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Guide to buying a Small Business

So you are thinking of buying a small business.

That’s great! This workbook will guide you through the buying process.

Before you hand over the money and become the proud new owner of a small business, there are many important questions you should be asking yourself and others. Seeking and finding answers to these questions will assist you in making a better decision. The checklist in this workbook, while not exhaustive, addresses most of the important issues that should be examined when buying a business.

To Buy Or Not To Buy

Basically there are three ways of getting into business. The first is to start a new business, the second is to buy an existing business and the third is to buy a franchise.

The best option for you will depend on your own personal circumstances and the type of business you wish to run. For example, if you are planning to offer a product or service which will be totally new to the market, you will probably lean towards starting a new business. In this situation you will not be limited by the operations and reputationof an existing business. Nor will you be locked into a predetermined image and structure of a franchise. In the end, your decision must be the one that best suits your objectives and matches your resources.

When buying a business you are purchasing stock, equipment, a location and more importantly, customers and a reputation. This reputation and customer base is quantified in the selling price as goodwill. To the buyer it represents the difference between the value of the net assets of the business and the asking price. Assessing the value of a business and in particular the value of the goodwill component is not an easy task. This workbook will highlight the questions that need to be answered for the purchaser to make an informed decision.

The advantages of buying a good business that was well researched are:

  1. Less risk and a better chance of success because you have assessed the opportunity and there is scope to build and improve the business.
  2. An existing business will provide you with an immediate cash flow. A new business will take time to achieve a steady cash flow.
  3. A successful business will have many of the processes already in place, therefore it offers a quick and less complicated route into business.
  4. A proven business track record can improve your chances to obtain finance.

The disadvantages of buying a business that is poorly researched are:

  1. You may buy a business with problems. These problems can be poor customer relations and reputation or outdated products and equipment. Some problems may be corrected in times but others such as the location not being suitable or the industry being in decline, can be disastrous.
  2. The success of the business may have relied heavily on the current owner and his/her knowledge of the market and this may not be easily transferred to you.

With this workbook and the help of your professional team, you can properly research a business, ask the necessary questions and understand your own resources and capabilities to help you make the right decision.

This book is a general guide to buying a small business. However, there can be no substitute for seeking professional advice and also talking directly to people involved in the industry of interest.

The theme of the workbook is to encourage you to seek advice and answers so that you can carefully plan your business venture. The trick is to do this with the help of your professional team. At the very least your team should comprise your Business Enterprise Centre Manager or Small Business consultant, an accountant, a solicitor and a bank manager. By working with your team, the task will not seem daunting and the process will be more thorough and effective.

Answering the questions posed in this book will not only minimise risk but will also improve your ability to access finance. By providing the relevant information to your financier and by demonstrating that you have researched the venture carefully, the financiers decision process will become easier and quicker.

Preparing For Business

Business is an opportunity to increase (or lose) your capital wealth over time. It is important to recognise that few businesses are a ‘licence’ to print money.

Your chances of success will be greater if you understand and prepare yourself for the problems you will encounter as a business owner. It is important to match your personal strengths and interests with a suitable business.

This self examination is the first and most important step to owning a business. It can also help to eliminate potential cause of failure.

Be honest

You must be sure that you want to go into business because it can be very demanding. It can place great stress and responsibility on you personally and greatly effect your lifestyle.

Be realistic

Consider the advantages and disadvantagesof being your own boss. While it may provide self satisfaction, independence and the opportunity to earn more money , you must also consider that it may mean:

Be self critical

You need to look at your own personal strengths, weaknesses and your general suitability to run your own business.

Are you:

Do you have:

Are you suitable?

The following table presents a list of personal characteristics which you will probably need to be successful in your business.

The best way to answer each of these questions is to think of past examples in which you have had to display each requirement. Did you cope adequately in that situation? If you did not handle the situation well, consider how you could improve this requirement e.g. undertake a training course?


