Buying a business
Buying a business? Take note of the old adage “Buyer Beware!”. Do your due diligence. Or it could be a costly mistake!
Buying a business can be an exciting and also daunting experience. Are you paying too much? Will the business work? How are you going to fund the transaction?
How much should I pay?
One of the questions often asked is how much should I pay? What is the business worth? Price and value aren’t always the same thing. You don’t want to pay more than its worth. Price isn’t just a function of the true value of the business but depends on the number of buyers and the buyer and seller motivations. Is the seller desperate or are there multiple buyers with multiple egos!?
Earnings and value?
Value is a function of earnings and the risk attached to those earnings. You need to consider the historical performance of the business, but as the investment disclaimer always points out, historical performance isn’t an indicator of future performance. How is the business performing at this moment? Do you have up-to-date current monthly management accounts? Does the business have a budget and forecast and how is it tracking?
Sustainability of earnings
Most importantly you want to know how sustainable earnings are in the future. You need to dig deep. Who are the customers? How long have the customers been with the business? Are there any customer contracts? Where are new customers coming from?
Who are the suppliers? Are there any agreements in place? Any there any supplier exclusivity agreements? Who are the competitors? How many and how do they compete? What is the competitive advantage of the business?
What are the true earnings?
Are the earnings that the business currently earns the same that you would earn in the business? Are there any adjustments you need to consider, for example:
- Owner’s salary. If the owner also runs the business they may take their remuneration out in different ways. This could be as a dividend rather than a salary. In projecting earnings, you need to consider what market salary you would reasonably have to pay someone to replace the owner-manager.
- Non-business expenses. Does the owner use the business to put through non-business or un-related business expenses? Are there any expenses that are not being recorded, for example, does the owner uses family members to help out with little or no remuneration?
- Property. Who owns the property that the business is run from? Is it owned by the vendor? If so does the vendor currently charge the company a fair market rent? What is he going to charge you?
Often private businesses are bought at a multiple of earnings. The multiple reflects the risk attached to the earnings. The higher the risk the lower the multiple.
Factors that influence the multiple, include:
- Industry. The type and risk profile of the industry. Is it an expanding growing industry or an industry in decline?
- Contracts. Does the business have customer, supplier and employee contracts?
- Lease. What are the lease terms on the property? How important is the lease to the business?
- Client base. Does the business have a well established, stable repeat client base or are all clients one-offs?
Assets and Liabilities. What’s included?
What assets and liabilities are required to run the business? Are they included in the transaction? For example, will the debtors stay with the vendor or are you collecting them on their behalf? Other important questions include:
- Non-business assets. Are there any assets in the company that are not really necessary in the running of the business, for example, company cars used by family members?
- Working capital. What level of working capital is required to run the business? How much cash do you need on hand to pay suppliers and staff, before you get paid by customers?
- Liabilities. Are you inheriting any liabilities? Are there any liabilities hidden away and not on the balance sheet? Are taxes paid up-to-date? Are they any disputes with suppliers or customers? Are employee long service leave and sick leave provisions reasonably accounted for?
Customer and Supplier Contracts
If customer or supplier contracts are in place how valuable are they to the business? If they are an important component then they need to form part of the sale and purchase agreement. Often contracts have clauses that if there is a change of ownership then the contract is void or renegotiable. The sale and purchase agreement needs to ensure that contracts are novated, transferred from one party to the other.
Management and Staff
Who are the key staff members? How long have they been in the business? Have they been in the business a long time because they are loyal and hard working? Or because the company can’t get rid of them?!
Are the key staff going to stay on with the business? If so, is there any encouragement to stay in the business? Golden handcuffs?
Often a large proportion of the sale price is for goodwill. What is this goodwill made up of? Is goodwill attached to the name of the business, the brand? Is it tied up to the location of the business? If so, what are the lease terms on the property?
Is the goodwill personal goodwill? Is the goodwill tied up with the owner? If so, how is that goodwill going to be transferred? Is the goodwill in vendor’s relationship with the customers and suppliers? Are the business operations and systems properly documented or are they all in the owners head?
If there is goodwill attached to the owner, how are you going to ensure you get the goodwill you paid for and that it doesn’t just walk out of the door with the owner? One way is to get the owner to sign an employment agreement. The owner agrees to stay on in the business for twelve months. During that time they will introduce all the customers and suppliers and pass over their knowledge and experience.
What are you buying?
Are you buying the business or the company? The company is the equity. The business is the assets and goodwill necessary to generate the same level of earnings. Buying the equity carries a risk. You could be buying skeletons in the closet. If you’re buying the business make sure you get everything you need to run the business.
How are you paying for it?
Are you paying for the business 100% up front? Or are you proposing an earn-out agreement? The vendor gets a percentage of the value, say 50% in twelve months time, subject to meeting certain performance hurdles? What are these hurdles? How are these hurdles to be measured and communicated, for example, are audited financial statements required? Is the vendor able to manipulate those measures whilst working in the business?
Is the vendor providing vendor finance? What are the terms? What interest rate are you paying? Is it reasonable?
Management buy out?
If you are part of a management buy out team how are you financing the transaction personally? Will the dividends be sufficient to pay off your debt? Do you have any more rights as an equity holder or are you just a passive investor and working in the same salaried position? Make sure you have a solid shareholders agreement in place.
Do your due diligence. It is far better to invest now than pay a much higher price later. Disputes and litigation are costly, drawn out and emotionally draining. Most of all, be prepared to walk away from the deal if it doesn’t add up!
Simon is a CA Accredited Business Valuation expert, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing transactional and valuation services. Simon advises clients on buying and selling businesses. Prior to founding Lotus Amity, he was a Corporate Finance partner with BDO Australia.
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