Before You Buy A Business
When you're investigating buying a business it's important to do a detailed review of the business's operations, finances, reputation and industry as part of what is called the ‘due diligence’ process.
Research undertaken by Griffith University’s Asia-Pacific Centre for Franchising Excellence included a survey of just over 600 current and former franchisees and independent small business owners and the findings were quite astonishing. The majority of new independent business owners and franchisees rely on their “gut feel” when setting up or buying a business. Incredibly, close to half of these business operators are not familiar with the term “due diligence”.
Let me ask you this question, would you buy a second hand twenty thousand dollar car without a detailed inspection by a qualified mechanic? Presumably not. Then why would you consider paying fifty, a hundred or two hundred thousand dollars to buy a business without a comprehensive review of the business, the historical sales figures, the assets included in the sale, the terms of the lease and what stock is included in the sale? Buying a business is an exciting time but it’s also a process. You need to be patient and to minimise the risk you also need an understanding of the industry and why the vendor is selling the business.
The due diligence process is all about making sure you know what you are buying. You want to be sure the price is fair and reasonable and you don’t want any surprises after you complete the purchase. If you don't fully understand the business, the ongoing costs, the staffing requirements and the likely profit and return on your investment, then you haven’t done your homework. Failing to plan is planning to fail and the business fairy tale could turn into a financial nightmare.
The Griffith University research revealed the level of due diligence undertaken by operators before buying or establishing a new business in Australia was “unsophisticated” and most business owners have a “naïve” appreciation of business. In fact, 42% said they had either not heard of the term “due diligence” or do not know what the term meant. The research also highlighted that prospective businesses owners don’t spend a large amount of money on the due diligence exercise. The average spend by current and former franchisees was in the range of $2500 to $2700 while independent businesses owners spent between $1500 and $2290.
Surprisingly, new business owners only spent a “relatively low” amount of time on the due diligence process and prospective franchisees tend to spend more time than independent business owners. This apparent lack of time and money invested on due diligence is a big surprise given business owners are often nervous and cautious when buying or starting a business. If you’re going to invest a large amount of money and you’re relying on the business to provide you with an income to fund your future lifestyle we urge you to invest heavily in the due diligence process and we can assist you.
Only around one third of business owners surveyed said they consulted with an accountant, lawyer or financial adviser prior to purchasing or starting a business yet the due diligence process should start with a professional consultation. While there are plenty of online resources to help prospective business owners, there’s no substitute for independent professional advice. No two businesses are the same and even franchises operate from different locations with different competitors and staff. All the excitement and optimism around the new business will turn south if you don’t really know what you are buying into.
THE FINANCIAL ASPECTS
While the due diligence process covers a range of issues, it all starts with a financial health check. If the business doesn’t satisfy the financial examination then it’s probably not worth investigating the other aspects. As a guide here are some questions we would ask regarding the financial aspects of the business.
- Have you received and analysed the financial records for the past 3 years including balance sheets, profit and loss statements and tax returns? There is no substitute for certified copies of financial statements and never rely on statements simply generated by the vendor’s accounting software.
- Is there a list of plant and equipment plus fixtures and fittings that the owner intends to sell and where has the valuation come from for these items? Are under of the items under finance agreements?
- Details of any stock being sold with the business and the valuation method. How will it be counted and valued at settlement?
- Do sales and purchase records reconcile to bank statements? Have the records been well kept? Are the total sales broken down by product or service line?
- Does the business have potential for growth and if so, what is your plan to turn that potential into profit? Can you increase sales with the current resources?
- Based on past financial results, have you done a future cash flow projection and profit forecast? What is the break-even point and are profits adequate to warrant the risk of buying?
- What are the sales patterns year-by-year and month-by-month? Is there a seasonal pattern? What is the sales mix (the ratio of each product sold to total sales)? Do a small percentage of clients represent a large percentage of sales?
- Are there any one-off sales that won’t be recurring? What is the impact on profit?
- Are you buying the accounts receivable/debtors? If so, do you have an aged listing of them?
- Has the existing owner received any pre-payments (e.g. deposits) that they should turn over to you at settlement?
- Is a particular salesperson critical to the business success? If so, will you be able to retain that person in your employment?