Personal Characteristics
Personal Characteristics
How do you rate your: Adequate
Yes / No		 If inadequate,
how can you improve?
Ability to handle stress?
Business, accounting and legal experience?
Knowledge of the industry or the profession?
Drive and energy?
Organisational ability?
Level of self confidence?
Commitment to the longer term?
Ambition?
Leadership ability?
(can you motivate staff? Could you dismiss someone?)
Level of determination and the ability to solve problems?
Ability to set clear and attainable goals?
Ability to take moderate, calculated risks?
Perseverance?
Willingness to seek and take advice?
Willingness to take personal responsibility?
Negotiating skills?
Ability to cope with crisis?
Ability to communicate?
Objectivity?
Selling Skills?

The reasons for going into business

The following table presents a list of possible reasons that you may have for deciding to purchase a small business. Answer the questions by ticking yes or no.


The reasons for going into business
Reasons Yes No
Frustrated in your present job?
To earn a better living?
To be more independent?
To be your own boss?
To do something different?
To have flexible hours?
To lead a group of people?
Out of work?
I want to prove that I can succeed in something challenging like having my own business?
I have seen an opportunity that is not being serviced by current operators?
Other?

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Now that you have answered these questions, take another look at this table. Of those questions that you ticked yes, which one do you think are good reasons for entertaining the world of small business?

For example, while small business owners may appear to have flexible working hours, more often than not the hours are just plain long. Or, if you are frustrated in your present job, why?

Is it because you don’t like your current boss or you have a burning desire to be your own boss. Remember every customer is your boss in business!

Think carefully, buying a small business is not easily reversible decision.

There are other important personal issues which need to be considered before buying.

These include:

Your health

Are you in good physical health, or do you regularly suffer from illness or have a condition which prevents you from working?

Family support

Is your family 100% behind you in your endeavour? The pressure and disruption that can go with running a new business can strain personal relationships. For example, one owner described the dilemma in the following way:

“I want to give more time to my business, but if I don’t give time to my family I will lose their support, and without their support I will lose the reason for having a business.”

Other obligations

Are you an active member of a club, society or association and will your participation distract you from your business?

To be successful, you must be 100% committed. Anything less and you will be substantially reduce your chances of success.

Your Financial Situation

When going into business it is essential that your finances are in order. Begin by being thoroughly aware of your personal assets (what you own) and liabilities (what you owe).

3.1 How much are you worth?

Your Personal Wealth
Your Personal Wealth
Liabilities (what you owe) Assets (what you own)
Housing loans $ House/property $
Bank loans $ Other real estate $
Other loans $ Cash/bank deposits $
Credit cards $ Shares/investments $
Hire purchase/leases $ Life insurance $
Income tax $ Superannuation $
Unpaid bills $ Furniture/personal effects $
Other monies owing $ Other assets $
Total liabilities $ Total assets $
$ Less total liabilities (ie. Subtract total liabilities from total assets) $
Your net worth $

You will need sufficient assets to support your loan application. The leander will want you to bear a substantial portion of the risk.

3.2 What are your personal financial needs?

Your new business must be able to support your current personal financial needs. To find out what income you require, add up all the expenses you have including all bills (monthly, quarterly and yearly) and your regular living expenses.

These expenses should be calculated on a monthly basis and will include house, car and loan repayments, insurance premiums, rates, taxes and any other bills particular to your circumstances. Your living expenses include food, clothes, entertainment, education, spport, transport, etc.

By totalling all of your expenses you have an amount that represents the net (after tax) monthly income you require.


