When Buying a Business, Applying This Information Will Keep You Profitable and Out of Trouble

For someone buying a business, your situation is similar but different from selling a business. Your main concern will center on getting an acceptable return on your capital. And that is at a minimum. Sounds quite simple doesn’t it? Well, it is simple, but it isn’t easy. As you have likely already seen, getting an acceptable return on your capital is the result of a whole bunch of other things working out right.

The first of these is that when buying a business, you need a price that makes good economic sense. As a starting point, this means that the price that you will pay for the business will provide you with a return that is considerably higher than the rate of return on risk free securities like government bonds. At some times that benchmark may seem a bit controversial, but is normally works. The reason for getting this premium is that with any business there is an element of risk. The future, by its nature cannot be known. So your job as a buyer is to be your own risk manager.

When you commence buying a business, you will be presented with many alternative opportunities. Each of these can lead you to examine a set of financial statements. There are any number of pitfalls for the unwary in these kinds of statement. For owner owned businesses, one of the most significant of the pitfalls deals with owner compensation. If the current business owner works in the business, how is he paid? And has his compensation been deducted from gross profit in order to get to earnings or cash flow? If it hasn’t the earnings or cash flow will have been overstated. So they need to be adjusted lower to provide for market compensation for the person doing what the current owner does.

With this as your starting point, you will be able to do a quick return calculation. Start out by dividing the yearly earnings or cash flow provided by the business, by the asking price. If that number seems to provide you with an adequate premium over what your money could earn from risk free securities, then you should continue considering the business as a reasonable target. And remember that if you really like the business for many other valid reasons, you can make an offer at a price that makes economic sense to you. After all, what is the worst that can happen?

Because the future is unknown, as a buyer you can be taking on the risk of an unknown future. In buying a business the big risks are revenue and cost. What drives revenue? What will continue to drive revenue in the future? How confident are you in your ability to drive revenue in the same manner as it has been done in the past? To answer this question satisfactorily you will need to determine whether revenue is based on the talents of one or more key people, or whether it is systems and process based. Remember that one of your key responsibilities is to act as your own risk manager. So you need to understand this key distinction. To learn more you will need to do a marketing audit.

The cost structure is also of key importance. You need to understand the underlying economic model. What kinds of margin does the business enjoy? What are the variables that impact break even? When total cost equals total revenue. And what are the various key levels at break even? Doing a break even analysis will give you a broader understanding of cost structure and how to evaluate it?

One of the things to remember as you examine various businesses is the reason for franchises being so popular. Part of it is their promise that you can be in business for yourself, but not by yourself. To fulfill that promise they provide franchisees with proven effective ways of handling most business critical issues. The franchisee does not need to reinvent the wheel. Nor learn what works and what doesn’t through trial and error.

When you consider a business as a prospective buyer, see how closely it resembles a franchise in terms of the documented systems and processes that come with it. When you are considering price, be sure that if the price clearly contemplates growing revenue and growing earnings, that the systems and processes that will drive all this are included. Don’t pay for what isn’t there. So you need to do an audit to determine how far the current owner has gone to systemize the business.

If certain systems and processes are absent, it may not be a deal breaker. Although their absence should definitely impact either price, or terms, or both. As an example, if the business lacks proven effective marketing and selling systems, that could be OK if you are a highly effective marketer. So long as you can develop and document the needed systems quickly. But if there is also a systems void in other areas, you may just have a deal breaker. You may not have the time or the skill to develop, implement, and document these missing systems. And still operate the business at an acceptable level.

Regardless of how it happens, if you buy a business lacking critical systems and processes there will be a cost to develop and implement them. It will include the easily overlooked cost of lost revenue and profit as you develop and implement them. It will also include any and all direct cost of developing and implementing the missing systems. Again, don’t pay for these if they are not there.

Remember, they are not visible in the price. However, their presence may well be implied in the assumptions underlying the asking price. So armed with what you have learned so far, you need to understand how the person selling the business arrived at the asking price. What does this price assume in the external environment, and in the internal environment of the business? And now the big question. Are these assumptions reasonable? And do they reasonably match up with the asking price?