is especially the case for small businesses who often rely on a small number of customers to make up the majority of revenues. Loosing any of these customers could have a devastating impact on the value of the business.
Key issues to consider include:
- customer concentration;
- customer loyalty and engagement;
- relationship to exiting owners; and
- future needs of the customers.
Tip 7: What about the lease?
When considering any leases for premises, potential buyers should understand the following:
- What is the remaining term of the lease (including options)?
- What conditions does the landlord have for transferring the lease to a new owner?
- Is the business highly dependent on its current location and what impact would moving the business have on its trading performance?
- Are their any refurbishment requirements and when are they due?
- Will the new owner be required to pay a rental bond?
Tip 8: Understanding working capital requirements
The fair market value of a business should include a “reasonable” level of working capital. This may include trade debtors, inventory and trade creditors but may also include other items depending on the nature of the business.
This means that if you are already paying “fair market value” for the business, you should not be paying additional amounts for the net value of these working capital items.
This is a complex issue and is often overlooked. A detailed working capital analysis should be undertaken and a “reasonable” level of working capital should be agreed between the buyer and seller prior to the signing of any contracts. Any differences at settlement would be an adjustment to the purchase price which could be in favour of the buyer or the seller.
This mechanism also protects the buyer from a seller attempting to manipulate normal business practice and extract as much cash from the business a possible prior to settlement, leaving the new owners to pick up the tab. The following are examples of the kinds of behaviours that these mechanisms are intended to discourage:
- sellers running down inventory prior to settlement;
- sellers delaying the payment of creditors prior to settlement; and
- sellers offering significant discounts on products in exchange for large deposits leaving the new owners to pick up the cost of the inventory with no corresponding revenue.
Be careful where buyers are requesting additional value for inventory, or require trade debtors to remain with them.
Tip 9: Understand the terms of material contracts
It is important to understand the terms of material contracts, especially where you are buying the legal entity of a business. Some factors to look out for include:
- equipment under onerous rental or lease terms;
- customer agreements with long payment terms and other onerous conditions;
- supplier agreements with short payments terms; and
- if buying a franchise, make sure to understand the terms of not only the existing franchise agreement, but also any additional requirements of the franchisor for entering franchisees.
Tip 10: Get professional assistance
OK – a bit of self promotion here, but we truly believe that getting professional assistance can prove invaluable.
In our experience, the cost of a DYI approach will often be a lot more costly (especially in the long term) than hiring financial and legal professionals to undertake due diligence, provide help with valuation and to generally guide you through a business acquisition process.
We understand that costs are always a concern, however experienced professionals will be able to assist you early on in the process to identify key risk areas and provide you with various options for the scope of work to be performed with the aim of keeping the overall risk of the acquisition low and fees to a minimum.
Navarra Kovac Chartered Accountants 