Buy a Business: What to Look For
18 June 2018
That being said, there are a number of important issues that need to be considered when buying an established business and most of such issues are part of the due diligence that any reasonable buyer would perform prior to writing the big check. Here is a list of some of the major ones:
Audit the Financials
One of the most important aspects of your due diligence is verifying the target’s claimed revenues and expenses. Ask for three years of income and expense (P&L) statements as well as three years of tax returns. Are revenues trending up? Down? Steady? Up is good. Steady might be good. Down is a red flag and a signal for a deep dive to try to find the reason.
Are expenses steady as a percentage of revenue? Has one category or another increased or decreased significantly in any of your year-over-year comparisons? If so, find out why and try to determine if such an anomaly is likely to occur in the future.
Can you identify any waste? Have the owners padded the payroll with their wastrel offspring who, in reality, spend their days playing video games in the darkened basements of their friend’s houses?
Study the numbers for hidden costs. Get bank statements for at least the most recent full calendar year and the current year to date. Do the math. Make sure the numbers add up. If there are discrepancies, get an explanation. Some discrepancies may be easily explained. If they aren’t, something may be fishy. If you are still keen to buy this particular business, keep digging.
Evaluate the Customers
A major concern in this category is how diverse the customer or client base is. If you are considering acquiring a wholesaler, 40% of whose sales are to Walmart, a change by Walmart could decimate the business. BIG risk! We’ve consulted with and handled the transfer of such businesses over the years and our experience suggests that any business that has a customer that represents more than 20% of revenue entails significant risk. In such cases, ask yourself the following:
- Can you, within a reasonably short period of time, build a more diversified customer base?
- Is the “major customer” locked in with a contract?
- Have sales to this customer been increasing or decreasing both nominally and as a percentage of overall sales?
Other customer-centric questions to ask include: how long has the business enjoyed a relationship with its existing customers? Are any of those customers under contract? (If so, get copies of those contracts.) What percentage of revenue, if any, could be classified as “recurring”?
Are the Sales Sustainable?
Every few years, there is a big and usually inexplicable craze – a recent example is something called fidget spinners – and for however long that craze lasts sellers make a killing. But the craze eventually cools and millions of fidget spinners get sent off to third world countries (thereby melting the frontal lobes of the brains of their kids) and manufacturers and sellers of such products see a big drop in revenue.
You would think that the first two steps described above – audit the financials and evaluate the customers – will go a long way to determining if the business’ sales are sustainable. After all, if you have three years of financial and tax information, all of which show steady growth, one might assume that the business’ revenue level and growth would continue. But that is not always the case.
Some businesses exist for a specific project and, once the project is completed, the business has no real purpose. Prominent examples of such projects are infrastructure and public works projects.
Boston’s “Big Dig“, for instance, took 16 years to complete and required 3.8 million cubic yards of concrete. If the concrete supplier was brought to market in year 12 of the project, its revenues over the previous three years would look very handsome, indeed. However, there was sure to be a significant decline in those revenues a couple of years later!
Speak to the Players
Who are “the players”? Customers, suppliers, employees, clients and anybody else with a hand in the operation of the business.
There is much debate about how to handle this aspect of acquiring an existing business. In many cases, the buyer would be wise to keep the acquisition confidential, at least for the first several quarters. (I discuss why, here.) But there are other circumstances wherein speaking to the players is a critical part of your due diligence.
- Key employees. You will probably want them to stay.
- Key customers/clients. You may want to develop a personal relationship with them early on. You may also try to get a sense of their needs and to assure them that you are committed to maintaining the relationship they’ve had with the seller.
- Suppliers/vendors. Developing a personal relationship with suppliers is not necessarily as important as developing one with your customers – unless only one supplier can provide a critical component of whatever it is that the business sells. If there aren’t multiple suppliers of everything you need, get to know the existing suppliers and get them onboard with the business transfer.
Understand the Value
What is the business worth? This is the eternal question.
Every business will represent a different value to different people. The seller will have one value in mind, the buyer another. The “market” a third. I advise getting a valuation done by an experienced professional business broker or business appraiser. Such a valuation will tell you – and the seller, if you feel the need to share it – what the market says the business is worth. A smart seller will have gotten a valuation done before bringing the business to market. If so, and if the seller is offering the business for a price that is at or near the business’ value, the seller will likely share the valuation with you as a means of justifying the price.
There are occasions when a buyer might be willing to pay more than the broker’s valuation suggests is the market value of the business. Such instances would include the ability to secure a lucrative contract that would be unattainable without the subject business. Another would be the buyer being faced with a firm drop-dead date for fully performing on a contract in hand. These are not situations we encounter every day but they do happen. If you’re considering acquiring a business because you “need” or just “have to have” the one you’re looking at, this may describe you.
Regarding Due Diligence
I’ve put together a list if documents any sensible buyer will need in order to perform a level of due diligence that will provide a high degree of confidence that the business is what the seller says it is. If you’re a buyer, you can download it for free simply by telling me where to send it.
If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. For example, if you’re looking for a business to buy, what is your biggest concern about the process? Are you wondering how much to pay or how long the sales process might be, let me know. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!
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