Validating the purchase price
The purchase price of a business is often calculated on the value of the revenue or earnings generated by the business less the expenses accumulated to generate those sales. The value might also be determined by comparing similar businesses, or if there is no revenue, the price might be determined by the value of the assets of the business. Due diligence on the business’s financial reports, source records and data and depending upon the valuation method, the results of similar businesses, helps validate the value of the business. However, there might be some of the following circumstances which mitigate the perceived value and potentially allow an adjustment to the purchase price.
1. Financial reports
If the value is equated on the revenue and expenses, request the financial reports and source documents including the profit and loss report for the current and previous two or three years. Review the financial reports carefully, including the sales, income and expenses and the value of the company’s assets, liabilities, creditors, and debtors. The information on the report should be compared to actual receipts and invoices to ensure that the figures are correct.
The financial figures can support the valuation and determine how well the business is proceeding over time and whether it’s been impacted by market conditions or other factors. If you notice for example that there has been a decline in profitability, this might alert you to potential business issues, including with management; the product or service; or market events. Any potential issues have the capacity to reduce the perceived value of the business.
Expenses can be divided into regular, discretionary and capital expenses. Discretionary expenses are one-off expenses which might be incurred by the business. These expenses are not required regularly and may change according to the activities of the business. Examples of discretionary expenses include advertising or training. Capital expenses are more expensive and incorporate items that add value to the business. They might consist of costs for photocopy machines or computers. Depending upon how you plan to operate the business after completion, some of the expenses could be reduced or increased.
Expenses are usually, but may not always be, listed in the financial reports. A business might enter into a contra deal, which involves the exchange of skills for goods or services but may not record the arrangement in the accounts. A coffee shop might provide free meals to a graphic artist in exchange for signage for example. However, if this arrangement is not continuing after the business is sold, but the business still requires signage, then the cost of that signage should be factored into the cost of the business.
You should also review staffing arrangements. If the existing owner has operated the business without a salary, you will either have to replace that worker personally, or employ someone to do the work, which would reduce the business’s perceived value. If the perceived value is reduced, then the price might be able to be renegotiated.
3. Creditors and Debtors
The business might owe money to others (creditors) or be owed money for goods or services it has provided (debtors). Determine whether this money is for once-off services or payable on a regular basis.
Creditors and debtors will have a different impact depending upon whether you are buying the business or the shares in the company that owns the business.
If you are buying the business, typically you take the benefit of the business from the date following completion and any money owing by or due to the business at completion is for the seller. However, if the payments relate to assets that are required to operate the business, then it will depend if the business will continue to receive the benefit of that asset following completion. Suppose money is owed to a coffee manufacturer. If the seller paid for the coffee, but the coffee will not be received until after completion, then the purchase price should be adjusted to allow for this purchase or the new owner might reimburse the seller as an adjustment to the purchase price on completion of the sale.
If you’re buying the shares in the company, given the company does not change after completion, any payments and debt will continue to remain with the company after settlement. For debtors, find out how long have these payments been outstanding and the likelihood of receiving payment. If these are aged debtors and unlikely to be recovered, ensure their value is not included as revenue.
4. Work in progress
‘Work in progress’ refers to partly performed jobs that are yet to be completed although they might already be paid for by the customer, such as when a customer pays for a gift certificate but has not received all of the services. If these jobs are not identified during the due diligence process, it might result in the business having to perform the work after buying the business but not being compensated for it.
The due diligence should involve understanding the status of the work, including where each job up to; the extent that the work has been paid for by the customer and the cost of delivering the work. Also determine who will settle the work after completion and whether that party has been paid for it. If the work is to be completed by the buyer, but if the customer has already paid the seller for the work, then there should be an adjustment to the purchase price on settlement.
The due diligence on the assets should commence with determining why the business does not have revenue it can base the valuation of the business upon. Is it as a result of poor management, issues with the product or service or issues in the market for example.
Due diligence should include reviewing the assets, and ensuring that they are in good working order, and the value is only attributed to assets that the business owns. If the assets are under finance, determine how much debt is owing on them and whether the finance will be paid out before completion. Unless you want the benefit of the asset that is subject to the liability, you might agree on adjusting the purchase price to allow for the debt, otherwise, the liability and the encumbered asset might stay with the seller.
Often the purchase price is calculated by reference to similar businesses in the industry. In this case, the due diligence should not only involve reviewing the business, but the market and competitors to determine whether the business has the capacity to perform on par or better than the market, and whether there are any contingencies that would vary that market value. If the business is operating under current benchmarks or if it must spend additional money to compete, then the perceived market value of the business will be reduced.
Key takeaways: Value and the Purchase Price
- The seller usually establishes the sale price of the business on a particular valuation, which might be based upon revenue and expenses; market; or on the assets.
- Undertaking due diligence can identify features in the business which will reduce the perceived value of the business, which might allow for the renegotiation or adjustment of the purchase price.
About the Author:
The following extract has been taken, in part, from the book, ‘Entrepreneur Know How – Mindset and Winning Steps for Buying a Business,’ written by Sharon Robson (Available through Amazon and select bookshops – see: https://entknowhow.com/the-bookstore
Sharon is the principal lawyer and founder of Antler Legal – a corporate commercial legal practice in Sydney, Australia.