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Due diligence when buying a business

If you’re looking at buying a business, finding out as much as you can (due diligence) is essential to establish whether the returns are going to generate the profit you need.

To help decide if the business is for you, research:

The business history

Businesses are sold for various reasons. While most may give the reason as retirement or wanting to move on, it could be a future issue or slowing of demand. It’s critical to find out why the business is being sold and how it’s been performing.

  • Uncover the business’s back-story by looking up contact details, length of time in business, customers and suppliers (it’s worth calling existing customers and suppliers to get a feel for the business).
  • Ask what the owner intends to do when they leave. It’s important you set a constraint of trade so the owner doesn’t start up again in competition.
  • Find out about the industry and ensure that future trends are positive.
  • Investigate the location of the business and determine any future developments and plans for the area, to double check there isn’t a looming regulation or zoning change that could impact the business.
  • Access the past 3-5 years of financial statements to get a picture of sales and expenses. Get professional help if you need advice interpreting this data to pick up on any anomalies.
  • Interview employees to better understand the culture of the business. If you can, interview past employees as they may give a more honest answer.
  • Review any data that could signal trouble such as the number of returns, complaints, or delays in payments. It could be useful to look through any social media comments for signals of discontent.

The total cost

One of the main dilemmas when buying a business is how much to pay, as there isn’t a full-proof formula to use as it depends on a many factors including current market conditions, if similar businesses are selling and how many buyers are in the market.

Arriving at a market value for a business can be subjective as the amount you’re prepared to pay will be based on what the business is worth to you. For example, you may have no interest in the business as a going concern, and want to just buy the net assets, the customer database or the number of subscribers.

Once you’ve arrived at a value for the business, you need to be sure you can afford to make the purchase. You’ll probably already have a financial limit in mind based on the:

  • Cash or equity you have available.
  • Amount you’ve been able to secure as a loan.
  • Number of partners, angels or venture capitalists prepared to invest.

You’ll should also work out how much additional money you’ll need to:

  • Cover additional purchase, transfer and set-up costs.
  • Pay for any unexpected problems, such as paying for overhead if there is a delay in launching or larger inventory requirements.
  • Provide your working capital or contingency reserve.

Identify the return on investment (ROI)

Another factor to consider is whether you’ll earn a reasonable return on your investment. Unless this is a lifestyle purchase, you’ll want to make sure your investment is likely to earn you a significantly better return than your money could earn sitting in a bank or medium-risk investment, earning interest.

It’s easily calculated by dividing the purchase price into the expected net profit, for example, a business selling for $2m that’s expected to generate $200k in net profit, will have a return of 10%.

Are you prepared to receive a 10% return for the risk of running the business? If yes (or you have plans to improve this ratio), then good.

Calculate the risk

The amount you’re prepared to invest buying a business will also depend on the level of risk involved. If you’ve done a thorough investigation and the business is in good shape and in a growing market, you’ll be prepared to pay a higher price. On the other hand, if it’s a new business or a new product, in a low-growth or untested market, the risk involved should mean a lower price.

One other point to consider is: how easy would it be to get your money out if your situation changes? Would you be able to sell the business easily if you needed to? If you can answer yes, the risk is less.

Summary

Due diligence is the process to make sure you get what you think you’re buying, and often it’s the intangibles that matter the most (reputation, brand, customer service, employee loyalty and business culture). Within reason, dig as much as you can until you get a feel for the business and then make your decision. It’s also worthwhile to seek professional advice from your accountant, lawyer or business adviser to check your calculations.