Your Personal Wealth
Regular monthly expenses Other monthly living expenses
House loan payments or rent $ Food (at home) $
Car loan Payments $ Food (away from home) $
Credit cards $ Clothes $
Store cards $ Entertainment $
Personal loans $ Transport e.g. fuel, parking & bus $
Health insurance $ Telephone $
Life insurance $ Electricity $
Superannuation $ Education $
Other insurance $ House maintenance $
Rates council & water $ Car maintenance $
Other $ Other e.g. gifts $
Total (1) $ Total (2) $
Total liabilities $
(plus) Total monthly living expenses(2) $
(equals) Monthly income needed $

Your new business, especially during the early days, will make heavy demands on your funds. As a consequence, you must ensure that there will be sufficient cash available for your personal needs.

Finding The Right Business

Selecting the business for you

There is a wide range of business types to choose from including retailing, manufacturing, service, wholesale, export/import etc. Before you start looking, think about which kind of business is right for you. The type and size of the business should be compatible with your experience, personality and capital.

Many people base their decision on their technical knowledge and experience of a particular product or industry. For example, someone who enjoys cooking or hospitality may assume that a small restaurant/café would be a suitable business.

While technical knowledge is important, operating a small business involves a wide range of activities. However, having experience and some knowledge of the industry you are entering is a definite advantage.

The type of business you will buy must suit you at a personal level. Refer back to section 2 where you examined your personal characteristics and requirements and think about the following:

Your business may occupy you between 60 and 90 hours per week, so it is very important that you enjoy it, otherwise you will soon want to sell.

It may be helpful to imagine the activities you will be doing. Even better, go and talk to the owners of the business type you are interested in. For example, if you think that you want to buy a newsagency, talk to a newsagent to find out what he or she does on a day to day basis (but make it clear you won’t be setting up shop around the corner!). You may be surprised how much some owners will tell you.

Where to look

There are many sources of information which you can use to locate the business for you. These include:

Business Brokers

Business brokers are an obvious source of information since it is their job to sell businesses. They may be a:

Remember that a broker represents the interests of the seller of a business and will be receiving a commission on the sale.

The people involved

During the buying process you will be dealing with a range of people, so it is worthnoting who is involved. They include the purchaser (you), the vendor (seller), the business broker (representing the vendor), solicitors (yours and the vendors), accountants (yours and the vendor’s), lenders of money, valuers, settlement agent, government departments, suppliers, the owner or managing agent of the business premises, insurance company, State Energy Commission, Water Authority, local council, telephone company, yellow pages, white pages and many more.

Your professional support team

While you may be keen to commence searching for your business, now is the time to take a step back and find yourself an accountant and a solicitor with experience in small business, and the nearest Business Enterprise Centre manager.

The buying process can be very complicated and making extensive use of these professionals is essential.

All three will be critical in helping you during the evaluation process. They can help you strengthen your approach to various complex issues in judging the worth of the business, and your prospects as the owner.

They can also assist you to arrange finance, undertake the purchasing arrangements, and provide advice when you are operating the business.

These professionals can be found through:

• Personal recommendations e.g. from your colleges, friends, other professionals. • Referring to section 10 of this work book for your nearest Business Enterprise Centre and the location of the Small Business Development Corporation, or equivalent in your state. • Contacting the relevant association e.g. the Institute of Chartered Accountants, The Australian Society of Certified Practising Accountants, The National Institute of Chartered Accountants, The Law Society. • Checking the White and Yellow Pages. It may assist you if these professionals are near the location of your prospective business.

You talk with them to ensure that:

• They have experience in dealing with small business (possibly even in the specific industry or profession you will be involved in). • That you feel comfortable with them. • That you understand how much they will charge you i.e. Hourly rate, quotation. • That they are prepared to work with each other as members of your team.

Business Enterprise Centres (BECs)

The BECs provide independent, confidential and practical assistance in the areas of business planning, finance, marketing, market research, trade information and industry regulations. The centres are also a gateway to private and public support programs for business.

The BECs will highlight issues to be discussed with your accountant and solicitor and they will put you in contact with other useful resources and information.

The BECs are managed by a voluntary management board representing business, private sector organisations and/or local government from the local area who support a fulltime professional manager. The managers are responsive and experienced with a background in business and management.

