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What to look for when buying a business

A business purchase is often an expensive exercise and can be motivated by a variety of needs including the expansion of an existing business, personal independence, return on investment or security of income. Regardless of the reason, investigating the business through a detailed due diligence process will help to ensure you make a fully informed decision.

Once you have indicated your interest in the business, you’ll need to sign a Confidentiality Agreement in order to obtain the initial information package provided by the vendor. This package should provide you with enough information to make an offer on the business which will allow you to engage in a detailed due diligence process. There are no secrets in the due diligence process. Most of it is common sense based on the idea that before you buy a business, you need to know what you’re getting into. For example:

WHY IS THE BUSINESS FOR SALE?
Is the business’s product or service coming to the end of its cycle? Has the business’s competition reduced its ability to maintain profitability? Is the owner retiring, or are there personal issues that are forcing them to sell?

Is the lease about to expire and the owner doesn’t want to carry on? Is there an opportunity to capitalise on the owner’s reasons for selling and give the business a new injection of life and enthusiasm. Is there scope for improvement?

DETERMINE THE STATE OF THE BUSINESS FINANCES
It’s imperative that you learn everything you can about the financial condition of the business. Make sure you and your financial advisors review the current financial statements, balance sheet, profit and loss statements, GST and tax returns for the previous 3 years. Also ensure you review the current bank statements and the current accounts payable and receivable, to understand the state of the business’s cash flow.

Have the owners kept complete and comprehensive financial records? Always make sure you understand the relationship between income (sales) and expenses.

Income (Sales)
-  What are the monthly and annual sales pattern? Is it consistent? Seasonal? Related to other cycles?
- Are sales fluctuations due to particular promotional campaigns?
- Are reported sales consistent with industry norms?
- Can sales increase with current resources?
-  Is there a salesperson who contributes significantly to success? Can you keep him/her?
-  Is the seller’s personal role critical to success?
-  Are the total sales broken down by product line if applicable?
- Will existing suppliers still support you as a new owner?
-  Are there advances or prepayments that should be deducted from the purchase price? 
- Are bad debts deducted from the accounts or are they still shown as receivables? 
- What’s the future of the product or service? Is it growing, stabilising or slowing.

Expenses 
- Will an increase in sales have a corresponding increase in expenses? 
- Are the expenses consistent with industry norms? 
- Have any expenses been deferred (e.g., equipment maintenance)? 
- Will any annual expenses be due soon? 
- What new or increased expenses should you anticipate? 
- Are staff salaries due for a review? 
- Are owner’s wages contained in the overall wages expense? 
- Are all interest payments directly related to business debts? 
- Does the depreciation expense reflect the true value of the assets? 
- Are there any prepaid expenses that will need to be reimbursed?

INSPECT THE CONDITION AND OWNERSHIP OF THE PHYSICAL AND FINANCIAL ASSETS 
The business purchase will often include physical assets such as plant, equipment and inventory. What are the book value, market value, replacement value of the fixed assets? Make sure the equipment is in good working order. If you’re new to the industry, engage an industry expert to provide a knowledgeable and experienced opinion for you. Is equipment in good repair, operating efficiently, current, easily serviced, and saleable?

Businesses often raise debt against physical assets so you’ll also need to understand the security provided for any business debt. Make sure you understand who the creditors are that have a security interest on any business assets. Is there a GSA (General Security Agreement) that will allow them to seize and sell the secured assets, even if you’re the current owner? If any plant or machinery including vehicles is being leased, ensure that the lease can be assigned to a new owner, or that the lessors or financiers are prepared to transfer the ownership.

Always review the current marketability of the business inventory. Make sure you’re not paying valuable money for dead or obsolete stock that you’ll have to discount heavily to turn back into cash. Also check if any inventory that’s been sold and not shipped and make the appropriate adjustments to stock. Are you buying accounts receivable as an asset? Do you have details on the payment history of the account holders? What is the risk that the aged debtors could become bad debts? Could you sell the accounts receivable to a factoring agency (bank or finance company) and turn them into cash?

ENSURE THERE IS ONGOING SECURITY IN THE LEASE 
Most businesses lease the premises from which they operate. Make sure you get a full copy of the lease and review it carefully. What is the term of the lease? How many Rights of Renewal are there? Are the current terms of the lease sustainable for the business? Is there a good relationship with the landlord? Does the current owner have any outstanding rental arrears? Will the landlord provide consent to transfer the existing lease, or are you able to renegotiate for more favourable terms and conditions. Is there a possibility you could be offered the opportunity to purchase the property on maturity of the lease?

WHAT ARE YOU BUYING WHEN YOU PAY FOR GOODWILL 
Goodwill is the value of intangibles, such as location, brand, business reputation, customer databases, franchise licenses, supplier arrangements or agencies, quality of personnel, etc. Goodwill can be thought of as the difference between an established, successful business and one that has yet to establish itself and achieve success. Thus a business that has run profitably for a number of years has a value over and above its asset value.

Sellers often try to increase the value of goodwill by promoting the potential they see for business in the future. Future potential will influence your decision to purchase the business, but it will be your efforts that will realise that potential so be very careful about paying for it. Understand what the intangibles are that you’re paying for. Research the business’s market and its main competitors. How does it compare with competitors? Talk to their customers, and anyone else involved, such as suppliers. What is good and bad about the business’s products or services? Do the customers use the business’s competitors? If so, what are their comparative advantages? What will the customer’s future demand be for the business’s products or services? Who is their main contact at the business? If their main contact turns out to be the owner, your goodwill may disappear with them unless you can secure their continued involvement. If part of the goodwill is a supply agency, check that the agencies are transferable and that the supplier will continue to supply a new owner? 

UNDERSTAND THE ASSOCIATED LIABILITIES AND GET THE OWNERS GUARANTEE 
Even after your careful investigation of business, there may be liabilities you could’ve overlooked. Are there contingencies such as warranties or guaranteed debts or accounts? Will customers expect you to make refunds or honour warranties on sales made prior to your possession? Will you be at risk of losing goodwill for not honouring warranties even though you’re not legally obliged to do so?

Have the business owner provide you with a personal guarantee stating that the information provided is complete and accurate. This can be listed in the Sale and Purchase Agreement under “Representations and Warranties.”

THE AGREEMENT 
Always make sure you know exactly what is and what is not included in the offer to purchase. For example, if inventory and/or work in progress are included, make sure the value has been agreed upon at the time of offer, with an allowance for adjustments at closing if required. Are intangibles like business name, mailing lists, exclusive rights etc. included in the sale? Will the seller agree to a restraint of trade for a predetermined period of time? Will the seller train and assist you after the purchase?

CHOOSE AN EXPERIENCED BUSINESS BROKER 
Choosing an experienced Business Broker will help to ensure that you get the assistance you’ll need to identify the issues described in this article, and many more.

Article written by Dave Morgan of LINK Wellington