- July 4, 2020
- Posted by: matogconsulting
- Category: Business Advisory
BUYING A BUSINESS
By Ayoade Apelegan
Introduction to buying a business
Buying a business is generally considered less risky than starting your own business, especially if you can buy a well-managed, profitable business for the right price.
Starting a business from scratch comes with its disadvantages, including the difficulty of building a customer base, marketing the new business, hiring employees and establishing cash flow.
Buying a business (an already existing business) shortens the learning curve, reduces the costs of “on-the-job training”, recruitment cost and helps you avoid many of the errors you might make in developing your business from scratch.
In an already existing business, everything is in place, from customers to the advantage of accessing credit facilities at the bank.
Advantages of buying a business
There are some advantages attributable to buying an existing business among which are:
- The arduous task of setting up a business from scratch has already been done
- Buying an existing business means immediate cash flow
- It is easier to secure loans and attract investors because an existing business has a financial history
- You will acquire existing customers, contacts, goodwill, suppliers, staff, plant, equipment and stock
- There is an already existing market for your product and services
- The risk of business failure is lower
- Trained employees in place
- There is an established brand
Disadvantages of buying a business
Below are some disadvantages of buying an existing business:
- The business might require major improvements
- The business may be poorly located or badly managed, with low staff morale.
- External factors, such as increasing competition or declining industry, can affect future growth.
- Under-performing businesses can require a lot of investment to make them profitable.
- The seller’s personality and their established relationships may be a major factor
STEPS TO TAKE WHEN BUYING A BUSINESS
FIND OUT THE TYPE OF BUSINESS ARE YOU INTERESTED IN
When deciding which business to buy, it’s important to go for the one that you are passionate about and have some experience in.
For example, if you’ve been a manager in a travel consulting firm for several years, it won’t be out of place to aspire to own a travel agency.
Buying a business for the financials is one thing, another is being knowledgeable and familiar with the business’s model, products or services, customers, industry, and trends.
SEARCH FOR BUSINESSES THAT ARE FOR SALE
There are various ways to find the type of business you’ve decided on.
- Online business marketplaces
- Talking to people in your network
- Contacting a business broker
UNDERSTAND WHY AN EXISTING BUSINESS IS UP FOR SALE
When you’re about buying a business, it’s important to know the reason(s) why the current owners of such businesses have decided to put them up for sale.
Ask yourself if you can solve the problems and challenges pointed out by the current owner(s) of the business.
You need to know as much as you can about the existing business’s successes, failures, challenges and opportunities.
PICK A BUSINESS THAT ALIGNS WITH YOUR GOALS
After checking out a couple of businesses and meeting with their current owner(s), the best option is to go for the business that aligns with your goals.
ENGAGE THE SERVICES OF EXPERTS
When either buying or selling a business, it is important to have experts to help you during these transactions. A lawyer is needed for interactions, contracts, documentation and various transactions, but an accountant is necessary for the financial data, numbers and funds either being obtained or when buying a new business.
Role of a Lawyer
Lawyers are needed for multiple reasons, but their greatest use when buying or selling a company is to ensure that the entire dealing is valid, legitimate and legal. There are many factors of performing due diligence, and many of these centres around researching the business being sold or purchased. The employees, agreements in place, clients, business associations and numerous other processes need to be checked out. A lawyer drafts contracts that the buyer or seller needs to sign with the other owner. These should have certain conditions to ensure the arrangement is beneficial, and when necessary, advantageous for both parties.
Role of an Accountant
When a company is accruing revenue, it is necessary to have an accountant to keep the books up to date. This means coordinating with payroll for employees, client payments and interactions and other financial matters. Without an accountant, it is more frequent that tax violations and other complications may arise. This means keeping accounts and books maintained is essential for the company. In this way, it is possible to provide the information to the new seller or buyer. This assists in due diligence and increases the perceived value of the company, or it could increase the knowledge with accounts, clients and the financial data.
It does not matter if the business is a well-established business or a startup. An accountant will be needed to assist in analyzing reports, statements and issues that may be complicated. This could all be negative or positive, and they may require the attention of the owner. The accountant knows if the equipment has been purchased or leased and other assets are on hand. This is essential when selling the company so the new owner is aware of what items exist in the inventory. The accountant may compare debt to income, future and past data and explain these matters.
