How To Uncover any Problems BEFORE You Buy
Due diligence is probably the most critical stage in the buying process. Many prospective buyers incorrectly identify this period as strictly a financial review, but it goes far beyond that. Due diligence encompasses a far-greater project and that being the complete investigation and review of the business.
One of the keys to buying a good business, comes from your ability to learn the intimate details of the business. To identify the strengths, weaknesses, pluses, minuses, growth opportunities and areas of concern. If you do not do a flawless job of gathering information, you will not be able to pull the trigger and complete the transaction since you’ll be uncertain about too many components of the business.
When To Start The Due Diligence?
The investigation process must begin the moment a business becomes of interest. Naturally, your goal is to make certain that you uncover everything about any business BEFORE you buy it. You don’t have to meet the seller or even visit the business for your research to begin. The Internet is an incredible tool that will allow you to investigate the business, the industry, the competition, the marketing, the suppliers, and on and on.
The importance of beginning your investigation early on cannot be emphasized strongly enough. This way, you’ll position yourself to ask the proper questions to the seller. Once you progress to the stage of an accepted offer, you will commence the inspection or financial due diligence. This period usually lasts 10-30 days. This is the time when you’ll have access to all of the company’s books and records.
Once you begin looking at a particular business, you’ll find a thousand things crossing your mind regarding the acquisition. Keep a notepad handy at all times and log your thoughts. You’ll have many thoughts about things “I need to check out.” Write these all in one place. Don’t trust your memory; these little things are the ones that can come back to haunt you down the road. Begin to put together your checklist of what you need to investigate and how you’re going to do it, along with the materials you may need from the seller to accomplish it.
A couple of things to keep in mind
Allow yourself enough time
Many sellers and some brokers will press for a very short inspection period; sometimes just days. Don’t get bullied into this – give yourself ample time to complete this part of the process. You should allow for, negotiate and not settle for less time than you comfortably need to complete a thorough inspection/due-diligence period. The financial review can usually be done in days but there is more to investigate and that is why a 20 business day period is not unreasonable for larger businesses, while a 15 day period is needed for smaller ones in order to complete the review and move the deal forward to closing.
Since you’ll have some time restrictions (you’ll only have x number of days per the contract), provide the seller with a listing of all of the materials required for you and/or your CPA to complete this exercise. No matter what you’re told, do not begin the process until they have provided what you/your CPA need to properly complete the review.
Dealing With Surprises
You’ll probably find some surprises; don’t panic, it’s normal. Work through them. Get clarification. Build your case. Don’t run to the seller or broker every time you find an inconsistency between what you’ve seen versus what you were told. No business is perfect. The rule to follow is do not treat any incidents as catastrophes or any catastrophes as incidents. If you find a major problem, get your facts in order and you can then decide the appropriate action to be taken with the seller (i.e. renegotiation, walking from the deal, etc.)
According to industry statistics, nine out of ten people who begin the search to buy a business never complete a transaction. While there are many reasons for this dismal figure, a lot has to do with the inability of people to “pull the trigger.” This gun-shy reaction is related specifically to uncertainty: if you have not gathered the right information or failed to investigate the business thoroughly, you will not be 100% certain of what to do. And so, you’ll drop the project. Conversely, if you do a flawless job of investigating the business, and everything else adds up right, then making the final decision is simply one more step in the process!
Five Questions Business Buyers Should Ask, but Usually Don’t
The average business for sale buyer goes into the buying process with an arsenal of boilerplate questions for the seller. But the questions buyers really need answered are the questions they usually don’t think to ask.
Buying a business isn’t for the faint of heart. A host of hidden pitfalls and dangers lurk beneath the surface of every deal, waiting to pounce on the blind enthusiasm of the first buyer that crosses their path.
To protect themselves, buyers have traditionally relied on a standard list of questions to shed light on the company’s historical performance and current financial condition. Due diligence itself is designed to focus the buyer’s attention on issues such as financial conditions, business operations, personnel, condition of assets, etc. – all of which need to be addressed before the buyer can make an informed buying decision.
But a growing trend in the business for sale marketplace is making it necessary for buyers to ask a new set of questions. The trend is called FSBO (For Sale By Owner) listings and it works just like it sounds. Although brokers continue to play a vital role in the business marketplace and participate in a substantial number of business for sale transactions, some sellers and buyers find it more advantageous to use the Internet and other resources to sell or locate companies themselves.
