Investigate these 7 Points When Buying a Business

Investigate these 7 Points When Buying a Business

Investigate these 7 Points When Buying a Business

Buying a business can be a great move but it takes a lot of due diligence investigation. Due diligence is often thought of as “finding the bad stuff” but it is also important so that you understand what it will take to operate the business after you own it. OJT (on the job training) is helpful but preparation is even better.

Buying a Business

Know what to research

Keep in mind that these magnificent 7 aren’t the only things you need to investigate but they are 7 that are often overlooked or short-changed when buying a business.

  1. Cash Cycle – understand the cash cycle from when you incur cost to when you collect cash. 10 days? 30 days? 60 days?  Think through the stages, when do you spend money? When do you collect money? Every business has a cash cycle, dissect the steps to make sure you understand when cash is expensed and when you receive cash. If you have 10% profit you have 90% you owe other people. You’ll need to fill the “cash gap” with financing or cash injections from other sources.
  2. Hidden Costs – know the “hidden” costs in the system, warranty, call backs, inventory losses, un-billable hours, and uncollected AR. Most business owners only think about these things at year end when the CPA does the business taxes but this effects your cash every day.
  3. Specialized Knowledge – know the specialized knowledge of the current owner. Technical knowledge? Craft knowledge? Relationship knowledge? Supply source knowledge? The employees will judge you beginning day 1. Make sure you know what they expect you to know.
  4. Cash Needs -know your cash per sales growth requirements; don’t grow yourself into poverty. For every dollar in sales you’ll need to have some dollars available to fund expenses and products until you collect the cash from the customer.
  5. Pricing – understand how the current owner prices products and services.  Markup? GM? Guesses? Competitive comparison?  Is there room for improvement? Does current pricing have anything to do with the market? Who has special deals?
  6. Insurance – understand the current insurance coverages and make sure your coverages reflect your risk tolerance levels. Get an insurance audit. Make sure you review every aspect of insurance you need. Often we find sellers are under insured. Getting proper insurance could effect the biz earnings and the amount you might be willing to pay to buy the business.
  7. Licenses – make sure you research the licenses, permits and compliance requirements needed to operate the business. Don’t assume the seller knows everything. Buying a business not in compliance with current requirements is risky business.

While you may be itching to simply sign on the dotted line..

Thinking about what businesses might be for sale?

STOP:  your preparation and due diligence will save you a great deal of  hassle and surprise. Buying a business takes time, thought and research. As an entrepreneur, this is just your first step in creating a successful business.

Business Sale: Tangible vs Intangible Assets a Quick Analysis

Business Sale: Tangible vs Intangible Assets a Quick Analysis

We find a wide variety of views and preconceived notions about business value from individuals as they review a business sale. Most the time, the discussion turns quickly to the business assets. That inevitably leads to a discussion of Tangible and Intangible Assets.

Investors involved in a business sale generally have a reasonable understanding of tangible assets but usually a less than good understanding of an intangible asset. They have a tendency to use disparaging terms like “Blue Sky” or “air ball” when they don’t understand the true value of intangible assets.

First let’s try to reach common ground on some basic definitions that are commonly used but not always understood.

Tangible Assets

Tangible assets are really based on banking and lending definitions. A general definition is an asset that has a physical form. For instance a truck is a tangible asset. You can touch it, feel it and more importantly sell it. While a truck is a tangible asset that may be salable, there are other tangible assets that might have different characteristics. Suppose you own a widget shop and you have a special machine you invented that bends the widget a special way. You love the machine but it’s of no use to anyone but you. That is still a tangible asset but it has relatively low value to the outside world. The truck you can likely sell pretty easily but finding a buyer for the widget machine might be a whole different problem.

Intangible Assets

These are assets that don’t have a physical form. For instance the trademarked Nike swoosh is a very high value intangible asset. One way to think about tangible vs intangible assets is tangible assets are used to make or deliver the product or service and intangible assets are what are used to generate the demand for the product or service or create the system to produce the product or service efficiently.

A very well known intangible asset is the secret formula for Coca-Cola. That formula has no tangible form, it’s basically words written down somewhere (likely different parts of the formula in different places). But that intangible asset is worth much more than the cost of the machines (tangible assets) used to produce Coke.

Now that we have a basic idea of the assets, let’s talk about why we have assets at all and how they effect a business sale.

Assets in a business have only one purpose (or one purpose that makes sense), to generate profits.

So what kind of assets are best for generating profits?

I’ll give you 2 simple but real life situations.

1) Let’s say you can buy a machine for $100 that will generate $25 more per year in profits. You decide that’s a good investment, so you invest the $100 and you’ll get your $25 per year profits for as long as the machine works. So now you have a $100 tangible asset (the machine) and a $25 cash flow from it.

2) Now let’s say you add an email capture tool to your website, it captures visitors’ email addresses which you can use to automatically send out specials and mailers. The email tool costs $100 and generates $25 in cash flow.

