When you are buying a business you hand over money (or sometimes other assets) and in return you typically get three things:
- Physical assets.
- Ongoing cash flows (from currently active customers).
- Potential future cash flows (new customers).
If it’s a new or relatively new business there may be a lot less of two and a lot more of three, and sometimes three is referred to as “blue sky” meaning potential for growth.
Physical assets includes the obvious ones in the balance sheet such as plant and equipment, inventory, land and building, but also includes things like documentation relating to leased or hired assets, front and back office systems, licences, branding collateral, trade marks, IP, website, procedures, maintenance agreements, employment contracts – in fact all the pieces of the existing business jigsaw.
Assets are usually quite simple to check up on:
- Fit for purpose?
One brief “beware” story from the archive:
The overly keen buyer of a really upmarket retail gift shop and gallery was given an all inclusive price (inventory and all physical assets included but not separately priced) for the business which seemed fair – this is also known as “walk in walk out”. The purchaser did their sums and then realised that a significant proportion of the inventory was on consignment from (and therefore owned by) the artists who created it and not the business. A quick price adjustment and a happy ending.
Ongoing cash flows from existing customers or clients.
The financial performance of the business should again be relatively simple to ascertain. Unless you have the expertise yourself you probably should get an expert experienced with that industry to review the financials so you can get some comfort on the results shown and also to detect anything “missing”.
Two brief “beware” stories from the archive:
- A take away food store in the city was sold and the final price was dependent on turnover for an “average week”.
The business was running two sets of books – the so-called “real ones” and the so-called “tax ones”, so the business owner had to prove the real ones were in fact “real”. The trial week came around and the new owner was working in the shop being trained. Meanwhile the previous owner had arranged for all of his friends and relatives to come in that week, be happy customers and buy, which boosted the turnover, and hence the final sale price, nicely.
Moral: Be very aware if a business is claiming income that has not been declared for tax. If they lie to the tax office what makes you think they are telling you the truth?
- A young person with a passion for music wanted to buy a privately owned retail music store.
Everything seemed rosy and the price seemed fair. Just before it was all finalised, the buyer’s accountant suddenly remembered buying a gift voucher at the store. But gift vouchers should be in a register and shown as liabilities in the balance sheet – they weren’t.
Being a helpful fellow, the vendor’s accountant had decided that these were actually sales and had re-engineered the financials to suit. This meant that the previous owner had collected the money but the new owner would have to redeem the outstanding gift vouchers when presented. In the end the difference wasn’t a deal breaker, but it could have been.
Moral: Know the industry so you can ensure the financials tell the whole story for that business.
This is the area where you will often find earnings multiples used to help set the price. This means that the turnover of the business is multiplied by a factor to give you a sales price to which the physical assets are then added. Of course it is this factor that you need to check up on. Is it fair? Is it typical for the industry, or for businesses in this area? What discounts should be made against it?
Potential future cash flows from new customers or clients.
The vendor may make some claims about potential growth, but be very wary about paying for blue sky. For example, if it were so easy, why didn’t the vendor do it, and thereby increase the sale price of their business? Do your own research and get some independent opinion when it’s outside your area of expertise. Of course as the buyer, blue sky potential is a good thing and the vendors know that.