When buying a new company, the accountant may have detailed documents about the company structure so that tax situations may be understood, how much in liabilities are accrued and what assets exist to assist with the purchase. The accountant will also help with business plans and help in determining the actual and perceived value of the company so that an asking price may be determined more easily. With the assistance of a lawyer, an accountant may even ensure that all due diligence has been performed so that no additional issues arise when buying or selling the company.
The accountant might need to visit the premises of the target business to do some confirmation and get a first-hand report.
The accountant conducts due diligence by requesting for some specific documents: the bank statement, the audited financial statements, creditors schedule, debtors schedule, payment vouchers, receipts and invoices, asset register, letter of employment of the owner(s) of the business, loan agreements, vendors agreements etc
The accountant needs all these documents to validate the position of the business as presented in the audited financial statements.
During the due diligence, the following matters, are to be considered:
Reviewing prior years’ financial statements
This process usually involves a review of 3-year financial statements. The purpose of this is to determine the reliability of the financial statements. The following matters will be considered during the review.
- The appropriateness and consistency of the accounting policies followed in the preparation of the financial statement.
- The accountant will set out the financial statements in a columnar format to enable their comparison yearly. Appropriate ratios will be computed to enable easy comparison.
- Variations in trend from one year to another will be investigated as this may be due to unusual non-recurring events or due to material misstatement of information in the financial statement.
Examination of the most recent set of accounts
This is done to enable the accountant to determine the accuracy, completeness and validity of the financial statements as prepared. This is done because the seller may have manipulated the financial statement to present a better view of the financial position of the company.
The accountant’s work is such that he checks to see if:
- Assets are not overstated,
- Profits are not overstated,
- Liabilities are not understated
The accountant pays attention to the following
- Other income
- Cost of sales
- Property Plant & Equipment
- Accounts receivables
- Accounts payables
- Major customers
- Contingent liabilities
- Taxations, amongst others
Other matters that the accountant looks into are:
- Adequacy of the labour force
- The impact of the business that may result from the change in the ownership and management of the business
- Outstanding contracts with customers and suppliers
- Unpaid taxes, levies and dues in respect of back duty assessment
- List of assets
- The remaining life of licenses or franchises and the possibility of renewals after expiration
- The competence, skills and experience of the entire management and staff
At the end of the due diligence, the accountant will write a report to the buyer stating his findings and advising him/her on the next line of action which usually comes in the form of recommendation. The recommendation usually contains the following:
- Technical assistance which may be relevant to the business after purchase
- Valuation and range of purchase price
- Reorganization of the business to staffing and management structures
- Recommendation on internal control and accounting systems
You can also read How to Prevent Having Bad Debts
CONDUCT DUE DILIGENCE
Due diligence is a process of a comprehensive appraisal of a target business undertaken by a prospective buyer, especially to establish its assets and liabilities and evaluate its commercial potential.
Due diligence allows the potential buyer to determine the financial risk involved as well as provide the potential buyer with a stronger position for negotiation.
In conducting due diligence, your accountant or lawyer will need to complete a checklist.
As a potential buyer, you should have an accountant to help review the business’s financials. It’s also beneficial to have a lawyer to represent you in negotiations and to help you understand how the transaction will be structured.
Before the start of the due diligence, the seller will most likely ask for a signed confidentiality agreement or non-disclosure agreement. By signing, you agree not to disclose any confidential information about the business that might be discovered during the due diligence process. This protects the seller in case you have a change of mind about buying the business after reviewing all the documents.
Due Diligence Checklist
A qualified representative should be present during the examination of the inventory. The status of inventory should be known, what’s presently on hand, what was on hand at the end of the previous financial year and the one preceding that. The inventory needs to be checked for salability. Age, quality, condition of the inventory should be known. You should know that you don’t necessarily have to accept the quoted price of the inventory as it is subject to negotiation.
Property Plant & Equipment
This includes buildings, vehicles, office equipment and all assets of the business. Request for an asset register (if available). Present condition, market value when the assets were purchased versus present market value, and whether the equipment was purchased or leased are all vital information. Cost of maintenance of the assets should also be known. For buildings, determine what modifications you’ll have to make for it to suit your needs.
Contracts and legal documents
Copies of all contracts and legal documents should be thoroughly scrutinized.