In this case you created 2 intangible assets:

a) the email tool on your website and b) the list of emails of people interested in your products.

The intangible asset with the highest value is the list of emails for people interested in your products. Anybody can buy the email tool for $100 but you have the specific list of people’s email addresses that represent potential sales, this list is an intangible asset.

Think of it this way. Two businesses are exactly the same except one has the email addresses for these customers and one business doesn’t, which business is worth more?

The moral of this story is that when investigating a business sale and determining the value of the business for purchase, the assets that have real value are the assets responsible for generating the business profit, regardless of if they are tangible or intangible. A smart buyer knows how to identify those assets and isn’t blinded by the tangible asset mantra preached by the bankers.

Buying a Business in Texas – Define Earnings and Profits First

Buying a Business in Texas – Define Earnings and Profits First

When looking at buying a business in Texas and other parts of the U.S. there are many different terms used and the same term can be defined differently depending on who is using the term.

In this post I’ll try to define some of the terms commonly used to represent the “earnings” or “profit” the business generates.

The terms below are attempting to describe the operating profit available to the new business owner when the selling business owner, and all of the selling business owner’s non-business expenses, leave the business. Keep in mind that the vast majority of small business owners do their accounting with a single intent, minimizing taxes owed.

Here are some common terms you will see when looking at businesses for sale:

Cash Flow (CF or C/F) – This is a commonly used term for representing the “earnings” of the business and is definitely not the same definition of cash flow that a CPA would use. A CPA would include changes in accounts receivables, accounts payable, capital expenditures and a number of other items when calculating the true “cash flow” of a business. When you see the term “cash flow” used on Business for Sale sites what they likely mean is the “Earnings Before Interest Taxes Depreciation and Amortization” (EBITDA) plus Owner’s Compensation. Once you understand EBITDA and Owner’s Compensation you’ll have the code for the other definitions.

Net Income – Net income is a fuzzy one because lots of people include and exclude items that others might not find appropriate. You’ll have to have the person claiming the net income number explain EXACTLY what the source of the information is and what is included and excluded.

EBITDOC – This is a term I have created that I’m hoping the industry adopts. This was explained above when you piece together EBITDA and Owner’s Compensation. It’s the business earnings before interest, taxes, depreciation/amortization and owner’s compensation. With this definition it allows you to focus on the most critical of the elements which is proving the claims of the Owner’s Compensation, in all it’s forms. Many small business owners are very creative with their accounting. Make certain you understand the source and veracity of the numbers before you make any decisions.

EBITDA – This is a common measure of earnings in larger businesses but is less useful when buying a business in Texas. This earnings definition assumes that the “owner” or CEO of the company is receiving fair compensation for the job being performed and therefore no adjustments need to be made. This is rarely the case in small businesses for sale and therefore EBITDA, without Owner Compensation adjustment, is generally useless in evaluating the small businesses earnings. You will however see some representations of ebitda that make total sense as a stand alone number if embedded in that EBITDA number is an reconciliation for owners compensation. This number is often called Adjusted EBITDA.

Pre-Tax Income – This term is generally useless when evaluating the earnings of a small business. The problem is all of the non-cash entries and the owner compensation entries that happen before the pre-tax number is established. Often times this pre-tax number is manipulated so that the business owner reduces his taxable income.

The takeaway for this is that when evaluating buying a business in Texas or other places in the U.S. you need to take the time to understand how the advertised earnings were established and understand the items included. Don’t assume one business broker’s earnings is calculated the same way as another business broker, do your homework.

The Value Goes to the Prepared.

earnings of a small business.

How to Make an Offer to Purchase a Small Business

Buying a small business is a unique process in many ways. Here is a list of “elements” of a contingent offer that might make sense when considering a purchase.

Contingencies are very important when making an offer. A buyer is not likely to get full access to all of the business books and records without first agreeing to a purchase price and terms CONTINGENT on full due diligence. Contingencies to consider when making an offer:

  1. Small Business Financing – If you will need financing include a contingency for obtaining small business loans on terms and conditions acceptable to you.
  2. Include a contingency for buyer and seller to agree on a specific training and transition plan.
  3. Contingency for any agreements to be assumed by buyer to be on terms acceptable to buyer (example, facility leases, copier contract, machinery leases, etc)
  4. Contingency for background check on the business and the seller’s themselves. It’s important for buyer to know who they are buying the business from.
  5. Contingency for full review of all business records including tax returns, sales tax reports, bank statements, etc.

As always, reassure the seller that you understand the confidential nature of this information. Those 5 contingencies above are a start to buy a business, some specialized businesses require more specialized contingencies. For instance there could be a case where a particular supplier is extremely important to the business, a contingency might be for the vendor to approve buyer and agree to continue to supply the buyer after closing.

These kinds of 3rd party approvals can be very tricky, get good advice before heading down this path. Think through your small business ideas and build your contingencies to make sure that you’ve covered all the bases.