The services are free of charge. Contact your nearest BEC for more information.

Your accountant

Your accountant should be a member of either The Institute of Chartered Accountants, The Australian Society of Certified Practising Accountants or The National Institute of Accountants.

Your accountant can help you with a range of issues including the most appropriate business structure for you business (i.e. sole proprietor, partnership, discretionary trust, unit trust or company), prepare a finance proposal for you lender, help research and assess the business, validate historical financial information, value goodwill, stocks and other assets, and provide ongoing advice and assistance following the purchase of your business.

Your solicitor

It is essential that your solicitor has experience in resolving the legal issues surrounding the purchase of a small business. Currently, you can contact your solicitor or there may be a Law Society in your State through which you may be able to obtain a list of solicitors who deal with small business in your area.

One of the most valuable services your solicitor can provide is to help you understand the contents of all the contacts that you will be required to sign.

Your solicitor can also help you negotiate with the seller, complete all legal requirements of the purchase and final settlement, investigate leases and negotiate a new lease, help you to understand government regulations specific to your business (if you contravene these regulations lack of knowledge is no defence), deal on your behalf with government and semi government departments, advise you on the legal implications of various business structures (e.g. partnership, company), and many other issues.

Settlement agents can also be used in finalising the transaction. This includes the arrangement of exchange and stamping of contracts, payment of monies and the adjustment of rates and taxes.

Your business consultant

They are trained to weigh up information provided by your accountant and solicitor and combined this with an overview of the business and its relationship to customers, suppliers etc to give balanced view of all the factors involved.

These consultants can be particularly useful when you intend to expand your business, providing advice on issues such as business planning, staffing, management and marketing.

Seeking A Fair Price

In order for you to determine whether the asking price is fair you will need to know how this price was arrived at. For this reason we have included this section on valuing a business, which explains the most commonly used methods. Remember, this is only a general guide and you should involve your professional team in this process.

5.1 Methods for Valuing the Business

The three most commonly used techniques for valuing small business are:

  1. Return On Investment (ROI)
  2. Asset Value – Going Concern
  3. Market Value

Prior to the 1980’s, Market Value and Asset Value methods were the most commonly used. However, since then the Return On Investment method has become the accepted technique for most business types.

5.2 Return On Investment

The RIO method is generally accepted as the best way to value small business.

The technique measures the return (i.e. profit before owners salary) received from an investment (i.e. purchase price) and is calculated by the following formula:

The price of the business is determined by rearranging the above formula:

For example: if a business is making $50,000 profit and the accepted ROI for that industry is 30% then the price equals $166,667.

As with any investment, the higher the risk, the greater the return required.

5.3 Using the ROI Method

Two figures have to be determined in order to calculated the value of the business using the ROI method. These are the profit figure for the business and the appropriate ROI for the industry.

Profit Figure

The starting point for arriving at the profit figure is the most up-to-date Profit and Loss Statement for the business. Tax return figures are the most reliable source. However, the tax return can become irrelevant if more than one business is owned by the seller of the business. In such cases, a profit and loss statement prepared by your accountant should be used.

For the vast majority of small businesses’ trading figures for the last two years should be used to determine a Profit and Loss Statement. For larger businesses and also for rapidly growing businesses, some averaging may be necessary e.g. a common method is to average the past 2 to 5 year’s, current year’s and future year’s profit. However, the need for averaging is rare for the bulk of businesses being sold.

When valuing a business, you need to consider what profit will be available to you as the owner. You are looking for the ‘operating profit’, which, is the profit generated from the business regardless of how an owner manages his/her financial affairs. Taking this step eliminates income or expenses which are personal in nature, used to minimise taxation, or that are non recurring. These are called add-backs.

The most common add-backs you need to consider in calculating the adjusted net profit for valuation purposes are:

NOTE – other business expense will need checking to verify whether they are accurate or not and the Profit Loss Statement adjusted accordingly. Your Business Enterprise Centre manager or accountant can assist you with this.

