You’ve weighed the pros and cons, and now you’ve made the decision to buy a business. But what’s the next step? Buying a business is a complex and time-consuming process. It requires thorough investigation of the business you plan to buy, and research of the market for its products or services to ensure it’s viable. This guide provides an overview of buying a business, but for such a major financial and emotional investment, it is vital that you always seek professional legal and financial advice before signing any documents.
Preparing to buy a business
Once you have decided you're ready to buy a business and have checked advertisements of businesses for sale, you will have a shortlist of potential businesses to suit your budget, interests and goals. The next step is to prepare thoroughly by seeking professional advice, getting your finances in order and starting to research the businesses in more detail.
Organising your business advisers
Getting sound professional is a vital part of the due diligence process. At a minimum, you will need the services of an accountant (to investigate the financial data and operations) and a solicitor (to investigate any regulatory issues, check licences and registrations and draft a purchase agreement).
Checking your finances
Buying a business is a significant investment, so you need to sort out your finances early and be well prepared and professional when applying for a bank loan or approaching potential investors. This will give them confidence to back your business and convince the seller you are serious.
When checking your finances, consider:
- the purchase price of the business
- transfer (stamp) duty, usually payable by the purchaser
- the working capital requirements for your business (your cash flow projections will show that figure)
- professional fees and charges related to the purchase
- any loan repayments and servicing costs, if applicable
All commercial lenders use the following criteria to assess loan applications:
- your ability to service loans (interest and periodic repayments)
- security (most banks require a 1st mortgage on real estate security and may lend up to 65% of the real estate asset being offered as security)
- the management and business skills of the borrower
- the trading history of the business (at least 3 years prior to purchase)
- the profit and loss and cash flow forecasts for 3 years (forecasts need to be supported by realistic assumptions about future trading).
It is important that you are able to supply the necessary information to the lender assessing your request.
Remember, every funding proposal will have its own unique features. Therefore, you should seek professional advice from your accountant or business adviser about the best way to organise funding.
Starting your research
Early research of potential businesses could include:
- scouting the location
- researching your competition (what do they offer that is different)
- checking the business's website and marketing materials
- trying the business's products or services
- checking demographics
- finding out why the business is for sale
- talking to the business's suppliers
- talking to the business's customers
- researching customer reviews about the business online
- performing a credit and historical search on the business's legal structure and/or its owners/directors
- researching industry and market trends.
Conducting due diligence
When buying an established business it is vital that you, the prospective business owner, examine the business in detail. This process is known as due diligence. Due diligence is generally conducted after the buyer and seller have agreed in principle to a deal, but before a binding contract is signed.
Conducting due diligence is the best way for you to assess the value of a business and the risks associated with buying it. Due diligence gives you access to important and confidential information about a business, often within a time period specified in a letter of intent.
With this information you can assess the business's financial position and identify risks and ongoing potential. It is your chance to answer any questions you might have about the business. The due diligence process ensures that you get good value for a business. Done correctly, it can be the difference between buying a business that makes you money and buying a business that costs you money.
You should always perform due diligence with the help of your lawyer, accountant or business adviser.
Investigating a business
To conduct due diligence you'll need to carefully review:
- income statements
- records of accounts receivable and payable
- balance sheets and tax returns including business activity statements (last 3-5 years)
- profit and loss records (last 2-3 years)
- cash deposit and payment records, as reconciled with the accounts
- utility accounts
- bank loans and lines or letters of credit
- minutes of directors' meetings/management meetings
- audit work paper files (if available)
- the seller's claims about their business (e.g. their reasons for selling, the business's reputation)
- privacy details (e.g. of employees, trading partners, customers)
- details about plant, equipment, fixtures, vehicles (are they in good working order and licensed?)
- intellectual assets of the business (e.g. intellectual property, trademarks, patents)
- existing contracts with clients/staff
- partnership agreements
- lease arrangements
- details of the business's automated financial systems
- details of credit and historical searches related to the business.
You also need to value the business to check whether the asking price is fair.
Warning signs for the buyer
You should be wary of sellers who:
- do not disclose important information (e.g. their reasons for selling, financial statements, licences and permits, staff contracts)
- won't agree to a trial period or enough time to conduct due diligence (you will need at least 30 days)
- won't introduce you to their suppliers, landlord or estate agent
- are involved in legal proceedings
- are keen to close the deal quickly
- have a questionable credit record and history.
Making an offer
After you've conducted due diligence and valued the business, it's time to begin negotiations - usually with professional support and business advice. Negotiating the purchase of a business involves making an offer, which is usually followed by the seller's counter offer and bargaining to reach an agreement.
- Know your limit (the highest price you're prepared to pay for the business) and stick to it.
- Never agree to the first price quoted. Remember that the seller's first price is a starting point. It's probably useful only because it gives you an idea of whether the business is within your price range.
- Open negotiation at the lowest price possible (but make sure it's reasonable and you're able to substantiate it). If you offer half the asking price, the seller may not think you're a serious buyer.
