How to BUY a Business The Smart Way

You will always buy a business successfully, with no hidden surprises, when you approach it like this.

1. Facts & Figures

Do you understand how to read a 'profit and loss' statement and a 'balance sheet'?

Your accountants and solicitors will be realistic and will understand the commercial realities of buying a business. Most accountants are very good at preparing tax returns and ensuring we all pay the minimum amount of tax but some can be overly cautious and ultra-conservative when assessing a business for a purchaser. They are very mindful of the risk of being sued if they happen to give incorrect advice. Nevertheless, a good accountant can scrutinise the P&L and normally spot a problem just by running his eye over it.

2. Due Diligence

Due Diligence - What it means to buyers and sellers.

Every business we sell has a ‘Due Diligence' clause in the contract and in buyer's terms it really means that all the financial details of the business must be accurate and verifiable.

The buyer's accountant will delve deeply into all aspects of the business and if the accountant smells a rat, it usually means there is one!

One of the main reasons why a business sales contract ‘crashes' is the failure to satisfy the due diligence process. It is very important that the seller of any business to have all their financials squeaky clean.

If you're planning on selling your business in the near future have a good chat with your accountant about the looming due diligence that the buyers accountant will perform on the business to ensure that there will be no unexpected hiccups or surprises. Here are the 20 principal things an accountant will examine in a full due diligence process:

Sales analysis: a comparison of the previous 3 years profit & loss statements together with balance sheets, plus the "year to date" figures of the current year, looking for any major trends or fluctuations and assessing if the figures look reasonable.
Gross profit (GP) analysis: compare the GP percentages from year to year. Are there any major changes, if so, why? Does the business compare with industry standards?
Overhead analysis; carefully checking that no overheads have been omitted or seem too low. Are the figures accurate and not just numbers supplied "for sale purposes". Copies of the tax returns are required to verify this.
Review the major overheads as a percentage of turnover and compare them year to year.
Identify the components of the sales figures (sales, service etc) and check if there are there any large clients who represent a big proportion of the turnover and that they will stay with the new owner.
What amounts are allowed for in "aged debtors", 30, 60 and 90 days.
Is an overdraft needed? If so, how much?
How much stock is needed and how much working capital is required to run the business day to day.
What is the background of the business; how long has it been established; how long have the sellers owned the business?
How much competition does it have?
What is the ‘Start from scratch' scenario is: that is how easy would it be to replicate this business, how long would it take to start from new and build the turnover to what it is today?
Does the business has an operations manual and a business plan; both are very useful tools for a new owner.
Staffing: will the staff stay with the new owner and how easy is it to recruit replacements?
What is the potential to grow the business? Ensure the buyer sees this and that it's matched to their skill sets and enthusiasm. All sellers of businesses are tired and have "run out of puff": a new owner will invigorate the business with their optimism and enthusiasm.
Are the buyers suitable for the business: can they operate it effectively with their skills, can they afford the business or will it stretch them too much financially? What hours will the buyer will need to work the business? Will they have to allow more for wages?.
Premises lease: Has the lease been carefully checked by their solicitor looking for problems such as demolition clauses, overdue rent reviews, annual rent increases and is the lease registered.
What marketing is currently being done? What other marketing possibilities can be suggested?
What licenses are required and how easy are they to obtain or retain?
Is there a trade restriction on the outgoing owner to make sure the contract restricts the seller from starting-up in competition?
What are the supplier arrangements and terms of trade?

This is the level of "due diligence" a buyer and a seller can expect to occur from a good accountant in a business purchase contract.

However, most accountants are very conservative when acting for a buyer and always take a pessimistic view of a business ... that's their nature. So if any of the required information is not forthcoming, they will immediately become suspicious and negative about the business.

It is essential that the seller has all the material ready for the due diligence, otherwise delays occur and there is a very real risk that the accountant will advise the buyer not to proceed with the contract and once that occurs it's difficult to persuade a buyer to reconsider the proposition.

Next, have your finance already organised or know how to do so quickly - (see 'How to Finance a Business').
Be decisive and, usually, know what type of business you want, as well as its location, size and approximate net profit. But at the same time, be open to intelligent alternatives - we've had some great success stories with people who wound up buying quite a different kind of business to the one they started out looking at.
Be able to confidently settle the transaction in a reasonable period of time.

These are the documents you'll want to see: (see a full, printable checklist in "How to Sell a Business the Smart Way")

Full financials including Profit & Loss, Balance Sheet, a true list of aged debtors, 30, 60, and 90 days and any other outstandings. BAS, (Business Activity Statements), for GST purposes, and tax returns as well. You will want to see at least 3 years' figures.
A detailed list and inventory of plant and equipment and fixtures and fittings that are included in the price. If equipment is leased you will want to know lease payouts, monthly payments and years to run. And you'll want to know whether the finance company will assign leases.
The lease on the premises together with any Deeds of Assignment, extensions and options to renew. Ensure your solicitor thoroughly checks it for such things as demolition clauses, relocation clauses and renewal options. Be very cautious about buying any business that has no lease on its premises.

