The basics of buying a business

Buying a business (as opposed to starting a business from scratch) can be daunting, especially if you have never been in business before. There are a number of steps you should follow to make sure you are making a sound investment.

Once you have found a suitable business, you'll need to verify the state of the business before you complete the purchase. This includes ensuring the sales are as good as the owner says they are, that employees will be happy with a new owner, and customers will remain loyal once you take over the business.

The main reason most people buy a business is for the infrastructure and ongoing cash flow. Make sure you investigate these thoroughly. It is also one of the reasons people buy franchises; they usually come with supplier agreements and a proven system of what works and what doesn'€™t.

On this page:

• The initial approach
• Initial due diligence
• Detailed due diligence
• Making an initial offer
• Next steps

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The initial approach

A business owner will want to sell the business for as much money as possible, and as the buyer you want to pay as little as possible. Once you have identified a business you want to buy, your aim is to make the seller want to sell the business to you on your terms and at your price.

Establish your credibility

Formally register your interest in buying the business. The owner will usually have instructed professional advisers, such as a business broker, lawyer or accountant, to sell the business. Approach the advisers, rather than the owner, to explain why you are interested. Your integrity and your future plans for the business are usually extremely important to the seller.

It is a good idea to get your own advisers to negotiate on your behalf. Often the buying and selling of businesses can get emotional, and your adviser will give you objective advice and negotiate on your behalf, without any personal stake in the outcome.

Work out the seller'€™s objectives

For example:

• Does the seller have to sell? If the answer is yes, what time pressures are they under?
• Does the seller wish to sell the assets or a company that holds assets?
• Is money the prime motivation for selling?
• Does the existing management aim to stay involved in the business?

If you know the seller€'s objective, then you have an advantage in the negotiation process. For example, if they have to sell within a certain time period then you are more likely to be able to negotiate a lower price.

A question always to ask is: €œIf the business is as wonderful as they make out, why are they selling?

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Initial due diligence

A preliminary '€˜due diligence'€™ needs to be completed, to ensure the business has no major problems, before you make a firm offer. The seller will often gloss over the weak areas of the business, or put effort into creating short-term gains to give a favourable impression of the business. For example, lowering stock levels to artificially inflate profit before stock needs to be re-ordered can make the business seem more profitable.

Stories of key facts coming to light after a business sale is signed abound: employees claiming ideas are their intellectual property and not those of the past owner, new zoning laws are passed, a larger competitor opens a store nearby... Often, these are the real reasons the business owner is looking to sell. Investigate the business thoroughly before you even hint at being interested in buying it.

Get a feel for the business

• Research its market and its main competitors.
• Assess the key risks associated with the business's future trading and with the industry as a whole.
• Talk to their customers, and anyone else involved, such as suppliers.
• Try to have as much access to a business as you can before you indicate any interest.
• If the business has a location, stand outside (out of view) and estimate the sales activity. Visit the business at different times, both announced and unannounced. A buyer of a restaurant was fooled into believing the business they were considering was doing well because the seller invited friends around for a free meal every time he knew the buyer was appraising the business.

Ask industry experts for their views

• What is the prospective demand for the business'€™s products or services?
• Are prices (and margins) rising or falling?
• How is the competition in that market changing? For example, which new competitors are entering or who else is looking to exit?
• Contact the local industry association if there is one (for example, if you were looking at a tourism business you could talk to the Tourism Industry Association).

If the business is not making a profit, try to uncover the '€˜fatal flaw'€™. For example, it is not a good investment to set up a cafe in a location where three other food and beverage businesses have gone bust.

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Detailed due diligence

Once you have indicated that you're interested in buying the business, you can usually get access to more detailed information after signing a Heads of Agreement, or confidentiality statement. For detailed due diligence, we recommend you do the following.

Contact some customers and ask them

• Who is their main contact at the business? If their main contact turns out to be the owner, his continued involvement will be more valuable.
• What is good and bad about the business'€™s products or services?
• Do they use competitors? If so, what are their comparative advantages?
• What will the customer'€™s future demand be for the business'€™s products or services?

Ask suppliers for their views

• Does the business pay on time?
• How does it compare with competitors?

Analyse historical information and trends

• Look at sales growth, profit margins, overheads and working capital (debtors, creditors, stock and work-in-progress).
• Is there scope for improvement?

Check for inconsistencies

• Has the business recently changed its accounting policy (for example, on stock valuation) to show better profits?
• Compare the business's financial projections with other evidence you have. Do they tally with the historical trends? For example, are the debtor payment periods and the bad debt provisions realistic?
• Is the sales forecast achievable, given the current order book and the customer statements?
• Does it reflect the outlook for the industry and the whole economy?

You may need to revise any projections that are out-of-step with these indicators.

Check up on major balance sheet items

• When was the last full audit? If it was over six months ago, do another one.
• What are stock levels? Rising stock levels may be a dangerous sign, especially in manufacturing, seasonal or fashion industries.
• How large are the bad debts?

Employee audit

Consider an employee audit if you are allowed access to the business.

• Identify the key employees so you can plan how to run the business.
• Assess the general skill levels, employee turnover and pay, compared with industry averages.
• How do the employees feel about a change of ownership?
• Would you expect any to leave? If so, would the key people stay?

Complete a legal due diligence

• Confirm legal ownership of all key assets. This might include property, equipment, vehicles and intellectual property (such as registered patents, designs and trade marks).
• Check for any past, current or pending lawsuits.
• Examine all contractual obligations. This includes employment agreements (including any superannuation), and contracts with third parties such as customers and suppliers. Look for contingent liabilities.
• Consider what effect a change of ownership will have. Some contracts may be lost as a result.

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Making an initial offer

Before you make an offer, get professional advice to help you value the business (especially if there are any tax implications). Make your own sales and profit projections rather than relying on supplied figures. If you can't identify where savings can be made, and where there is scope to increase profits, then you shouldn'€™t be buying the business. The fact that you have ideas on how to increase profits is your good fortune, so don'€™t inflate the price you offer because of opportunities you have identified.

Consider your level of risk. Risk is higher if the target business:

• Has assets (stock and equipment) worth less than your offer price.
• Relies on one or two major customers (or contracts, or suppliers, or key employees).
• Is currently unprofitable, or has a history of losses. In this case, you may have to fund losses for some time to come.

Though it sounds obvious, starting with a lower offer and increasing it if required is always a better strategy than going in high at the start.

Ultimately, the business is only worth what someone will pay for it. The seller might have to lower their expectations.

Goodwill

Goodwill is an amount you might be expected to pay in recognition of the value of the business's intangible assets like loyal customers, high profit, great staff, good location, long lease, and supportive suppliers. Try to negotiate goodwill down to zero if you can. Paying for goodwill is not always required and it is better to agree to pay more for assets than pay goodwill because assets can be depreciated over time.

Buy now, pay later

You might want to ask the seller if they will consider 'buy now, pay later'€™ options. Instead of paying a once-off lump sum, you'€™ll pay them off over a coupe of months or years. This arrangement allows you to pay using cash generated from the business itself, and hints at the confidence of the seller that their business will be able to fund repayments.

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Next steps

• If the business is a company, go the www.business.govt.nz/companies website and search for the company name.
• Get an expert to help -€“ someone who understands how businesses in your industry are valued. Ask your accountant or bank manager.
• Search the Insolvency Register to ensure that the owner isn’t bankrupt.
• Find out more about due diligence when buying a business. You'€™ll need to do detailed research on the business you want to buy, the owner (credit history and Internet search), the business suppliers, customers, staff, and competitors.