We get asked these questions often: How do I buy a business? What documents should I request and how do I value a business that I want to buy? We’ve broken it down into these tips so that you don’t buy a bad business.
1. What type of business are you buying – franchise or individual?
Stand alone businesses have different factors to consider versus a franchise. Franchises may offer you a good brand name and support but there is a lot to consider, such as franchise entry and exit fees, royalty fees, marketing fees, training costs and contractual obligations. Make sure you have a good understanding of the franchise model before buying in. Also, just because a brand has a good reputation doesn’t mean the particular location you’re considering will do well. You need to do your due diligence on that specific unit.
With a privately owned business you should look at the legal structure of the business, as well as do your due diligence. Is it operating as a sole trader, partnership, company or trust? Each will have its own legal and tax implications to consider. Be very careful about taking over an existing structure such as a company. There could be guarantees and potential debts of which you are not aware. We recommend you buy any business in a new structure. You can read more about the different company structures here.
2. Due diligence – don’t believe everything you see.
Due diligence is the process of carefully investigating the financials that you request from the seller or agent. Remember, the primary motive of both parties is to sell the business. Don’t completely trust what you see, hear or read. The only person looking out for you, is you (and hopefully your accountant if you’ve taken the numbers to one).
Generally, agents don’t care if the figures shown aren’t 100% true. They make a commission on the sale and forget about you once the handover is complete. The seller will most often try to inflate the profitability of the business to raise the proposed value of the company. If you don’t request the right information and then buy a bad business, you’ll be stuck with it while the seller and agent move on.
3. Due diligence – what to know when buying a business.
Step one in due diligence is verifying if the requested figures are correct.
Some common items to look out for are:
- Does the turnover figure match with the BAS returns?
- How reliable is the turnover going forward?
Is this a stable business with a reasonable expectation that sales will continue or grow? Or is it a fad or a product / solution that’s nearing the end of its life cycle?
- Does the revenue include any once-off income that will not be ongoing?
Things like a once off sale / contract could have significantly inflated the profitability but you won’t see that money in the following period.
- Has a wage cost been provided where an owner is working in the business?
This is a common way to significantly boost profitability – especially when you have someone trying to sell a struggling business. You need to know that there’s enough money to pay yourself (or an employee) and still walk away with a profit, meaning that you’re generating a return on your investment.
- Have all costs been taken into account?
Has depreciation been taken into account and tax deductions claimed at the correct ATO rates? Small business owners often do their own marketing and may not account for the time and resources required.
- Are staff being remunerated at least the minimum rate?
- What leave and long service leave are they due?
You’ll need to deduct this from the purchase price as this is a cost you’ll be responsible for after the takeover.
- Has the business paid the employees superannuation guarantee?
- Request figures for a few years.
This will help you get an idea of trends, averages and how the business has been run.
- Is the business seasonal and has it been affected by Covid?
Things like JobKeeper payments may have been included erroneously which would inflate the profitability.
- Are they legally compliant?
A client once brought us the finances of a potential purchase that wasn’t GST registered but should have been as they had recently crossed the $75k annual threshold.
- Are there any cash takings?
If cash takings have not been declared then this should not be taken into account as you will not be able to verify these figures.
Additional considerations
An important part of due diligence is also looking at the assets of the business to see what state they are in and whether they need replacement or repair.
If the business has a lease agreement, look at the terms of the contract, expiration date and terms of renewal.
In most cases when you buy a business you’ll need to know what working capital is needed for stock, debtors, etc. You’ll have to invest this amount on top of the purchase price you pay to the seller.
Understand the relationship between the owner and the larger clients. Are any of them likely to move once you buy the business? Perhaps the only reason they are clients is due to a strong relationship with the seller (like family or friends).
You should also get a lawyer to review the purchase and sale agreement as well as any franchise agreements.
4. How to value a business to buy.
If you are happy with the details you have requested and are ready to make an offer, you need to know how to value the business you want to buy.
You can calculate that value by taking the correct annual profit (normally using a weighted average of 3 years), and multiplying it by a factor.
The factor you multiply the annual profit by is generally around 3 – 4, meaning that you are expecting to recoup your investment (the purchase price of the business) in three to four years through profits earned.
The actual factor you use essentially depends on how confident you are that this business will continue to generate similar or better profits going forward.
The riskier the purchase, the lower the factor. Take an Instagram drop-shipping business, for example, that has been running for 1 year. That is a risky business to buy with little track record and exists entirely on online platforms that you don’t own and that could switch you off tomorrow. 1 year’s profitability is the most you should consider as reliable and therefore use a factor of 1.
However, if you’re buying an established business, with a good name and track record, good clientele and staff, and can safely assume that revenue will continue and grow, then a factor of 4 or 5 will be more accurate.
In looking at your total capital investment, you need to take into consideration any additional costs you are going to incur to start running the business, for example, working capital to finance stock and debtors, and franchise entry costs.
The assets needed to run the business, and included in the purchase, are already incorporated in the business valuation so they do not need to be added to the calculated value in arriving at a purchase price.
The purchase price of the business should be apportioned between the market value of the assets being acquired with the balance being goodwill. We recommend that this breakdown be reflected in the purchase agreement. If you end up purchasing the business, the asset value will be depreciated in your records for tax purposes. The goodwill portion remains at cost in your balance sheet and only comes into consideration in working out the capital gain when you sell the business.
5. How to avoid buying a bad business.
It’s important to remember that when you buy a business you’re not only investing your money.
Owning a business affects your personal finances, time, family life, energy and mental health.
When you buy a bad business that impact can turn negative very quickly. You can avoid that mistake by doing your due diligence well and getting the advice of a trained, financial expert upfront.
At Teamwork Accounting we’ve been helping local Melbourne business owners make sound financial decisions and buy good businesses, for over 20 years.
Please note that the above is general advice only and does not constitute advice on your particular situation. If you’re considering a business to buy, contact us for a free 45 minute consultation.