This article aims to provide a general guideline to understand the steps of buying a small business and getting a sense of its true worth:
- Scouting for targets
Buying a business is not as easy as it sounds. Many people underestimate how complex and challenging buying a business can be. The foremost challenge is to first find a genuine and high-potential business that is up for sale. Looking such deals is not a part-time job and is often a journey involving a roller-coaster ride of emotions. Even though this is the first step involved in buying a business, this is one of the most difficult but an important step in the journey of buying a business. Online private marketplaces like Businesses for sale, SMERGERS and Biz Buy Sell help people list out all available options and suggest the right valuations for a business. Some of these online resources are not only convenient but also provide authentic and credible deals available at any point of time. Especially if the buyer has limited experience buying a small business, then it would be advisable to consult such online resources.
- Preliminary Research
Researching the business’ operations, product lines, industry, competitions, and the seller’s background is invaluable. Taking to different companies in the space like a customer, trying their services and products as a customer could give insights into how the business and industry operates. This is a crucial step of the preliminary research which one should not overlook.
- Understanding the seller’s motivation
It is also particularly important for the buyer to connect and understand the motivation and emotions of the seller. Sellers or business owner usually have strong emotional attachments to the business that they have built from scratch. The buyer should be considerate and willing to understand the motivation to sell and to know about the fundamentals of that business which will ultimately help the buyer in identifying blind spots. A buyer would also profit from trying see if the businesses operational and financial condition is coherent with the seller’s motivation to exit the business.
- Understanding the business and its divers
A buyer would have to delve deeper into the operations of the business and understand its revenue and cost drivers thoroughly. Every seller or the broker will go out of their ways to make the business look appealing and attractive to the buyer and many a time it is not easy to understand the fundamental drivers of the business’ profit engine.
If the profit margins have been increased recently, then it is questionable and warrants further investigation. To eliminate this issue, always dig deeper into the financials. Understanding the cash flow characteristics, unique assets and patents the business owns, economic moats of the business, capabilities of the management team, USPs of the business, competitive advantages etc. In a few instances, it is the personal network and reputation of the seller/original owner that has kept the business going up until now and many buyers are unaware of this which can. Firms offering services tend to be more prone to this ‘key man’ risk as opposed to those that sell products.
Refer to as many sources as you can to investigate the business. A buyer should thoroughly investigate and try to obtain information from a various data sources such as financial accounts, annual reports, former employees, industry experts, current and former suppliers, customers, investors, and competitors. The intangible data concerning the positioning of the products in the store, company image, culture, loyalty of the customers, customer satisfaction and their perceptions of the business is very crucial to determine whether the business will deliver profits in the future or not.
Often, it is not easy to retrieve financial data of small businesses because of the lack of public directories that maintain this in information. In the case, raw data is extremely helpful in understanding trends in margins, discounts, revenue etc.
- Valuing the business
Once the business’ operations are understood, it is time to delve deep into the financials to understand the financial position of the business and extrapolate a valuation range for the business.
It is often said that “Valuation is not a science; it is an art”. A business valuation represents a business’s total worth considering the assets, earnings, industry and any debt or losses. A mistake that most buyers tend to make while buying a business is to overestimate the value of the business. Buyers should be conservative when forecasting future cash flows. The assumptions for the future of the business should be carefully examined making allowances for any risks that can be reasonably expected to arise. Underestimating the future capital expenses, IT investments, machinery and equipment, maintenance, working capital needs, and regulatory and compliance costs can result in losses. Performing valuation of a small business should include the cost/salary of additional people that you might need to hire or replace, company expenses and as well as your own salary.
While there is no right or correct way that one could probably use to value a business, there are several wrong ones. In the end however, a business is worth whatever you think its worth. Several different methods can be used to estimate a business’s value. You can begin by identifying the value of the business’s assets. What kinds of equipment, patents, brands, trademarks, inventory, software technology does the business already own? Balance sheets also provide a good indication of the value of the business’s assets. It must also be noted that depending on the asset, the book value shown by the balance sheet may significantly defer from the market value. In practice, there are about four business valuation methods that a buyer should be aware of. These are- discounted cash flow, capitalisation of earnings, asset-based and market-based.
The discounted cash flow method calculates the present value of a business’s future cash flow. There is always a risk involved in purchasing the business which is why it is discounted to adjust for the uncertainty involved. This method is apt for new business with high-growth potential. The capitalisation of earnings method calculates a business’s future profitability, accounting for cash flow, annual ROI, and expected value. This method should be used by established businesses with stable revenue. The asset-based method focuses on the net value of a business’s assets, both tangible and intangible excluding the value of liabilities. This method is often used by businesses that hold investments or real estate. The market-based method is all about a company’s value-based in the purchases and sales of comparable companies in the same industry segment. This is a flexible method that can be used by any business if they can find sufficient data on comparable companies. It must be noted that that these valuation approaches are not mutually exclusive, and it is always advised to value a business by all possible approaches to arrive at a valuation range that is confirmed by the different valuation methodologies used.
- Due diligence of the business
Once a valuation for the business is arrived at and you intend to move forward with the investment or acquisition, a thorough due diligence exercise is indispensable. A thorough due-diligence exercise involves closely examining the operational and financial practices of the business, the promoter’s background, and motivation to sell the business, background checks on key employees, the business’ claim on its assets, its exposure to liabilities and potential litigation.
Buying a business often is arduous and requires long hours of research and contemplation and it is always better to have no-deal than a bad deal. Leveraging online resources and marketplaces such as SMERGERS which has thousands of small and mid-sized businesses, investors, acquirers, advisors, and franchisors advertising their deals can be invaluable to a buyer.
