What to know before you buy a business

There are important elements to consider when reviewing a business with the intent to purchase.

Taking the time complete a thorough investigation is critical to discover the hidden facts.

First glance

Don’t invest time or energy until you’ve seen the financials.

I estimate that only 30 per cent of owners who request an evaluation have realistic expectations.

It is my policy to see a recent 12-month income statement before investing too much time.

Important questions

Why is the owner selling?

Is there competition or new technology threatening the business?

Answering this question will typically involve speaking with owners of similar operations in other markets and using as many other resources as possible to investigate completely.

Can future potential income be taken into consideration? 

It’s important to know the potential that exists to add value to the operation.

That future potential should not be used to form your opinion of how much it is currently worth.

How integral is the current owner to the success of the business?

If the owner is the current principal driver, are you able to find a suitable replacement who can achieve your future growth expectations?

How do you deal with unreported cash taken from the business? It’s difficult to substantiate and cannot be used to determine its current value.

Make sure the owner has talked to his accountant and is aware of tax implications of the sale.

You don’t need to hear after investing time and money in your due diligence process that the owner has decided not to sell due to excessive tax that will be triggered upon disposition.

Determining the price

Internally generated income statements are acceptable for my initial review.

An important part of my formal due diligence must be analysis of “Notice to Reader” statements used for tax purposes.

There are obviously many different types of businesses which means that there could be a high amount of capital assets (such as a manufacturing plant) or low or no assets (such as an insurance company).

Typically the value of the business will be more weighted on the reconstructed EBITA rather than the value of the assets.

EBITA is an acronym for earnings before interest, taxes and amortization. Before calculating EBITA it is always necessary to determine if it is necessary to reconstruct the expenses.

Examples of when adjustments are required include but are not limited to, attributing market value numbers for all wages including  Operations Management ( the current owner(s) may be paying themselves above or below market ), removing personal insurance or vehicle expenses, adjusting for a one time legal expense or an unusual non-reoccurring capital improvement.

There may be occasions when you know that property taxes or lease costs will be increasing considerably next year.

Factors such as these could significantly reduce the bottom line.

Businesses such as hotel/motels, apartments and self-storage facilities are commonly appraised by applying a capitalization rate to EBITA to arrive at a combined value for the business and real estate.

The formula is different in examples where the business could easily operate from an alternate location but the real estate and businesses are nonetheless being purchased together.

In that case it is necessary to calculate the value of the real estate and the business with separate methods.

Differences between an asset & a share sale

Agreeing to enter into a “share sale” means that you will be assuming the owners depreciated book value of the current assets.

This will impact your annual corporate tax payable.

I advise that the owner’s accountant calculate the consequences of a “share sale” to both buyer and seller.

Be sure that the “share sale” purchase contract provides for the liability of future employee remuneration and unknown legal issues that could surface.

It is common practice to establish an “asset sale” value based on 3 to 4 times EBITA on businesses under $10M. Businesses with a value above $10M warrant a higher multiplier.

Once the “asset sale” number has been established, the “share sale” value is arrived at by reducing the “asset sale” price by an amount equal to the savings in tax that a seller will realize by entering into that “share sale”.

Other considerations/questions

Is there deferred maintenance or outdated systems which will require significant capital expenditure in the near future?

Does the business rely upon one or two key clients or is it well diversified?

Is it important for the owner to spend time training the new owner?

Financial institutions aren’t typically excited about lending based on “goodwill.”

Are you aware of the amount of initial investment and ongoing cash that will be required?

Is the purchase/sale contract a document which has been developed for this type of specific business purchase? 

There are many elements of a business sale that differ from a real estate purchase

This gives you a quick overview of some things to consider. Be sure to engage a team of professional accounting, legal and commercial real estate advisors to assist with due diligence and closing.

Posted by Barry Stuart

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