All lease and purchase agreements, distribution agreements, subcontractor agreements, sales contracts, union contracts, employment agreements and any other instruments used to legally bind the business will be should be made available upon request.
All legal documents such as articles of incorporation, registered trademarks, copyrights, patents, etc, should also be made available. In the case of a real estate lease, you will need to find out if it is transferable, how long it runs, its terms, and if the landlord needs to give their permission for assignment of the lease.
The certification of incorporation, permits and related documents needs to be checked and verified.
Other documents like NSITF compliance certificate, PENCOM compliance certificate should also be requested for.
Tax returns for the past five years should be requested for. This will you enable you if the business has been performing its tax obligations to the government. Also, you get to know if there is the likelihood of a tax audit and investigation in future. The outcome of tax audit and investigation will come with penalties and sanctions if the business is one that hasn’t been performing its tax obligation. Tax clearance certificate, PAYEE returns, are some of the documents you’ll need to check.
Financial statements of the business for the past five years, including bank statements, payment vouchers, receipts, invoices and other financial records should be checked and compared to the tax returns. This is especially important for determining the earning power of the business.
Check the sales ledger. Even though sales will be logged in the financial statements, you should also evaluate the monthly sales records for the past years. Sales breakdown by product categories if there are several products, as well as by cash and credit sales. This is a valuable indicator of current business activity and provides some understanding of cycles that the business may go through.
Compare the industry norms of seasonal patterns with what you see in the business. The sales figures for the 10 largest accounts will also be checked.
The operating ratios should also be compared against industry ratios which can be found in annual reports of businesses that are in the same industry.
Schedule of liabilities
The list of creditors will be checked to determine potential costs and legal ramifications. There will need to ascertain if the business has used assets such as equipment or accounts receivable as collateral to secure short-term loans if there are liens by creditors against assets, impending lawsuits, or other claims. The accountant will also check for unrecorded liabilities such as employee benefit claims, out-of-court settlements being paid off, etc.
Accounts receivable schedule
Accounts receivable list should be broken down into 30 days, 60 days, 90 days period and beyond. Checking the age of receivables is important because the longer the period they are outstanding, the lower the value of the account. The creditworthiness of the top 10 accounts should also be checked.
Account payable schedule
Accounts payable should be broken down by 30 days, 60 days, and 90 days. This is done to determine how well cash flows through the company. On payables more than 90 days old, you should check to see if any creditors have placed a lien on the company’s assets.
This includes all outstanding loans and any other debt to which the business has agreed. There’ll be a check to see if there are any business investments on the books that may have taken place outside of the normal area. Look at the level of loans to staff and owners of the business as well.
You must find out if any of the customers are related or have any special ties to the present owner of the business.
Some of the questions that need answers are:
- How long has such a person been transacting business with the company?
- Is there any agreement between the related party and the business?
- What percentage of the company’s business is accounted for by this particular customer or set of customers?
- Will this customer continue to purchase from the company if the ownership changes?
Organizational chart and list of employees
The organizational chart will be evaluated to understand who is responsible for whom. The management practices of the company, the wages of all employees and their length of employment need to be known. Any management-employee contracts that exist aside from a union agreement, as well as details of employee benefit plans; profit-sharing; health, life and accident insurance; vacation policies; and any employee-related lawsuits against the company all need to be known.
The type of insurance coverage that is held for the operation of the business and all of its properties as well as who the underwriter and a local company representative is, how much the premiums are, all needs to be evaluated. The accountant will determine if the business is underinsured.
MAKING AN OFFER
After conducting due diligence and valuing the business with the help of your accountant and lawyer, it’s time to begin negotiations.
Negotiating the purchase of a business usually involves making an offer, which is usually followed by the seller’s counteroffer and bargaining to reach an agreement.
It is advisable to ask a professional adviser to negotiate on your behalf.
DETERMINING THE VALUE OF THE TARGET BUSINESS
The valuation methods presented below is intended to give you an insight into how to value a business and to get a general idea of where to start a negotiation between you the buyer and seller of a business.
Don’t assume that any, or all, of these valuation methods, will give you a true number, but they are a start at a valuation. In some businesses, you might end up using all of these business valuation methods.
