Buying a Business? Know What You Are Getting!

When buying or investing in a business you need to evaluate that business carefully. One tool is the Investment Analysis.

The Investment Analysis table gives you discounted cash flow analysis including Net Present Value (NPV) and Internal Rate of Return (IRR). Both of these are important financial analysis tools that will help a business present itself via its plan in the terms used by the more sophisticated investment analysts.

Investment analysis

The estimated cash stream
The Investment Analysis starts with the Cash Flow stated in investment terms. That means that an investment is a negative number, and the return is a positive number. This example is typical of formal investment analysis. Sales, Profits, Expenses, Assets, and Liabilities are not included in the analysis. The analysis even ignores Cash Flow in this case, because Cash Flow is irrelevant unless it becomes a Dividend.

The example treats the company from the investor’s point of view. Namely, there is only one flow into the company that matters, the investment. There are only two flows back out as returns, Dividends and Equity Valuation. Equity Valuation really matters only when the investor cashes out. Until equity is sold, valuation is just paper money only, not real.

Questions to Ask When Buying a Business

There are so many questions to ask when considering the purchase of an existing business. In fact, there is not enough room on this page to list them. But let me give you a few examples that relate to financial, marketing, ownership and operations:

• Most importantly, why is the seller selling? The answer will either raise red flags or be consistent with, and met with, no resistance when asking the information in the questions below.
• Have you asked to review the certified financial statements of income, cash flow and balance sheets for the last three years? If you borrow from a bank to purchase the venture, the bank will want to see them.
• Have you asked to see the company’s (not the owner’s personal) IRS returns for the last three years? The bank will.
• Have you asked for a copy of all documents of all outstanding indebtedness like notes payable, accounts payable, real estate and equipment leases? The bank will.
• Has the seller offered to stay around for awhile after the sale to help with transition, and have you discussed some compensation for his services during that transition period?
• Have you been allowed to talk with the employees, or is this sale of a confidential nature at this time? If so, why are the employees not being told of the impending sale?
• Has there been any significant turnover of employees? If so, why is that?
• Have you learned anything about the quality of customer relations at the company? Is there a close relationship between company and customers?
• Have you learned anything about the relationship between the company and its vendors? Do vendors display preferred, regular or irregular relations with the company?
• Are there any members to a management team for this company? If so, are they aware of the impending sale, and how do they feel about it?
• What are the actual conditions of the working environment? Are there any hazardous situations or is this a well-kept workplace?
• What are the actual conditions of existing fixed assets like office equipment, machinery, vehicles and the like? Do employee, managers and supervisors demonstrate good maintenance and cleanliness of company property?
• There is so much more to ask, but this is a brief list designed to give you a starting point from which to begin the investigation of the venture in which you are about to invest.

We have not even discussed the issue of fair market value or selling price of the venture. I would suggest you will want to examine some of the expert panel responses on this subject. It is a detailed matter requiring a significant explanation.

Another relevant source of information on buying and selling businesses is the Entrepreneur Magazine Small Business Advisor. It is an excellent book with a most extensive array of subjects for any small business entrepreneur, addressing all aspects of the operation in easily understood language and graphic examples of the topics. It is an excellent investment for the purchasing process and can be used repeatedly when operating the venture. It is readily available online or at a reputable bookstore.

What’s That Business Worth?

When valuing a business for sale, start by reviewing basic financial statements.
Example: A husband and wife have been working in his father’s small business for almost four years now. They would like to buy his small business from him. It is a independent copier/fax dealership located in a small town.
They know the market potential and that his accountant has taken advantage of all of the possible loop-holes to shelter him from taxes. This will be the first year that the financials will depict a (pretty close) picture of the company. How do they evaluate the company and gain a fair evaluation of what they should offer him for his company?
Two major financial statements should be reviewed with their accountant, the balance sheet and the statement of income and expense.
The Balance Sheet should show how the assets, liabilities and net worth of the business are valued. Items shown on the Balance Sheet may not tell the entire story. For example, is the equipment valued realistically? The equipment may be obsolete despite what is shown on the statement. Are the accounts receivable fully collectable? Also, the liabilities may not reflect contingent liabilities, such as a pending lawsuit or potential tax liabilities. These are just a few of the many questions you must ask to determine true value of a business.

Looking at the next important financial statement is the Statement of Income and Expense (also called the Profit and Loss Statement). Are the sales correctly reflected? Unfortunately, many businesses dealing with cash do not deposit all the sales receipts. If so, how can the seller prove the correct sales. Or, when anticipating selling the business, the sales may be overstated. The expenses may contain personal items that are not business related. The point I am trying to make is that you need an experienced CPA or business appraiser who represents your interests to represent you when buying a business.
In this example we may be dealing with a father who is trying to help his kids as fairly as he can. He may be willing to agree to terms that will not be a strain on their finances. We may also assume, that in retirement, he would like to have an ongoing income stream from the business. Since the business shows good prospects for the future I can envision structuring a deal that is beneficial to both of them. The idea is for the buyers to give as small a down payment as possible to afford them maximum working capital.
A percentage of the gross sales or net profits can be paid out to the father for a certain numbers of years. Using such a formula will enable him to benefit by any future growth in the business. To arrive at a total payout amount would, of course, require knowing a lot more information than is provided in this quick example.

