More things to think about when buying a business

Buying a business can be daunting; especially if you’ve heard even a small fraction of the horror stories that those “experienced in the art” will have to share.

Last week we covered 6 important things to think about when buying a business; this week we continue with a look at how to build confidence in your understanding of any business through more detailed financial analysis and due-diligence.

It’s very important to remember that when buying a business we’re investing, and when investing the most important thing we’re trying to do is protect our capital, and the second most important thing is to grow it. This means that we need to identify all risks and price them into the deal. If the risks are too big then there is no deal, and if the risks are manageable (i.e. the probability of them occurring is low and if it does occur then the impact wont be fatal) then we can build them into the deal terms.

Risks are anything that can impact the future cash-flow generation potential of the business. Understanding them means you need to be able to identify all risks and understand their impact. The only way to really understand the impact of anything is to build a good financial model of the business, that allows you to see how a change affects the cash flows, and hence the valuation of the business.

To help you get started, here are some of the biggest risks you’ll find in the SMB ‘businesses for sale’ market.

Variability/Predictability of cash flows, including seasonal businesses:

To begin, I’m assuming the business you’re buying has full, audited financials for at least the last 3 years and monthly management accounts. If you don’t have this type of information you’re really shooting in the dark and I’d suggest looking elsewhere (or making the entire deal price dependent on future performance). If you have this info then you need to do what is called a ‘horizontal analysis’: this means you compare the same categories from year to year. How much has sales grown or contracted by? Did all expenses stay in proportion? You’ll need to work your way through the financial statements in this manner. What you’re looking for is any year when sales grow faster/slower than the ‘normal rate’ for the business, and also each income statement line (as a percentage of sales). E.g. if Salary expenses go from 15% of sales in 1 year to 25% of sales in the next, you know you need to dig deeper into why this happened. When you get to the Balance sheet, a useful tip is to calculate everything as a % of total assets – this will make it far easier to spot changes from year to year.

Be especially aware of seasonal businesses – they have to generate sufficient cash in the peak season to fund the low season, and you will want to model this carefully. Tourism, agriculture, restaurants and anything in small coastal towns are likely to be very seasonal businesses.

Key staff retention:

The productive capacity of any business depends on its staff, and you’ll always find 20% of staff who account for 80% of the knowledge, client relationships, and whose loss would severely damage the business. You’ll need to identify who these people are beforehand, understand their contractual obligations, and make sure they stay on post your acquisition. Be very aware the key staff are likely to be poached by the seller if he chooses to compete with you, so you’ll need to build your own view as to who is key and who isn’t.

Competitive action by the seller, pre or post sale:

One of the reasons to defer a large part of the payment for any business into the future is to keep the seller motivated to grow the business. In many situations, this means that you want to prevent the seller from competing directly or indirectly with you. It’s crucial to understand who has client relationships and why a particular business buys from you, then you can lock the current owners and employees into a contract that prevents them competing with the business they have just sold. You’ll have to use a carrot and stick approach – a bonus for good behaviour and legal action or damages for poor behaviour.

Concentration of suppliers, customers and product:

A business that has only 1 supplier, a few major customers, and a limited product line is immediately at risk through concentration. Broadly, this means that if one supplier or customer changes their terms with you the business could die. Simiarly to product concentration – a business with only one product can be easily wiped out when the competition change prices, launch a new version, or the Chinese start supplying your customers directly.

Management systems:

A business that is well systemised, that operates as a machine where processes are documented, followed, and improved is far less risky that one where everything is ad-hoc or simply not done at all. The simple reason is that well designed and implemented systems reduce the reliance on key people: a good system means that risk of a key person leaving is reduced because someone else can quickly pick up where they left off. It also means that new staff (yourself included) can quickly get up to speed on the business.

Legal action:

Almost every business faces legal actions at some stage of its life. Sometimes these can be crippling. Pending legal action is easy to hide from a buyer, so you need to consider an independent legal review and also making sure the seller indemnifies you from legal action relating to the business before the sell it to you.

There are many more areas of risk, which we’ll cover later. Hopefully these tips will prevent you making some of the bigger mistakes.