The purchase of a business is a serious transaction, which can have a profound effect on your life and your financial health. This guide offers some practical measures you can take to help ensure you buy a sound business for a sensible price.

Why buy a business instead of starting up your own?

The three main advantages of buying an existing business are:

Reduced risk

A successful existing business will already have proved its viability in the marketplace and have built up a trading record that you can analyse.

Many of the factors that you would normally have to estimate when planning a start-up – such as number of potential customers, number of staff required to run the business, fixed and variable costs etc. – will already have been established. These will, of course, vary from business to business, but may help guide your calculations.

Time savings

By buying an existing business you may avoid having to:

• Build up a customer base from scratch.
  
• Establish relationships with suppliers and distribution channels.
  
• Find suitable staff.

Although all of these may need attention after buying a business, they will normally all be in place at the time of the purchase.

More security

Few, if any, start-ups are profitable from the outset. If you select a suitable business to buy, you should be making money from the very beginning (before debt repayments).

There are two disadvantages to buying an existing business, however:

Reduced reward

The more successful the business you are buying, the more you will have to pay for it. The financial reward you can hope to gain from buying a business depends on the improvements you can make to it. The more successful the business you buy, the less potential there is for improvement. A start-up, on the other hand, allows you to determine your own levels of achievement.

Being hit by the unexpected

There is always the possibility that the business you buy turns out to be less successful than you expected, either because the economy or the marketplace changes, or because of previously unforeseen problems. Clearly, the more you pay for a business, the more you stand to lose if you get it wrong.

Buying the right business

Before deciding to buy any business, it is helpful to consider carefully where your skills and interests lie:

• What are you really interested in doing?
  
• What would you like to be involved in on a day-to-day.basis?
  
• What kind of environment do you like to work in?
  
• What fields are you technically qualified to work in?
  
• In what fields do you have useful contacts or other knowledge that you can exploit?

How to assess a business

Once you have found a business that might be suitable to buy, it is in your own interest to make sure you evaluate it in as much detail as possible. The more work you put in at this stage, the easier it will be to raise finance to buy the business, and the more likely it is that the business will come up to your expectations and justify the price you eventually pay for it.

Your financial success in the future will depend heavily on how well you evaluate any business before you buy it.

Important things to examine are:

Financial reports and tax records

It is prudent to examine these for the last three years, if possible, to get a picture of the overall health of the business.

It is also useful to examine whether the vital business ratios are in line with similar successful businesses or the industry average. Although these will give you a clue as to how well the business is doing and how competently it is
being managed currently, it's important to remember that you should not necessarily be put off buying a business simply because it has been poorly managed in the past. The health of the business should be reflected in the price you pay for it, but a poorly managed business may have greater potential for improvement than an expertly managed one.

If you feel you are not qualified to analyse financial figures, it’s wise to employ an accountant or ask your bank for advice.

Invoices

Checking the business's invoice records can give you some helpful clues about the state of the business. If invoices are not being paid within a reasonable time (this period varies from industry to industry) this may indicate that the current owner is facing cash-flow problems.

Checking the accounts receivable can also give you an insight into the business. How many outstanding receivables are late? What percentage of receivables comes from the business's largest five or ten customers? If this proportion is high, it often proves sensible to run credit checks to ensure that your key clients are financially secure.

Customers

It is important to establish how likely customers are to remain customers if you decide to buy the business.

Things to examine include: how long individuals or companies have been customers; the rate of turnover of the customer base; whether any one or two customers account for a large proportion of sales; and the strength of
the relationship between the existing owner and his or her customers. If the existing owner is intending to remain within the industry, are they likely to take customers with them to their new business? Check also the extent of the potential customer base that has so far remained untapped.

Competition

When you buy a business you will almost certainly be competing with other, similar businesses, so it is worth considering how competitive the environment you will be entering may be. Is there a dominant player who, because of superior technology or funding, is driving competitors out of business? Are price wars common?

Do you have any advantages or disadvantages because of your reputation, location or anything else that you should be aware of? Have any other similar businesses recently gone bust?

Location

The old retail adage that the three most important things are “location, location, location” still holds true.