Planning for Purchasing a Business

A business plan is normally essential to the process of purchasing a business. A good business plan always defines the business’ specific mission and objectives, new ownership, sales focus, market, strategy, management team, and financials. This is particularly important when you are purchasing an existing business, because there is so much uncertainty involved.
Start with existing information
Start with the information you get from previous owners. Ideally, during the purchasing process, you received a business plan from the previous owners. One of the important functions of a plan is to define business prospects, therefore, sophisticated business sellers normally use a business plan as a selling document. It should contain information about business history, financial history, previous management, and possible prospects. You may want to read through a related article on this site, Steven Windhaus’ recommendations for questions to ask when buying an existing business.
Proceed with caution
If you do have such a plan, provided by the sellers, proceed with caution. Assume the seller’s plan was developed to sell the business, not to manage the business, and may be too optimistic. Question the assumptions. At every point that you possibly can, compare the seller’s plan for the business with its past financial information, market data from objective sources, and whatever other reality checks you can find.
You should always have financial information. Normally you’ll have past financial statements, and copies of tax forms, at the very least; few transactions take place without some basic financial information. Use this financial information as a basis of comparison. Question the information sources: copies of tax forms, if they are real, show what the sellers have told the government. Do they match the financial statements coming from the accounting iptv links ? How reliable are the financial statements? Have they been audited by outside accountants? Is the seller willing to allow an audit?
Growth forecasts are immediately suspect. Compare projected growth to past results. If the seller shows a future much more rosy than the past, ask why? What assumptions justify the change? Why was this business for sale ifprojections are optimistic? However, sometimes sellers have good reasons — needing capital, aging, divorce, for example — so don’t automatically assume that all growth projections are false. Try to understand why owners are selling a business, and how this affects their willingness to produce real numbers, and how it affects your own possibilities to make this purchased business work for you.

Don’t underestimate the importance of reality checks. Don’t rely on second-hand information. Where possible, spend time at the business in question, talk to customers, eat at the counter, use the service. For retail locations, for example, you can spend some time outside the store, count the customers, see how many go in empty-handed and how many come out with bags.
Make estimates. Count the business for some sample hours, and then calculate what total sales might be by multiplying your estimated average purchase value per hour. For example, say a shoe store has three customers per average hour, and guess that the average sale is $50. That’s $150 per hour total, which would be $1,200 per day and $7,200 per six-day week at eight hours per day. If that’s what you estimate and the seller reports $30,000 in sales per month, you’re reassured, because the two numbers — your estimate and the sellers reports — are in the same range. $7,200 per week for 4 weeks is $28,800, so $30,000 is close. However, if the seller is reporting $100,000 per month you will need to investigate carefully to explain this discrepancy.
Plan a new business or an existing one?
As you plan for the business you purchase, you start by making an important choice: business plans can be either for start-up new businesses or for already-existing and ongoing business. When you buy a business from somebody else, either option is acceptable. This is a choice you make.
The main difference between the two options is the existence in the plan of either a start-up table, or a past performance table. In a new business, a start-up table establishes opening balances for starting expenses, and financial balances including initial capital, debt, and assets. For an existing business, a past performance table shows past history of profit or loss, and balances of capital, debt, and assets. Business Plan Pro, for example, starts a plan with its PlanSetup Wizard that asks you whether the plan will be for a new start-up business, or an existing business.
How to decide? Either way can be acceptable. Here are some suggestions:

• Does the previous history build your business reputation? Would a loan or a new investment be more likely based on the previous history, or less?
  • When you are purchasing a strong business with a good past, use that strength as an asset by developing a plan for an existing business. Develop a plan for an ongoing business, use the past performance table to set your balances, and include a section on company history.
  • If you’re purchasing a failed business (presumably for a good price), then start over, with a new plan, built for a new company. Set your start-up table for a new business, and treat the business as a new business when you describe its history (or lack of history), ownership, and strategy.
• The better the information available from the sellers, the more advisable that you develop the plan as a plan for an existing business. In the worst cases, when you have little information available, then you don’t really have the option of starting with past performance, because you don’t know about past performance.
• Consider the name. If you plan to keep the business name, lean towards a plan for an existing business. If you are planning to change the business name, then you’re more likely to be better off with a new plan, not an existing plan. The naming decision is often a tip-off to the same variables that affect the plan. The factors that make you want to keep the name will make you want to use past performance and develop a plan for an ongoing business.

Ultimately, it’s your choice
Remember a business plan is always your plan; not the consultant’s plan, not the expert’s plan, but your own plan, for your business. As you look at the business you’re purchasing, decide what makes you feel best about it, and make that the choice for start-up or ongoing.