There are a lot of compelling reasons to buy an established small business. Existing customers, trained staff, goodwill and immediate cash flow can all make the purchase of an operating small business a sound investment.
But it’s important not to just jump in. A thorough process of due diligence is required before you commit your money to an existing small business. This is an essential process because how a business appears on the surface may not always reflect its inner workings or other internal problems it may have.
From the initial cost of buying the business to its current financial position, its client relationships, the status and entitlements of its employees, the lease of its premises and many other issues, a prospective buyer needs to enter the transaction with clear-eyed knowledge of what they’re buying.
Some buyers like to undergo this process on their own but many will avail themselves of the services of a commercial broker and/or an experienced legal representative with expertise in commercial conveyancing, such as Strathpine’s Big Law.
A basic checklist for due diligence
It’s a wise course of action for anyone looking to buy a small business to make a checklist of the issues you should investigate before proceeding to purchase.
At the outset: Initially, you will need to register your interest in the business with the seller’s lawyer, agent, broker or financial adviser. It’s a wise idea to find out as much as possible about why the current owner is selling. Is there a personal/family reason? Do they know a competitor opening nearby, or some other change that will impact the physical location of the business (lengthy roadworks in front of a store, for example)? Are you buying just the trading part of the business, or also the premises?
The pertinent question must be, why is the owner selling? A prospective buyer needs to be alert to tactics of some business owners such as keeping current stock artificially low to inflate the apparent profit level. Such moves are part of the due diligence investigation.
Wider research: Next up you should commence a broader research mission to understand the environment in which the business operates. Who are its closest competitors? Is the business in the optimal location? Are there variations in its level of trade depending on the time of day, or the time of year? The Discovery of the answers to these questions can take some time.
Discuss with suppliers, clients, retail associations and other industry figures related to the small business to find out its strengths and weaknesses; what risks now and into the future it may face; whether prices and other economic trends, both micro and macro, are in the business’ favour; and the state of its competition.
Financials and operations: A closer focus on how the business has been operating in the next stage of proper diligence. This requires examining financial records, to the extent possible, to determine the true state of the business. What are its payment terms? Do the current roster of clients pay on time, or are there outstanding debts and goods supplied on credit?
Past sales records and profit margins need to be compared with forecasts to determine whether the latter is realistic. Is there anything to suggest the forecasts for growth and profits have been inflated or manipulated to make the business appear more attractive? In some cases, a prospective buyer may engage a specialist accountant to conduct an audit on the business’ finances to determine the true picture.
Current employees: If permitted by the current owner, it’s advisable to do an audit of current employees to determine a range of facts, from their attitudes to new ownership, their pay and skill levels, the extent of their current entitlements (accrued leave, etc.), and the terms of their employment contracts.
Legal issues, including leases: To avoid any horrible surprises, legal due diligence should be undertaken to ensure there are no past, current or pending legal matters which could impact the operation of the business. What contracts does the business have in place with suppliers, contractors and clients, and what are their terms? Are patents, logos and other intellectual property of the business included in the sale, and are they legally protected?
If the business leases its premises, the buyer should make sure to check the state of the lease, including its length and the clauses referring to changeover, rent reviews and renewal, among other terms. Is a new lease required or can it be easily transferred to a new owner?
Goodwill: The price of the business will include an amount reflecting its non-tangible assets, commonly referred to as ‘good will’. Things such as the loyalty of clients and the experience of staff can all be counted as goodwill in valuing the business. Ensuring this amount is an accurate reflection of the true value of these assets can be a tricky exercise, and the guidance of an experienced commercial lawyer or accountant can be vital.
Consult with us at Big Law
At Big Law, we have many years of advising clients on purchasing small businesses. Commercial conveyancing, whether buying or selling, is one of our specialties. We can guide the due diligence process outlined above, and make sure the key issues are checked off before you proceed to purchase the business.