Before making a final commitment to an acquisition, it is essential to complete a thorough Due Diligence. Here are a few important things to consider when completing a due diligence. Be sure to inspect all aspects of the business before moving forward. Pay attention to detail and consult with advisors where necessary. Your experienced and qualified business broker will guide you through the process, making use of checklists and their wealth of knowledge related to the due diligence.
How is this business operated, what are the daily weekly and monthly requirements to operate the business? What is your time requirement in operating the business? Where is the business located, are the premises leased or owned? If leased, is the landlord aware of the sale and what are their approval requirements and lease terms? Is there an experienced team and will they be staying on if you purchase the business? Are staff well-trained, are there performance appraisal records to review, are all contracts up to date, are there any targets and incentives in place? Is the business fully compliant in terms of industry requirements, licenses and regulations? What are the key compliance areas for this specific business? In terms of intellectual property, does the business own any unique IP? Does the business have the right to use what they are using? Are there any trademarks and or copyrights or patents in place? If purchasing a franchise, its important to understand the nature of the franchise agreement, training, support and royalties.
When you buy a business, you are also buying outstanding legal issues. It is essential to check if there are any claims, past or pending cases as these will transfer to new owner unless a special include clause is included in the sales agreement. Does the business have a valid tax clearance certificate, have the financials been audited, are there any problems with previous tax returns? What is the financial position of the business in terms of total revenue, gross profit and net profit figures and what is the cash flow requirement? What are major expenses in the business? Does the current owner draw a salary from the business and are there any discretionary earning that you need to be made aware of? What is the status of the balance sheet, what does the business own and what does it owe? Does the business make use of credit and if so what are the credit terms with suppliers? Does the business have good, long lasting relationships with its suppliers? From a customer perspective, are here any testimonials or references to review? Are there customer contracts in place, who are the biggest customers in relation to the total income of the business? Is customer support or spend related to a personal relationship with the current owners?
Pay careful attention to the DD and take the time to do it properly. This is your last chance to ensure you are entirely happy with the business to proceed with the purchase. The DD is signed off by all parties and is a binding addendum to the sale agreement.
Prior to the Due Diligence process (after having identified the business you intend to purchase), there are a number of important questions to ask the seller when considering a possible acquisition.
- Why are you selling the business?
- How long has the business been on the market for?
- Who knows the business is for sale (competitors, employees, customers)?
- What is the average turnover of the business?
- What are the net operating profits of the business?
- Who are the biggest competitors in the market?
- What is the business’s value proposition and unique selling points?
- What are the trends in the industry?
- What are the average industry benchmarks?
- What can a new owner do to increase profits?
- Why is the seller not implementing the answer to the previous question?
- What sort of training will be provided when taking over the business?
- What will the period of handover be, to provide support to the buyer?
- What does the seller intend to do after the sale of the business?
- Will the be willing to sign a restraint of trade?
The first step in successfully acquiring a business, is to understand your affordability. Many people begin their search for a business without first considering their financial position in terms of their personal balance sheet and net income requirements from their new investment.
This of vital importance to determine what you can afford as a deposit in relation to the total purchase price, as well as which funding options you could pursue to raise the balance and what the cost of capital impact will be on the business you intend purchasing.
Depending on the size and nature of the business and if it is part of a franchise, there are specific requirements in terms of the purchasers affordability. In general it is expected that the purchaser is able to provide a 40% deposit of the loan amount required.
Certain franchisors also require the purchaser to have additional unencumbered cash available for working capital purposes. In order to determine affordability a review of personal income, expense, assets and liabilities is required.