The advantages of FSBO listings for both buyers and sellers are clear. However, FSBO listed businesses require the buyer to assume greater responsibility in the buying process. For some buyers, the lack of broker expertise can ultimately lead to a purchasing decision based more on gut feelings than facts. For those business buyers unsure of their ability to make a sound purchase decision on their own, professional business brokers can play an important role.
FSBO buyers can overcome the gap in expertise by asking questions that go beyond typical due diligence and probe more deeply into the seller’s thought process. While answers to the regular financial and operational questions are still crucial, there are five other questions today’s FSBO buyers also need to ask.
Question #1: “When Did the Owner Decide to Sell the Business?”
In some ways, buying an existing business is like buying a used car. If you’ve ever bought a used car, you probably asked the dealer why the previous owner sold the car in the first place. And then the car dealer probably told you that the previous owner was a little old lady who only drove it church and was recently placed in a nursing home.
Business buyers have a similar curiosity about the owner’s decision to sell. Owners usually respond with an answer from the seller’s playbook. Variations of “I’m ready to retire,” “It’s time to do something else,” and “It’s time to give someone else a chance” lead the pack.
Yet much of the time, the reason behind the owner’s decision to sell is less important than when the owner decided to put the business on the market.
Ideally, the answer buyers should look for is that the listing didn’t arise suddenly, but came as the result of a well-thought out, multi-year plan conceived by the owner as a means of achieving his personal and business goals. If that’s true, the owner should be able to provide the buyer with a copy of the plan upon request.
But if the owner’s decision to list the business happened quickly, that could be a red flag that the business is in trouble, that there are economic threats on the horizon, or that the owner hasn’t taken the time to properly prepare due diligence materials.
Question #2: “What Valuation Method Did the Owner Use to Determine the Asking Price?”
In a typical business for sale transaction, the buyer and the seller each perform their own valuation of the business’ worth. So from the buyer’s perspective, the seller’s valuation method isn’t an essential element in determining a reasonable price tag for the company.
However, the seller’s valuation method does become a factor when it comes to gauging the owner’s basis for the asking price. Many sellers assess their business’ worth by way of an asset-based valuation method simply because it is the easiest valuation method. Unfortunately, it is also the least accurate way to determine a value for small businesses. Income capitalization methods are equally unreliable for small company valuations.
Instead, savvy small business buyers utilize a multiplier valuation method based on the owner’s benefit. If the seller also employs a multiplier valuation method, both parties enter the negotiation process on the same page. If not, the negotiation process will likely become an exercise in apples and oranges. The buyer and the seller will both experience frustration because they are unable to agree on a common basis for valuation. If buying or selling online, users of business for sale marketplaces can find multiplier-based business valuation tools available at no or little cost.
Question #3: “What Does the Owner Want to Walk Away With?”
Although it may seem unlikely that the seller will disclose his bottom line before the negotiation process has even started, it’s important for the buyer to make an effort to discover what matters to the seller.
At the very least, buyers who are willing to ask this question will begin to get an idea about the seller’s non-cash motivations. The vast majority of small business owners are just as concerned about the business’ future as they are about how much money they will make on the sale.
The seller’s non-cash motivations can be a powerful negotiation tool for buyers. When the negotiation process hits a wall, knowing everything that is important to a seller can sometimes close the deal.
Question #4: “What Would the Seller Do to Increase Sales and Profits”
More than anything else, buyers need to create opportunities to inject a dose of reality into the buying decision. Presumably, the person who is most qualified to offer a realistic perspective about the business and its future growth prospects is its owner. Yet sellers often prefer to paint a rosy portrait of the company rather than simply telling it like it is.
One of the ways a buyer can break through a reluctant seller’s defenses is to invite the owner to make suggestions about how to increase capacity, market share and profitability. With the right approach, a buyer’s appeal to owner expertise can change the seller’s posture from defensive to collaborative.
Question #5: “Is the Seller Willing to Sign a Non-Compete Clause?”
An established customer or client base is one of the reasons existing businesses are so attractive to buyers. That incentive disappears if the owner’s intention is to sell the business and take the company’s customers with him.
There is no surer way to surface a seller’s real motives than for the buyer to request a contractual non-compete clause. If the seller refuses, the buyer should proceed with caution since the business’ customer base may be soft. On the other hand, if the seller agrees without blinking an eye, the existing client base can probably be used as a reliable gauge for financial projections.