The Bewares in Buying a Business

Chilman Central Australia

It has been said that a business is often like an iceberg…………one corner is exposed to analysis whilst two thirds are hidden, either for good or ill. This is further complicated by financials which one must unscramble in order to determine the real rate of return of the business. It is therefore important when purchasing a business that after evaluating the business in principle, the services of an experienced, competent accountant are employed to assist you in making a rational, un-hastened decision.

There are many important areas to address and “beware” of in the assessment of a business with some of the more important considerations set out below.

1. Suitability

A basic factor is a combined assessment of a buyers suitability, experience, age, background, culture, physical strength, type and size of the business, financial position and so on. For example the ultra fastidious person who finds it hard to tolerate children and mess should avoid purchasing a toyshop and likewise a person who finds it difficult to smile should avoid retail sales involving direct customer contact.
9. Valuation

There are many formulas in existence that it can be confusing to establish a fair market value. Advisors tend to wear different hats depending on whether they are advising the vendor or the purchaser. In general I would recommend avoiding rule of thumb methods. Even comparable sales are fraught with danger as each business is different dependent on its market, running costs and so on. No single value is absolutely correct – there is a price range and by using a common sense approach this can be realistically determined. Seek advice from your accountant or business broker who is experienced and competent in this area.
2. History of the business

Establishing a comprehensive history of the business including how long it has been operating, major improvements undertaken, plant expansions, product additions and other milestones is important in giving clues to its likely upward trend or demise. A fall in turnover does not necessarily mean the business is deemed and vice versa. Vital clues may influence your overall decision.
10. Restraint of trade

This is a very important clause and should be used with discretion. They are drafted to ensure the buyer enjoys the full benefits of the goodwill of the business. The key to this clause is that it is reasonable. Clauses which are unreasonable can be invalid. It may be advisable to seek advice from your solicitor regarding tiered clauses allowing various levels of restraints, each less restricting than the preceding one.
3. Reason for Sale

The list is endless including retirement, ill-health, decline in trade, industry upheavals, poor location, increased competition, obsolete products, franchisor problems, creditor problems, partnership problems and so on. It is important to study the local environments and the real reasons for sale and how they relate to you. It may represent an excellent opportunity or suggest that the buying path be trod with caution.
11. Industry Prospects

No matter whether the past records indicate growth or otherwise, the important question to ask is what are the future trends for the industry as a whole? Is it a shrinking market or a growth market?
4. The lease (your “title” to the business)

A few simple questions regarding the lease can prevent financially upsetting results. Many people are unaware of the difference between a stamped lease and a registered lease. If possible leases should be registered thus protecting the interests of the tenant in the case of the sale of the building. Items to take particular note of are the term of the lease, rights of renewal, rent reviews and tenant and landlord responsibilities. A lease is one of the most important assets of a business which requires location to survive. Accordingly the time and money should be invested to evaluate each individual lease clause both in present terms and future likelihoods.
12. Cash Flow

As borrowings are involved in the purchase of most businesses it is common sense to expect that cash flow is sufficient to provide the necessary repayments with some cushioning in case of a downturn in trade. Your accountant should prepare a cash flow allowing for seasonal variation. Cash flow not only assists in establishing what capital requirements are needed on a monthly basis but also will assist in presentation of finance applications.
5. Plant and Equipment

The more plant involved in the sale of a business, the more this area should be looked at, particularly in regard to when plant was acquired, its original cost, depreciation to date, condition, whether it is obsolete, whether it is designed for a specialised process and whether it is on lease, hire, loan or has a Bill of Sale. It should be clearly established in writing whether value is to be at depreciated value or at fair market value as a going concern. Projected capital expenditures over the next few years should be assessed and taken into account.
13. Suppliers

Whether the business be involved in wholesale, retail or manufacturing, lack of supply can adversely affect the viability of that business. Simple questions like identification of suppliers, volume, any written contracts, the terms of any agreement and who would be likely backup suppliers is vital information in assessing the future of that business.
6. Profitability

Profit and loss statements need to be unscrambled in order to establish the true profitability. Various add backs (eg. owners superannuation, excessive motor vehicle expenses, excessive directors salaries etc.) but care should be taken that these are justifiable (eg. a proprietor working 60 hours within his business should be allowed considerably more than $20,000 per annum). Gross profits and ratios should be checked against industry norms and against previous years trends. Gross profit rises or falls can indicate levels of competition, poor inventory controls, inadequate costings or staff thefts. Sales projections and cash flows should be undertaken to assess future maintainable profits and assist in obtaining finance.
14. Records, lists and agreements

These are important documents. Ensure that items such as customer lists are made available at settlement and that it is a term of the agreement that such lists will be supplied.
7. Stock (or inventory)

Stock is another contentious item and the following is suggested:

  • Is stock at its normal operating level?

  • Wherever possible seek an independent stocktaker.

  • Allow for a stock limitation clause within any Agreement.

  • Never agree to a sale on a walk-in walkout basis. This is an invitation to disaster.

  • Ensure that the method of valuation of stock is clearly worded in the Agreement.

  • Prior to stocktake determine the degree of stock which may be slow moving, obsolete or unsaleable.

  • How many times a year is the stock turning over? A stock turn of twice per annum would generally be considered most unsatisfactory.

15. Warranties

These are only a few of a myriad of possible warranties that can be used, depending on the type of business may include some of the following:

  • Disclosure ie. any contracts or arrangements entered into by the Vendor which is material to the operation of the business should be disclosed in writing to the purchaser.

  • Vendor ownership ie. the assets are in fact owned by the Vendor and free from any encumbrance.

  • Condition of stock ie. current stock is merchantable quality.

  • Hired assets ie. that details of all hiring agreements have been notified in writing to the Purchaser.

  • No litigation ie. no proceedings, claims or demands pending against the Vendor.

8. Employees

Hidden traps can sometimes be overlooked until after the purchase unless this area is looked at carefully. Again, questions can establish clues to trends and health of the business. Obtain employee breakdown by category, the number and average wage/salary level for the last three years, benefits and incentives, union agreements and establish who are the key personnel and are they likely to stay. Adequate compensation should be paid to directors and their families in direct proportion to their amount of input. Salary allowances for directors are sometimes understated and sometimes overstated. Make allowances in profit add backs or deductions. Ensure that provision is made regarding long service leave (employees with more than say five years service), sick leave and holiday pay (check with Workplace Services for the various awards). Check WorkCover claims, current rate and ongoing issues. Is Super up to date?
16. Conclusion

The above comments represent only some of the knowledge which is required in order to fully assess a business acquisition. Remember to be a good listener, be inquisitive, ask questions and be observant, ask device only from those qualified or competent to do so, then proceed to negotiate or withdraw. Never make assumptions either for better or worse - find out the facts.