3. The Human Side

Here's what you'll know about yourself and your personal skills and knowledge

You'll have sufficient skills to run a business, but without being ridiculously particular.

Many people have bought businesses through us that have had no experience in that field but are sufficiently competent managers to succeed. For example, we sold a steel fabricating business to an ex-policeman who had never owned a business before but was an effective people manager and very good with customer relations. He has enjoyed growing success year by year.

Conversely, an ex-bank manager once bought a lawn mowing round through us because he was 'sick and tired' of people but soon discovered that mowing lawns gave him little satisfaction and that he still had to deal with 'people'. He wisely sold the business after six months and took the loss his 'decision' and inability to run the business cost him. The next owner was very successful. So the business was ok, the buyer wasn't.

You won't be over-influenced by 'armchair experts' but rather you'll listen to those who offer sound, balanced professional advice based on real business knowledge.

Likewise you'll be aware that many accountants and solicitors are historically conservative and if you listen to everything they say you'll never do anything! Many people have bought businesses through us where their accountants have not been able to see past the black and white figures. Remember, accountants are usually good financial planners and tax advisors, but not necessarily the best business advisors, and in many cases, neither are solicitors.

You won't over-extend yourself - go into a new venture under-funded or under-capitalised.

You will know that as a rule of thumb, you should have at least 3 months' total operating expenses in cash, in hand, or at the very least available.

For tax reasons, you'll know to finance all or as much as possible of the investment, ideally using real estate to set up a 'line-of-credit' loan which enables you to claim the applicable tax deductions. Your personal accountant will probably give you best advice in this area.

You'll also know what 'entity' or name you should buy the business in - either as a sole proprietor, partnership, Pty Ltd company or a family trust. You need to know this before you sign the contract because it can be a real drama to change it afterwards.

You'll buy the business with the clear view to re-selling it.

Here on the Sunshine Coast businesses generally turnover every 3 to 5 years. Your goal is to be out with your target profit in that time, but to be committed to that time as a minimum. Buyers are very suspicious of businesses that have only been owned for a short period.

You'll see the real potential in this region.

We have been and are in one of the most buoyant economic times ever. National economic growth rates are predicted at a minimum 3% per annum, perhaps even more here, because on the Sunshine Coast we are looking at a 100% increase in population in the next 20 years. Many people who have bought through us in the last 5 years have succeeded beyond their best expectations. We will be happy to introduce you to them.

You won't be frightened of competition but have a healthy respect for it, keep your eye on it, and be able to learn from it.
From a location point-of-view, you'll know the best place you can be is where there are similar or the same type of businesses.

Whenever you see a McDonalds, nearby will be a Hungry Jacks, a Pizza Hut and a KFC. Car dealers cluster together. Shopping centres contain many similar fashion stores. Industrial areas contain many similar businesses. You'll know that the important thing is to be where the traffic is, or where you can attract it. After that, it's up to your skills to maximise the opportunity.

You'll know the wisdom of always dealing with the vendor through a thoroughly experienced third party like us who can easily resolve the many issues that can come up.

Situations sometimes arise where, for example, a vendor may be reluctant to show you the balance sheet because it contains personal details which are pertinent to the business, e.g. loans to children, but which do not affect the final outcome. There are ways around this, as there are ways around a vendor's refusal to show you tax returns for personal reasons.

On the other hand, balance sheets can hide many skeletons, e.g. accumulated losses. It is always better to deal at arms length.

You'll discuss the purchase with your insurance broker. With the skyrocketing litigation damages being paid out today, having insufficient cover is courting serious danger.
You'll buy a business you'll enjoy working on!!

Your business should be a source of pleasure and satisfaction as well as wealth. So, if you don't like people, don't buy a people-orientated business. If the business requires more than 5 days a week, be sure you are ready for the commitment and ready and able to put in the time and effort. If you're not used to more than 5 days a week, think carefully. If you are used to longer hours and you can find the right business that requires less, you'll think you're on a permanent holiday!

Profit & Loss (P & L) and Balance Sheet Explanation
The primary purpose of any business, big or small, is to make a profit. If a business doesn't make a profit, it is just a question of time before it goes broke. ‘Cash' or ‘income' is the lifeblood of the business. All businesses sell something, either a product or a service and if the amount of sales they make doesn't exceed the costs involved in producing and selling the product or providing the service, the business is in trouble.

The combination of the Profit and Loss (P & L) statement together with the Balance Sheet reveals the true performance of any business.

The P & L tells you how ‘profitable' the business really is.

The Balance Sheet tells you where that profit then went - usually into buying new equipment, repaying a loan, or as Owner's Drawings.

The P & L has just three main components: First, the total ‘Gross Sales' of the business: Second, the ‘Cost of Goods Sold': and, Third, the general day-to-day ‘Expenses' of running that business to make those sales.