Goodwill

If a business has a bad reputation it may not be easy to?change that. Equally, beware of a great reputation, which you will be expected to pay for, but which could quickly evaporate in the early days of your stewardship if you make any mistakes. It can often be useful to speak to existing customers, suppliers, trade bodies and the like in order to gauge the business’s reputation.

Other points to consider:

• Is any of the equipment (or other assets) leased? If so, be sure to ascertain how much the monthly payments are, whether all payments are up to date, and how long you will be obliged to continue with the leases, even if you decide the equipment no longer fits in with your plans.
  
• Will you have exclusive rights to the business name, all product names, trade marks, logos, Internet domain names, and contact details such as existing ‘0800’ numbers?
  
• Are there any long-term agreements in place that will restrict your ability to improve the business? For example, a long tenancy agreement could prevent you from moving to a better location, or agreements with certain suppliers could make it hard to seek cheaper or better quality supplies.
  
• Are there any impending changes to regulations, from the EU or elsewhere, which could affect the profitability of the business?
  
• What are the seller's intentions? If he or she intends to continue in the same line of business this could have a serious effect on the viability of the business you are buying.

Valuing a business

Paying the right price for a business is absolutely crucial. If you pay too much, you may struggle to make repayments and ultimately be forced to sell the business at a loss. On the other hand, if a business looks too cheap, it's likely that you have not picked up on something of importance. Unfortunately the process of valuing a business has a strong subjective element – which is why stock markets can wipe billions off the valuation of large companies in seconds. It's sensible to use a range of valuation methods and take an average valuation, while paying particular attention to the lowest.

Some common methods of valuation are:

Multiple of earnings

A common method for profitable businesses, in which a business is valued as a multiple of its current profits. The higher the projected growth of the business, the higher the multiple.

Balance sheet method

For loss-making companies, a valuation can be made based on the value of the net assets being bought with effectively no premium being paid for the business or its potential at all.

Cash-flow method

Based on how large a loan you could secure using the cash flow of the business, adjusted for depreciation and equipment replacement.

Intangible assets method

In some businesses, the value of a mailing list or customer base is the most valuable asset, as they would be expensive to acquire using other methods. The intangible assets method attempts to value how much it would cost the buyer to build up these intangible assets from scratch.

It is wise to seek advice from an accountant or other business professional about which valuation methods are most appropriate for the business you are looking at.

Making a contract

You will need to use a lawyer to draw up a purchase contract between you and the business seller, but you should ensure that the following points are all dealt with and that you understand what is being agreed:

• Exactly what you are buying, and at what price. The prices should be broken down as much as possible so you know what you have paid for each asset.
  
• Details of leases or other liabilities you are assuming.
  
• Guarantees by the seller of the truthfulness of any information supplied, and penalties that will be incurred if these are broken.
  
• A description of the seller's obligations in running the business up to the sale date.
  
• A dispute-resolution procedure.
  

Financing the deal

Buying a business is usually expensive, so it is unlikely that you will be paying cash. There are a number of approaches to financing you can take.

Bank loan

Banks have special expertise in financing businesses, and if you are able to borrow from a bank you will also be able to take advantage of its considerable business knowledge and the advice of its specialist staff. This makes a bank loan one of the most sensible ways of financing the purchase.

Seller finance

Many sellers are keen to help finance the deal for tax reasons. Sellers may be flexible in the way they structure the deal, and a continuing relationship with the seller may be useful, as it is likely they will continue to act as a consultant, although the level of expertise available will not rival that offered by a bank.

Venture capital

Venture capitalists are increasingly interested in investing in going concerns, but it is likely they will want a large proportion of the business in return, limiting your scope to profit if you grow the business successfully.

Real stories

Sally Godfrey and her partner decided to buy a retail business at the beginning of 2001. In mid-May they were introduced to the proprietor of the Glo-Worm candle shop in Marlow, Bucks, who was looking for a buyer for his
business.

With the help of a local accountancy firm, Sally went through Glo-Worm's books. A price for the business was agreed, based on the shop's turnover and the value of the stock, plus a premium for the fact that the shop was well-known locally and had a loyal customer base.

Sally saw an opportunity to expand the shop's range of products to include helium balloons, party accessories, gifts and aromatherapy oils, which would appeal to the existing customer base and attract new customers.

The purchase was financed from personal funds, but she took out a loan with a local bank to use as working capital.

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