Buying an existing business can be a suitable approach to getting into your own.
But when you haven’t had a lot of small to medium business experience I’d imagine its pretty bloody hard to know where to start to qualify whether a business up for sale is worth the asking price.
Let me qualify this advice first.
Although I’ve never bought a business for myself, I’ve started a few, and lead just as many. I’ve been all over Profit and Loss Statements, Balance Sheets and Cashflow Spreadsheets for almost all of my working life – so it’s fair to say I have a bit of an idea about business financials, a businesses health, and the present and future value of a business.
So here’s the necessary statement – I’m no accountant. What I’m providing here is some ideas on where to start, when trying to qualify the purchase of a small business. This advice does not substitute nor negate the need for proper advice, legal and / or accounting.
Know why they’re selling.
Geez this important. You want to work out if this is a one owner car, always loved and cared for that heaps of great years ahead, or if the owner sees a problem with the motor coming up, and they’re trying to pass the problem off.
The motivation to sell should be a massive factor in your decision to buy,
Understand the financials.
Not just, ‘they said they were doing this much in sales’.
See the financials.
If they can’t provide solid financials – I’d walk away. At minimum, they should have a neat monthly Profit and Loss they can generate, showing at minimum 6 months. If you can see greater than 12 months, even better – it’ll take into account seasonality and other ups and downs.
Sales don’t mean they’re making money on the bottom line (net profit). Sales are an indication that people are buying the product – that’s all. And we all know you can price yourself at the bottom to win sales. That doesn’t mean you’re making money.
The bottom line is an indication of if there’s value in the transaction (and hence business) for the owner.
Does it look like a legitimate P&L? If they’re a wholesale business, have someone that understand that business model look at it. They know the Gross Profit % you should expect.
If you don’t understand margins, profitability, expenses, and bottom line expectations, consult with someone that does. Perhaps in the early days, this isn’t an accountant, its someone that just gets it.
Maybe when you get a bit further along with your due diligence, that’s when you go to the expense of hiring an accountant to look at it from a professionals point of view.
Do they have all the costs in there? Are the owner’s wages or salaries in there or they taken out post Profit and Loss? i.e. The monthly Profit and Loss shows a profit, but there are no wages in there. Wages are being taken as profit. This is fine, but you need to consider it in your valuation of the business.
Does the business money? After all is said and done, you should care about this more than anything – what profitability is dropping to the bottom line every month. This figure should be the key driver in the negotiation on the sale price of the business. It represents you’re ability to make an income from the business AND MORE IMPORTANTLY your ability to repay the business loan you take out to buy the business.
Understand yourself, and the business.
- Are suppliers stable.
- How has the market changed since they began?
- What does the future look like?
- Have sales plateaued or are they on the rise?
- What are the strengths, weakness, threats and opportunities?
- Is it a trend, or is it a viable long term business?
- Does the business rely on the expertise of individuals currently in the business, or can it operate successfully without them?
- Is it the right business for you and your family? Can you love it? Will you want to work on it, when you don’t want to work on it?
- The questions could go on, and on, and on. I imagine, if I was in the situation of looking to buy a business, I couldn’t ask too many. Neither can you.
What I’d consider when valuing a business.
There are a number of models one would use to value a business for potential sale. Google them if you like…
Here’s what I’d be doing if I was considering the value of one I was looking at.
How much profit are they making per annum? As mentioned – pretty simple. Its an indication if the business is healthy, if you’ll get paid for your hard work, and if you’ll have the capacity to pay off your debt.
How stable is the business? This will give an indication of future profitability. Just because they’re making money this year, doesn’t mean they will next year. Make sure the profit isn’t from a flash in the pan trend, or a business threatened by a greater risk in the market. e.g A change in laws, supplier issues etc.
What is the potential size of the market? Have they extracted the value out of the market, or is the room for growth? Are you the right person to take the business to the next level?
What assets are held by the business (or being sold with them)? How much stock is coming with it, and what is the value? Are there machines or other tools of the trade included, and what is their current value.
How much of the profit could you take as wages, and what would be left over to service the business loans?
Again – caveat – I’m no accountant, this is anecdotal only. Always get advice first.
Most valuation methods will go off a multiple of the net profit (EBIT or EBITDA). A business with massive future potential will command a higher multiple than say a flash in the pan.
It could be upwards of 3 to 4 or even more. That is, the business will be valued at 3 to 4 times to annual net profit. e.g. They’re making 40K per year, multiply that by 4 and the business is valued at 160K.
Things that may move the multiple (business valuation) up;
- Rock solid financial history, long term business, predicable profitability
- The market has a lot of unrealized potential, or is predicated to grow significantly and the business is perfectly positioned to move on it
- You have particular relationships or contacts that could help you achieve success in this specific industry
- Rising market share in sales, or rising profitability
- The business has a good spread of customers – no one customer commands more than 25% of the business sales
- The business has predicable recurring revenue
Things that may move the multiple (business valuation) down;
- The business is new, has very little history and trends to go off
- The product or service creating the sales is a trend, and there isn’t plan to grow the business after that dies off
- The owner / operators wages are not on the P&L as a business expense
- Insufficient financials
- Stagnate growth
- Other threats to profitability or growth exist – supply chain issues, customer issues etc
- The business is reliant on a small number of customers for it’s success
In summary – if you’re in the position of considering the purchase of a new small business, make sure your due diligence and a lot of it.
Make sure you see plenty of tangible evidence of the business’ position and get appropriate advice to help you substantiate and understand it. Finally, ensure it fits the lifestyle you want to build.
- Get professional advice if you’re in a position to make a business decision like this. This will probably include lawyers and / or accountants dare I say it.
- I’ve never bought a business myself, however, I’ve started two of my own, one for someone else and lead others before as well. So feel free to take this advice with a grain of salt, if you’re more qualified. And good for you if you are!