The asset-based method looks at the business’s assets and liabilities. It is carried out by calculating the value of the business by finding the difference between assets and liabilities.
To find the value of the business, subtract liabilities from the assets.
For example, if the business has ₦32,000,000 in assets and ₦20,000,000 in liabilities, the value of the business is ₦12,000,000 (₦32,000,000 – ₦20,000,000 = ₦12,000,000).
With the asset-based method, you can find the book value of the business. The book value is the owner’s equity on the balance sheet. The book value should be the lowest price the owner of the business is willing to sell the company.
The market method compares the business to similar companies that have already been sold. The value of the business depends on the market.
Data from comparable businesses’ sale prices are used. The value of the business will be a similar amount to businesses that are like the target business.
The market method offers an amount close to the fair market value. These values represent the en bloc value of a business. They are useful for M&A transactions, but can easily become stale-dated and no longer reflective of the current market as time passes.
This method uses information from the cash flow statement showing the inflows and outflows of cash for the business over a specific time. Then the current cash flow number is discounted for its future value. Cash flow value is often used for valuing companies that have shareholders.
Multiples of gross sales are the “crudest approximation” of business valuation. For example, gross sales for the three previous years might be used. But there is no guarantee that this level of sales can be supported, which is why it is less useful for valuation on its own.
Multiples of Earnings
For businesses that have shareholders, looking at multiples of earnings per share of stock is a common valuation method. This number shows the earnings of each shareholder, or EPS, which is not the same as any dividends. The principle here is that the higher the EPS, the more valuable the company.
Here’s how the earnings method works: The earnings/profits are determined. Most often, the “raw” earnings number is reduced further, usually by taking out interest and taxes (called EBIT or Earnings Before Interest and Taxes). Another common measure is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Then the final earnings number is multiplied by the number of shares.
Seller’s Discretionary Earnings (SDE)
The seller’s discretionary earnings valuation method is similar to multiples of earnings, but it’s used for small companies in which there is one owner, like a professional practice or sole proprietorship.
In this method, the gross profit is reduced by several numbers.
+ Non-recurring (one-time) expenses.
– Non-recurring (one-time) income.
+ non-operating expenses, like personal expenses and non-essential expenses (operating expenses are those needed for the day-to-day operations of the business).
– Non-operating income (from sources other than the day-to-day operation of the business.
+ Depreciation, amortization, and interest expenses.
+ cost of any wages or salaries for workers (If the owner is not working in the business)
= SELLER’S DISCRETIONARY EARNING (SDE)
Valuation is usually expressed as a multiple of SDE, from one to four times. The multiple depends on the type of business.
Discounted Cash Flow (DCF) Analysis
Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst forecasts the business’ unlevered free cash flow into the future and discounts it back to today at the firm’s Weighted Average Cost of Capital.
It is the most detailed of all the methods, requires the most assumptions, and often produces the highest value. However, the effort required for preparing a DCF model will also often result in the most accurate valuation. A DCF model allows the analyst to forecast value based on different scenarios, and even perform a sensitivity analysis.
For larger businesses, the DCF value is commonly a sum-of-the-parts analysis, where different business units are modelled individually and added together.
DRAFT A PURCHASE CONTRACT
A written contract ensures that both parties (the buyer and the seller) clearly understand what each is agreeing to provide, for what cost and for what method of payment.
Your accountant and lawyer should be present during the drafting of the purchase contract.
There are 2 types of contracts:
The purchase contract for the assets of a business (you purchasing only specific assets that the business currently owns)
The purchase contract for the shares in the business (you are purchasing all the shares in the business and, so, take over all its assets and liabilities).
It is important to understand that;
when you buy assets of a business, you are not inheriting any potential liabilities that may be associated with the sellers’ history (e.g. pending legal action, tax disputes, overdue creditors, loans etc.)
when you buy shares of a business, you are taking over all outstanding claims against the company in which you will own equity.
Make sure you seek professional advice before you sign the contract.
What to include in the purchase contract
This is a breakdown of the purchase price, allocating specific amounts to goodwill, plant, equipment, etc.
This is the payment plan. It covers what percentage of the price will be paid now and when the next payment will be made. It’s a timeframe for payment.
Restraint of trade clause
This protects you from a situation that may arise where the seller decides to open a competing business within a certain distance for some years.
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