- Australia, the Small Business Nation
- Should you buy a small business?
- Due Diligence
- CFO’s focus on this when buying a small business
- Have you found the right small business to buy?
- Prior Planning Prevents Poor Performance
- The Last Word
Australia, the Small Business Nation
Australia really is the Small Business Nation. Almost half of the country’s workforce are employed in small businesses (those with less than 20 employees) and they contribute 35% of Australia’s GDP. They are also literally everywhere – 98% of all businesses have less than 20 employees! So if you’re looking for a business to buy, the odds are you’ll be buying a small business. When you’re deciding if a business is worth buying you’ll need advice from a financial adviser (among others). In this guide I’ll be explaining things from a CFO’s view. A CFO works with owners and managers of businesses to ensure businesses achieve their desired outcomes. We’re often called in to advise on buying and selling businesses by conducting due diligence, helping to plan strategy, feasibility studies, forecasting, helping to obtain funding, and more.
Should you buy a small business?
I can’t stress this enough – if you don’t have a very good reason for buying a business, DON’T BUY IT! Have you always liked eating donuts and that’s why you want to buy a Donut King franchise? The technical term for this is “not a good reason to buy a business”. Other not good reasons include:
- Having no prior experience in the industry – even if you learn quick, it will be a painful and expensive learning curve.
- Wanting to work for yourself – if this is the only reason for buying a business, invest your money instead.
- Not understanding how the business works – this is surprisingly common, especially when buying a franchise.
- Not having a plan for the business – you need to drive the business, or it’s not going to go where you want it to go.
If you have a very good reason for buying a small business, then go for it – Just do your due diligence first!
If you’ve heard the term due diligence before you probably understand that it means investigating the business to verify what’s on offer. You may be able to verify some aspects for yourself if you have through knowledge of some aspect of the business (eg the industry, the staff, the customers, the suppliers). This is rare though, and you need to be aware that you’re likely to be biased.
What do you do then? The simple answer is, get good advice in key areas. This sounds obvious, right? But it’s worth saying, because often emotion takes over and decisions are made based on things like “a good feeling”, or “trust” … and unfortunately these don’t lead to good decisions being made.
Getting good external advice takes the emotion out of making decisions, by expert advice in areas that you probably don’t have enough knowledge in. For any business purchase this means getting solid advice from:
- Lawyer – legal due diligence means reviewing commercial agreements/contracts the business has (think leases, large customer/supplier contracts, and even staff employment contracts).
- Lawyer – to create the sale contract and make sure that all the specific things you’ve negotiated are included properly. For example, do you want the previous owners to stay for 12 months to handover? Your lawyer will ensure this is in the contract. Want to make sure the previous owners don’t just start a new business and poach your clients? Your lawyer will make sure the contract allows you to enforce this.
- Accountant – financial due diligence will help ascertain if the business is actually as profitable and secure as the seller claims. It will help unearth as many skeletons as possible so you can make an informed decision about buying the business, and help you to negotiate the price.
- Other industry or technical experts – depending on how the business operates and what it does, getting other specialists in will help you understand the pain points within the business, or where there are opportunities for improvement. If the business sells online, you might include an SEO review or assessment of their webshop. If the business is highly dependent on an overseas supply chain then a sourcing specialist may identify opportunities to reduce cost or improve production time. This aspect of due diligence is sometimes forgotten but can actually be the most beneficial.
CFO’s focus on this when buying a small business
As an external CFO engaged to conduct financial due diligence for a prospective purchase (or get a business ready for sale) I’m mainly interested in making sure the asking price is reasonable. This means examining the business’ P&L and Balance Sheet to see if the asking price is under or over valued. In this section we’ll run through a commonly used valuation method and the most common assumptions that are tested during due diligence.
Asking price – the earnings multiple
For many small businesses the sale price will be based on a multiple of earnings (generally EBIT, or Earnings Before Interest and Tax). This multiple is based on the probability of earning future earnings which is a popular way to value businesses. This is really important to understand – when you buy a small business the price you’re paying is based on the likelihood of future earnings.
As an external CFO engaged to conduct financial due diligence for a prospective purchase (or get a business ready for sale) I’m interested in making sure the asking price is reasonable. Let’s take a look at an example business where the owner is asking $300k, which is a multiple of 4 times the most recent earnings (Year 3 $75k x 4 = $300k):
I mentioned above that the multiple is generally based on the future earnings/EBIT. But total expected future EBIT over years 4,5 & 6 is $444.5k, not $300k? This is because those future earnings are discounted, or reduced to their present value based on how likely they are to actually come true. The $300k asking price is a discount rate of 20% per year, indicating the owners think their projections are pretty accurate. I then test whether their estimates are correct, by answering these questions:
Are Revenue projections realistic?
Over the last 3 years this business has grown fairly rapidly – revenue has increased 14% in Year 2 and a further 25% in Year 3. Not bad! What we want to know is will the forecast doubling of revenue over the next 3 years come true. For this we go behind the numbers to find out what’s driving this growth. Is it new products, expansion into new regions, hiring new Business Development staff, or something else? What’s their competition like? What barriers will they need to overcome to see those numbers?
Forecasting sales is hard, and as we know ….
What could derail their Gross Profit?
