The steps you need to take BEFORE buying a business

Make sure you understand what you are buying before committing to the purchase

5-minute read

Before buying a business, you need to be sure you understand exactly what you're buying. That can be difficult.

Valuating a business is not a simple exercise or an exact science. It simply provides a theoretical figure that will give you an idea of a fair price to pay.

Here are some of the major steps you need to follow to arrive at a proper value when buying a business.

Perform due diligence

Proper due diligence is the first thing to do when considering purchasing a company. You need to assess its financial statements, legal status and assets, including inventory, equipment and accounts receivable. You should use the services of in-house and outside experts to do this.

You should also confirm the vendor's good faith and the soundness of the business. If most of its sales are generated by only a few customers, for instance, you will need to confirm that they intend to continue doing business with the firm once you have acquired it.

You must also take into account any changes you intend to make to the company after acquiring it. No matter how essential these changes may be, keep in mind that their cost may substantially reduce the return on the capital you have invested.

Tip

Get a detailed list of exactly what the vendor is selling, including land, buildings, equipment, inventory, the business name, its customer list, any contracts it has with employees and suppliers, and prepaid expenses and intellectual property.

Get an independent business valuation

Determining a company’s value is a complex process—part science, part art. It’s usually a good idea to hire a chartered business valuator to get an objective and realistic understanding of a company’s value. A valuator may use one or more valuation methods depending on available information and the type of business.

The three most common methods:

1. Earnings-based methods

These approaches are commonly used for businesses that generate reasonable returns and whose value is greater than that of their assets alone. A valuator determines the company’s value by reviewing past results and forecasted cash flow or earnings.

2. Market-based methods

These approaches calculate a valuation by applying a valuation multiple, which may be based on EBITDA (earnings before interest, taxes, depreciation and amortization), revenue or other metrics. The specific figure used and type of ratio vary depending on many factors, such as industry and size of the company, market conditions and multiples used by comparable businesses.

3. Asset-based methods

Asset-based approaches are typically used for businesses whose value is asset-related rather than operations-related, such as those in the real estate sector.

Assess the company’s assets

There are a number of ways to determine an asset's fair market value. A specialist's appraisal may be needed for assets such as real estate, major equipment or specialized inventory. Likewise, a collection agency can help you evaluate the true value of accounts receivable, especially when assessing a company with many customer accounts.

The vendor should supply you with a detailed list of what is up for sale. These assets may include land, buildings, equipment, inventory, the name of the business, its customer list and any contracts it has with employees and suppliers, as well as prepaid expenses and intellectual property.

When assessing the value of a company's equipment: Make sure you have:

model numbers
dates of purchase
a record of how well the machinery is working
maintenance schedules
warranty details.

When appraising inventory:

check the age and condition of the stock
ask if any of these items are obsolete
if items are perishable, ask whether their are within their best-before date

When assessing accounts receivable:

determine how likely it is the amounts owing will be repaid
check the age of the receivables and whether they are collectible
ask whether adequate provision been made for bad debts and whether there are any disputes

Look into any liabilities

Depending on the nature of the assets, a company's loans or unpaid liabilities may become your responsibility as a buyer. A previous lender might even be in a position to seize the company's assets as repayment for an unpaid loan, leaving you with nothing. You need to know if the company has signed agreements that might lower the value of the assets or limit your freedom of action.

Decide whether its best to go all in or buy shares

Anyone buying shares in a company takes a stake in the business, its assets and its liabilities, whether they are recorded on the company books or not.

A purchase agreement can include a provision that involves a buyer directly in the management of the company, or the purchaser can remain a silent partner. This latter option can smooth the transition between owners, lowering the price paid by the purchaser and allowing existing owners to show buyers how a business is run.

The purchaser sometimes has the option of buying out the remaining shares and becoming sole owner later. Such a scenario is more likely if the target business is publicly traded and if the buyer has purchased enough shares to have some influence on how it is run. If a business is privately owned, the owners may prefer an outright sale.

There are always risks. Deals like these can sour if the buyer does not get along with the original owners or if the new and original owners have conflicting strategies. A purchaser may also unwittingly become responsible for liabilities such as unrecorded income tax reassessments, lawsuits and warranty claims that were not recorded in the financial statements. The new owner should also avoid being bound by the previous owner's depreciation schedules, which can be altered based on the purchase price.