- Always take your time during negotiation. You're buying a business that may well be your principal activity for many years. An extra few days or weeks are worth investing to ensure you purchase the right business for you.
- Make your own list of items for negotiation, placing them in separate categories based on what you can compromise on (nice to have) and what you can't (must have).
- Challenge the seller by asking 'what if' questions. What if a major client goes bankrupt? What if a key group of employees leaves with the changeover?
- Do not reveal your own reasons for buying or how badly you want the business. If you really want it, you'll probably end up making more concessions to get it or paying more for it anyway.
- Avoid being overly critical and confrontational. Keep the conversation focused on facts.
- Practise the negotiation with a friend or relative beforehand (role play).
- Make sure you're satisfied with the outcome. The product of successful negotiation is both parties satisfied with the end result. But if only one party is satisfied, make sure that party is you.
- Be prepared to strike a deal if you're comfortable with the price. Be prepared to walk away if you're not.
- Above all, keep emotions away from negotiations. If you can't do that, ask your professional adviser to negotiate on your behalf.
Buyers and sellers often enter into negotiations from what's sometimes called a 'positional bargaining' standpoint. Since both parties want to achieve the best outcome for themselves, the seller's interests will be different from your interests.
- The seller's interests will include wanting to make as much money as possible on the sale of the business, attending to the sale transaction in the way that's most tax advantageous for them, severing liability ties and avoiding any contract conditions they can't meet. Most of all, the seller wants a profit.
- Your interests will include wanting to pay the least amount possible for the business, with the inclusion of as many tangible and intangible assets as possible in the purchase price, favourable payment terms and warranty protection against false claims from the seller. Most of all, you want a bargain.
A shrewd bargainer would be able to convince the other party that the other party is getting more than they're paying for or, alternatively, that they are paying less than what the business is worth.
Business legal structure
If you're satisfied with the due diligence report, have the necessary finance available and are ready to sign the contract, you must consider how to structure the purchase. The most common structures include:
- sole trader
The structure you choose must be defined by key considerations, including:
- financial risk of the business
- personal financial exposure
- requirements from outside partners or investors
- expansion plans
- federal and state tax efficiency.
It is very important that you decide on the correct legal structure for your business before you sign the contract. Asset transfers attract taxes, such as stamp duties and capital gains.
Make sure you don’t need to re-structure your business soon after you have signed the contract, as this will attract unwanted taxes and additional professional fees. Seek professional advice before deciding on the ideal structure.
Drafting a purchase contract
After you and the seller have agreed on a price for the business and what the price covers, you'll usually draw up a contract to give legal force to your agreement. A written contract ensures that both parties clearly understand what each is agreeing to provide, for what cost and for what method of payment.
You should consult a legal adviser and accountant for advice on the tax and legal implications the transaction has for you.
Types of purchase contracts
There are basically 2 types of contracts:
- purchase contract for the assets of a business (i.e. you purchase only specific assets that the business currently owns)
- purchase contract for shares in the business (i.e. you purchase all the shares in the business and, so, take over all its assets and liabilities).
Before deciding whether to buy shares or assets consider the following:
- When you buy assets, it is relatively easy to establish whether the assets are unencumbered and that you are not inheriting any potential liabilities that may be associated with the sellers past history (e.g. pending legal action, tax disputes, overdue creditors)
- When you buy shares in an existing company, you are exposed to all outstanding claims against the company in which you will own equity. Even if the seller agrees to provide legal indemnities, you may be exposed to unexpected claims.
Make sure you seek professional advice before you sign the contract.
What to include in the purchase contract
This will usually be a break-up of the purchase price, allocating specific amounts to goodwill, plant, equipment, stock, etc. You should seek accounting advice regarding allocations of assets, as this has serious taxation implications.
You should determine exactly what aspects of the business you're interested in buying. For example, the business manufactures an item and sells it in a store. You'd need to determine if you want to buy both parts of the business.
Type of purchase
You need to determine if you want to make an offer for the business's assets, its shares, or both.
What you will pay, how and when.
Seller's involvement after purchase
This might include providing you with training so you can continue operations in a seamless manner.
Restraint of trade covenant
This protects you from loss of business through the seller's opening of a competing business within a reasonable proximity.
Any other conditions
This might include the things you and the seller each agree to do before settlement, and arrangements for current employees.
In addition to the basics of price and purchase, contracts should address contingencies such as:
- whether the purchase is subject to finance approval by a bank or other financial institution
- your defaulting on instalment payments
- the seller providing inaccurate or false financial information
- the seller having more liabilities than were known at the time of purchase
- the seller not owning some of the claimed assets
- material changes in the business occurring before the transaction is closed
- the seller opening a competing business in a location too close to the business they've just sold you.
Most of these provisions work to protect you, the buyer, since the seller knows what they're selling and the amount to be received. You'll want to limit your risks as much as the seller is prepared to allow.
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