Appropriate ROI figure

Because your investment will comprise both your money and your time, the ROI figure used must represent an appropriate return for your time and money, given the inherent risk in the type of business being considered.

If it is difficult to get full and detailed information about the business, then buying the business will be a more risky proposition. If detailed information cannot be found, then the ROI percentage used should be on the high side to reflect the greater risk. Most business brokers and trade associations can provide you with an average ROI for particular industries. Your BEC manager or accountant can also assist you with this.

What should you check

Profit figure:

ROI figure:

To answer these you should analyse some of the questions in the following section. Section 6 considers issues which may seriously undermine the assumption that the profit estimate is reasonable and will continue.

Section 6 covers the overall business situation, so that you can look more closely at whether the business risk demands that a higher ROI percentage be adopted.

One final point, do not pay to much heed to the possibility of capital gains. This will depend heavily on the state of the market at the time you sell the business. As many people have discovered over the last few years, this future market value can fall far short of what was expected when the business was purchased.

5.4 Asset Value – Going Concern

This technique adds the assets of the business (e.g. stock, plant and equipment) to a goodwill figure to arrive at the price of the business.

The goodwill figure is usually assessed as being a multiple of net profit e.g. one years net profit, two times the net profit etc. This is the best illustrated by an example.

Say a business has tangible assets of $100,000 and a profit of $50,000, this method would value the business at $150,000.

*In this example goodwill equals one year’s net profit.

This method will over value businesses with high level of assets. Thus, the technique works best when the assets of the business are low in relation to the profit e.g. service and retail businesses. For manufacturing and wholesale businesses, this technique will often give an over-valuation.

What you should check

5.5 Market Value

The Market Value technique is based on multiplying the turnover of the business by an industry “multiply”. The method was commonly used by business brokers up until the mid-1980s for most retail businesses.

Examples of some of the “multiples” used for retail businesses during the early 1980s when this method was in vogue were:


Business Type Multiple of Weekly Turnover
Lunch bar 20-30
Coffee Shop 20-25
Health food 10-15
Fish and chips 15-20
Restaurant 15-25
Delicatessens 10-15
Florist 15-18
Hair salon 15-20
Liquor Store 10-15

Today, this method is rarely if ever used for retail businesses and these multiples are not necessarily relevant now. However, valuations of professional practises such as legal, accountancy, medical, veterinarian and medical specialist are still done using this technique (instead of weekly turnovers, yearly gross fees are employed in the valuation calculation).

The current “multiples” for professional practises are:


Profession Multiples of Annual Turnover
Accounting 0.70-1.00
Legal 0.30-0.60
Medical 0.40-0.70
Veterinarian 0.80-1.00

The medical and veterinarian multiples can be higher than these rates if considerable plant and equipment is owned by the practice.

What you should check

If the seller has used this method, you should ask why the seller believes that this business is similar to other businesses in the same industry.

5.6 The cost of buying a business

The asking price of the business will generally be the most significant cost to you. However, there are many other costs which you will be required to pay. So, the next time you see an advertisement saying:

Business Opportunities DELI Rapidly expanding area Long lease, new fit out Net profit $50,000 per annum plus Asking $70,000 plus stock

Have a think about what the total cost to you will be.

In addition to the purchase price, you will have to pay for:

All these additional items must be identified and costed so that you are fully aware of the total purchase price of the business and can budget accordingly.

When buying a business the evaluation process is important and you should not be pressured by the vendor or their representatives. You and your professional team, as discussed earlier, should reach your own conclusions on the value of the business.

Many vendors will try to at least recoup the amount that they originally paid for the business. This figure is irrelevant and should not be considered in your assessment. You are only interested in what the business is worth to you today.

 

Botany Bay BEC
21A Dalley Avenue, Pagewood 2035, Telephone: 61 2 9316 5877, Facsimile: 61 2 9666 5141
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