The following information is generally used to complete an affordability assessment:
Assets (present values of):
- Life Assurance Policies
- Listed Shares
- Credit cards
- Unencumbered cash
Liabilities (amounts owing):
- Mortgage Bonds
- Lease agreements
- Bank loans
- Loans from other financial institutions
- Balance due on Credit Cards
- Balance due on clothing accounts
- Other liabilities
- Allowances in cash
- Investment returns
- Salary – spouse
- Tax – PAYE / SITE
- UIF (includes spouse’s UIF)
- Medical Aid
- Rent / Bond
- Lease agreements
- Loan repayments
- Insurance premiums
- Life assurance premiums
- Electricity and water
- Rates and taxes
- Telephones including rental, cellular, internet
- Planned Savings
- Credit Card accounts
- Clothing accounts
There are many different methods used to value a business, most of which conclude similar results, however it is ultimately subjective and based on what the sellers view of the value of the business is, and what the buyer is willing to pay. There are many factors which have to be taken into consideration such as:
- The financial position of the business (good or bad)?
- How long has business been in operation?
- How long has the present owner owned it?
- Are their audited financial records for the business?
- What condition are the assets in?
- Is there a renewal option on the lease?
- Are the products or services in demand?
- Are the products being marketed effectively?
One of the most effective ways of valuating a small to medium size business is to use the following formula, which over the years has proved itself in the business broking industry to be fairly accurate. The method is based on using the average of three valuations namely; Extra Earning Potential (E.E.P.), Return on Investment (R.O.I.) and the Payback Period.
- Extra Earnings Potential (E.E.P.) – The extra earning potential is the extra one expects over and above a salary, plus the investment income from banking the money available to buy a business when one takes on the risk of owning that business.
- Return on Investment – The return on investment is the rate of return one receives from investing the capital cost of the business taking into consideration the risks associated with that business.
- Payback period – The Payback Period uses an experienced “guess” as to the number of months one would expect to take to pay for the business out of the monthly profit. When making use of the above formula there are certain “cap rates” which apply and are most important when valuing a business.
As a professional business broker, it is our responsibility to advise clients on the valuation of their business. Based on the complexities and subjectivity, we also advise our clients to have their accountant or auditor assist with valuation inputs, as they have a better view of the businesses historical financial position.
There are many important factors to consider when buying a business. An initial assessment of the business will assist you at determining if it is an acquisition worth pursuing. The starting point is for the buyer to ask themselves the following questions:
- What skills or expertise do I have?
- What kind of business am I best suited to?
- How much liquid cash do I have available?
- What do I need to raise in finance?
- What income do I require from the business?
- How many hours do I have to spend in the business to earn the required income?
- How far am I prepared to travel?
- How will this business affect my family and leisure time?
If you don’t have a gut feel for the business, then you shouldn’t buy it. A buyer should always buy a business that they feel they can improve on, which has potential. They should complete a detailed due diligence on the business to verify figures and profitability. Below are a few of the advantages and disadvantages to be considered when buying a business:
- Immediate profits – don’t have to wait to establish profits. Average estimated time is 18 months.
- Less risk – success of the business model is already proven
- Base to build on – new owners drive can increase profits and growth.
- Hiccups ironed out – free of start-up problems + you have existing clients, employees and suppliers etc.
- Smaller capital outlay – you may be able to buy an existing business with established profits for less than starting a new concern.
- Assistance from seller – 99% of sellers stay on in business for a period of time to assist buyer with takeover and to ensure continuity.
- Problems – you could be taking over problems someone else has created.
- Location – maybe not situated in good position.
- Future area developments – maybe not conducive to business sustaining the market, products etc.
- Time factor – minimum of 3 quotes required by bank for equipment required + one still has to find suitable premises
Other important points to consider when buying a business:
- Always remember that CASH is KING, look carefully at the figures and concentrate on the cash flow rather than on the NET PROFIT.
- Buy a business you can improve on. If there is no potential to grow the business, don’t buy it.
- Make the decision to buy yourself, don’t rely on an advisor.
- Ascertain what the appropriate method of financing the business is.
- Identify any major problems that may exist in the business and see if it can be minimized or eradicated.
- Seller finance in most cases is a form of protection, so it is important to concentrate on the terms of the agreement rather than solely on the price.
- Establish what the exact reason is for the seller wanting to sell the business
- Think creatively about the future and buy something you are going to be proud of.
- Don’t procrastinate, GOOD BUYS are GOOD BYES if you wait too long!