‘Gross sales' is the total amount of money the company takes in from the sale OF EITHER THEIR PRODUCT OR SERVICE before any costs or deductions are made.
‘Cost of goods sold' is the cost of what you have to buy (products} to resell it for a profit. If a business sells a product, the business has to either manufacturer that product or purchase it from another business. For instance, if the business is a restaurant, they purchase meat and vegetables from butchers and fruit shops, then cook the food to produce meals to sell to customers. These food purchases are the Cost of Goods Sold.
‘Expenses': In the process of selling meals to customers, the restaurant incurs everyday expenses, such as rent on the premises, wages for staff, electricity, insurance, phone, and all the other costs involved of running a business.

This applies whether the business sells either a product or a service.

From the GROSS SALES, deduct the COST OF GOODS SOLD to get the GROSS PROFIT.

From this GROSS PROFIT deduct the EXPENSES and you have the NET PROFIT. Net profit shown as a percentage (%) of Gross Sales is good indicator of the performance of the business compared with other similar businesses.

GROSS SALES - often called income, revenue, or turnover
(total amount of money that was paid by customers for all meals sold by the restaurant)
$345,678

Less the COST OF GOODS SOLD
(total cost to buy the meat & vegetables)
$123,456

GROSS PROFIT
(the difference between the ‘Gross sales' (income) and the cost of the meat and potatoes etc)
$222,222

Now deduct the Expenses
(see the breakdown of expenses below)
The day-to-day costs of running the business
-$192,200

Therefore the NET PROFIT of this business is
$30,022

The difference between the ‘Gross profit' and the ‘Expenses' is the net profit; the actual net earnings that the owner of the business has as his/her income, before repaying loans, paying income tax or buying new equipment for the restaurant.

The NET PROFIT as a percentage is
13.5%

The NET PROFIT expressed as a percentage gives you a good idea of the efficiency of the business. In this example the business shows a NET PROFIT of 13.5%, which just happens to be the industry average profit for that type of restaurant.

The day-to-day expenses of the restaurant would look similar to the following:

Expenses:

Accounting Fees - $200
Advertising - $2,000
Bank Fees - $1,000
Cleaning - $1,500
Insurance - $2,000
Laundry - $1,200
License Fees - $200
Repairs & Maintenance - $2,000
Wages - $100,000
Postage - $100
Rent - $80,000
Telephone - $2,000
Total Expenses - $192,200

Some businesses may appear to be very successful because they are busy with plenty of customers. But until you see the Profit & Loss statement you can never be certain how profitable the business really is.

Using the restaurant as an example, if the restaurant has reduced the price of its meals to be very competitive against its nearest opposition, it may be very busy, but the Cost of Goods Sold will be higher relative to Gross Sales. There will be less Gross Profit so our restaurant's Net Profit will not ‘look' as good.

Another example is a restaurant where the Owner showed us figures that just didn't seem right. In our (long) experience his Cost of Goods Sold was much less as a percentage of Gross Profit than the industry average for that type of restaurant in that area. On closer examination it turned out that the Owner had been paying for these supplies with a private credit card and not shown this expenditure in his P & L at all in order to make both his Gross and Net Profits look better.

There are many factors which can affect the profitability of a business. With our restaurant, the Cost of Goods Sold may also be too high because the staff may be pilfering food for their own use unbeknown to the owner, so the Gross Profit will appear to be too small because the owner is buying more meat and vegetables than is required for the amount of meals they are selling to customers. That's why profit percentages are useful in determining how well the business is being run or to show if the owner is not telling the truth in their P & L.

Also, for example, if the rent on the premises is excessive, the % of the rental cost is sapping the profitability of the business. Wages are another key factor which can significantly reduce the profitability.

The Balance Sheet is the second part of the performance indicator and shows where the Net Profit has actually ‘gone' at any time. It is a ‘snapshot' of the full, financial position of a business at a specific particular day or time.

The Net Profit will normally have gone into Increasing the Assets (more plant and equipment), Reducing Liabilities (repaying a loan by using some of the profit to reduce liabilities in much the same way a mortgage repayment reduces your liability and increases your equity); or it has gone into Owner's Equity.

A Balance Sheet can be confusing, but shouldn't be, and is sometimes used to ‘hide' certain expenses of the business to make the profit picture look better. Look out for expenses such as ‘Repairs & Maintenance' which may be shown as Assets in the Balance Sheet but are really expenses that should be in the P & L.

This means the Net Profit figure in the P & L will be wrong and is not a true record of the company's profitability.

The most notorious case of this was the Enron scandal in the USA where company executives placed huge sums (billions of dollars) of Expenses in the Assets part of their balance sheet. The profit looked great but in fact the company was effectively bankrupt and trading illegally.

There are 3 main components of a Balance Sheet: Assets, Liabilities and Owner's Equity.

Assets are tangible items that a business owns, such as plant & equipment. (P&E)
Liabilities are what the business owes, such as a loan from a bank.
Owner's equity is the remainder and is what the owner's investment in the business is worth.

So, with the restaurant, it looks like this:

ASSETS - Plant and equipment (P&E)
$120,000

LIABILITIES - Bank loan
$100,000

Owner's equity
$20,000

When assessing a business, always insist on seeing figures produced by the owner's accountant, to help ensure the integrity of the P & L and the Balance sheet.