Gross Profit (GP) is the money made on selling each product or hour of services. It’s handy to calculate this as a percentage of revenue because not all products and services can be purchased or sold at the same price. The fact this business has had stable 30% GP in Year 1 and 2 then jumped to 35% needs to be explained, as does the assumption that this 35% GP will continue for the next 3 years. We’re now in the parts of the finances that can be manipulated by the owners to show the results they want, so be on guard for:
- Has revenue been brought forward into year 3 to improve GP? Invoicing some Year 4 clients a few days early may not bother them but if this is done without the associated product/service costs this is falsely inflating GP.
- Product and Service costs can be quite variable. Think of the impact of inflation, material shortages, supply chain disruptions, labour shortages, currency exchange rates, interest rates, and more. Some businesses work on a cost-plus pricing model which may make them more predictable, but even these will be affected by external influences.
- Are the GP assumptions conservative, or overly optimistic?
Are expenses reasonable?
The operating Expenses of a business will generally increase in steps. As the business grows, new staff are added, premises are expanded, vehicles and equipment are acquired. As we saw above, this business is forecast to steadily grow EBIT through to 20% of revenue by Year 6, driven by strong Sales growth, high GP, and a lower increase in Expenses. This is healthy growth … but I know you’re wondering what could be hiding here!
Two major problems could be hiding in relation to Expenses. One is that expenses have been hidden on the Balance Sheet (keep reading to check out that one), and the second is – beware the Family Business!
Many small businesses are family businesses, which is a really good thing. They’re great for employment, awesome for transferring skills and knowledge down across generations, and let’s face it, who doesn’t want to help their family? Over time though, the line between business and personal can get blurred. Some over-ordering of office supplies that ends up at home, a second car for the owner’s partner, mobile phones for the kids on the business account … you get the picture. We calculate the impact of removing those additional costs (this is called normalising). They represent opportunities to reduce expenses after the sale of the business but you have to do this quickly – they are a drain on cashflow.
Scrutinise the Assets & Liabilities!
Assets represent costs that have not yet become expenses. For example, you purchase a vehicle and it is depreciated (written off to expenses) gradually over a few years. Likewise some expenses are prepaid (like insurance premiums) and written off over the course of a year. If somebody is preparing their business for sale assets are a great place to hide costs! Here are some examples we’ve come across, all of which would have resulted in large losses to the new owners after a business was sold, and so should be written off prior to sale and the sale price adjusted accordingly.
- Software implementation costs booked as an asset but never depreciated until new software was installed 5 years later.
- A very large customer debt which was never going to be repaid, not written off because it would result in a huge loss.
- Prepayments for supplier shipments that were never going to be delivered.
- Loans to related companies that were either closed down or no longer operating.
Liabilities are a bit trickier. We’re checking the existing liabilities to make sure they are correct and complete. Are all business liabilities accounted for? Is the correct balance owing reflected in the financial reports?
It’s not all doom and gloom though. While sellers are incentivised to make their financial figures look great, we often find opportunities. Here are some common ones:
- Assets being depreciated too quickly. We often ask how revenue is generated, and normally this will involve using some assets (equipment, computers, desks, vehicles, etc) so the next question is, when should they be replaced? (because replacement assets need to be paid for, either out of profits, via lending, or owner’s cash). A lot of small businesses’ financial reporting is prepared by tax accountants, and it makes their life easier if the assets are depreciated the same as they are for tax purposes. Remember the Instant Asset Write-off? Those purchases are frequently written off immediately in financial statements. Instead, asset values should reflect the real “useful life” of the assets – recognising their true asset value in accounting records improves the financial position of the business.
- Loan facilities are sometimes not utilised effectively. A good cash management strategy includes using lending as needed to minimise investment in working capital.
Have you found the right small business to buy?
The due diligence will always raise issues to be discussed. You need to decide whether they are:
- Dealbreakers – you’ve discovered risks or problems that are just too heavy for you to take on, regardless of the cost. A good example of this might be overdue tax payments for which the ATO has not agreed to a payment plan.
- Negotiation points – some of the assumptions underlying the financial forecasts are a bit rubbery or just plain unrealistic. This is a chance to renegotiate the purchase price.
- Opportunities – Often due diligence unearths more positive aspects than negative ones. If these are good enough then the asking price may become a bargain (but still use the negative ones to negotiate the price!)
Prior Planning Prevents Poor Performance
So you’ve found a great business to buy. Due diligence went well (found a few issues that can be resolved before sale but nothing major), got a decent sale contract drawn up, and you’re heading towards settlement. In the first few weeks you’re going to meet the staff, introduce yourself to the major customers and suppliers, and then what? Relax? Sit back and count the money rolling in? Golf on Wednesdays and an early mark on Fridays?
Even though this business is profitable and running well, it’s just been through a massive change. Staff want to know what’s going to happen. Everybody wants your time because they want to know what’s going to happen next. They want to know what your plan is, and you need to be ready to share it with them, to get them engaged, to “bring them along on the journey”. All platitudes aside, you need to have a plan for where that business is headed and how it’s going to get there. And the ideal time to start that plan is before you sign the contract:
- Document your plan.
- List business targets – some people use 30/60/90 day plans, others prefer quarterly or monthly targets. Use what makes sense to you.
- Detail how the business will reach those targets and what changes (if any) need to be made to support this.
- Share your plan with the people who need to know, whether it’s staff, managers, banks/lenders, etc.
- Monitor progress and share it with the same people – informed stakeholders are happy stakeholders!
The Last Word
Buying a small business can be a great way to build your own lifestyle. If you already have a business then targeted business acquisitions can help you expand into new regions and services, or secure your supply chain or customer base. Make the most out of the purchase process by getting good advice.