So you want to buy a small business. You may have worked already in your target industry, even for the employer that you are thinking of buying from. What should you look for?
1) Cash flow of the business is the key, critical indicator of success
Make it your mission to know how every dollar comes into the business (revenue), and every type of expense that will require signing cheques or moving cash out of the business (expenses). Most business purchases fail because a new owner did not identify all of the needed cash outlays, or they did not forecast accurately how high costs and expenses would be.
Know what kinds of capital equipment you will be required to purchase, maintain or replace in the next 10 years of your target business (vehicles, computers and software, buildings, warehouses, physical equipment, tools, etc.).
You will need enough positive cash inflows (revenues less expenses) to replace your equipment, vehicles etc when they wear out or become obsolete. Many businesses fail within the first five years because they did not generate enough cash to reinvest in future assets.
2) Request copies of documents from the business.
Documents that are provided by independent third parties are the safest way to verify the facts of the business so you can determine a proper value for the purchase price. Most critical to obtain:
a) Financial Statements: Ask for the past 3 years of financial statements. Most businesses should provide at least an annual income statement (report of annual revenues and expenses) and a balance sheet (report of existing assets and liabilities at a given date, usually December 31 of each year). Get a year-to-date statement if you are buying in the middle of a year.
Find out if the annual statements are prepared internally or by an outside accountant. Also ask if they have been “audited” or “reviewed” and get the audit or review opinion letter issued by the accountant each year. Note: audits and reviews are a process where accountants scrutinize the business’s financial statements to assess if they are reasonably complete or accurate — an audit has much more scrutiny and independent verification of statements’ content, but neither audits nor reviews are a definitive guarantee that the business is clean of fraud or error).
If your target business does not have financial statements, you are stepping into a whole new area of risk and taking a chance on the viability of that business. The purchase price would be much lower based on inadequate information to support a value of the business.
Check the source of deposits into the business: if owners have to regularly deposit personal funds into the bank accounts (to keep the business afloat and able to pay its bills), beware! You may also have to continually prop up the cash accounts with personal funds, unless you have an amazing plan to run the business differently than the current owners.
Review carefully the kinds of cheques written on the business account – consider which of these expenses would be at risk of increasing if you take over the business.
c) Income Tax Returns and Tax Assessments: Most businesses will be reasonably careful in preparing good financial statements for governmental income tax returns. The penalties for lying or misleading statements to avoid taxes can be large.
Consider that some businesses will try to inflate their revenues to a potential buyer on internal financial statements, but will try to inflate their expenses (for tax deductions) to tax authorities. Tax returns always have financial statements attached to each submission — check them and compare with the financial statements the business owner has provided to you. If they are not the same, beware!
If there are no tax returns filed, you may have an even bigger problem – you could be buying into a large liability. Think instead about buying only the business “assets” (customer list and equipment), and starting up your own business from scratch. Always remember if you buy another company or business, you assume all the debts and liabilities, which can be significant risk.
d) Customer Lists and Aged Accounts Receivable Report: Customer lists should give you an idea of the sources of revenue in your target business. Ask to see any formal contracts between the business and the Customer – is the customer obligated to continue using your target business for purchasing goods and services or not? Side note: make sure you have a non-compete agreement in your deal so the exiting owner will not set up a competitive business after he sells to you.
Review the accounts receivable and find out how long customers take to pay their invoices. If the accounts receivable have invoice dates from many months ago, they may be a “bad debt” or give you an indication of high risk and poor cash inflows. A revenue is really not a good revenue until the invoice is paid — high bad debts can cripple a business’s cash flow and ability to survive, especially during market downturns.
e) Supplier Lists and related purchase agreements: Ask for a list of current suppliers and contact names. You may want to call a few of the larger suppliers to make sure the business doesn’t owe a lot of money for goods ordered. Companies on the verge of receivership and bankruptcy often push for large orders from suppliers on extended credit, then are unable to pay. These are the “invisible liabilities” that may not be disclosed on the financial statements. Pay particular attention to volatile swings, or increases, in inventories as this can be a signal of heavy supplier commitments.
3) Use professional accountants and lawyers to draft a solid Purchase and Sale agreement. This costs a bit of money, but accountants and lawyers are trained to find issues and protect you from fatal flaws in a purchase arrangement. Ask around for recommendations from friends or others in the same industry business. A few hundred dollars can save tens of thousands, and be the difference between success and failure going forward.
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