Buying an existing business may have advantages over starting from scratch, such as existing operations, customers, and cash flow. But the due diligence process can be quite involved. Here’s a checklist to help you do it right.
Buying a business can be an exciting and deeply engaging experience. Here are some of the main steps to follow:
Finding a business that looks appealing to buy is one of the first steps. But before you can ink the deal, you will need to perform due diligence, which is a deep dive into the details of the business. Due diligence is your chance to make sure there are no red flags or hidden risks to avoid. Here is a non-exhaustive list of the sorts of things to look for:
There is more than one way to calculate the purchase price for a business. In many cases, you can obtain a fair estimate by analyzing the company’s assets minus any liabilities, its revenue minus any expenses, and looking at the current environment surrounding the business. For example, you might evaluate the health of the business’s industry and the recent selling prices of similar businesses.
As part of your due diligence process, you can retain an independent business valuator with the knowledge and experience to come up with a reasonable range of values. You can then use that insight to negotiate firmly but fairly with the seller.
Perhaps the most fundamental valuation metric used by stock market investors is the price-to-earnings (or P/E) multiple. In short, this is the ratio of the price per share versus the company’s earnings per share. For example, if a company earns $1 per share and its stock trades 15 times higher than that at $15 per share, the P/E ratio is 15. In other words, investors are paying $15 for every $1 of current earnings.
This format allows an apples-to-apples comparison of different businesses. Imagine that companies in your industry have a P/E ratio of 15, as in the example above. Now let’s say you are analyzing two businesses that both have $1 million per year in sales. If one has net earnings of $200,000, this method implies that it might be worth $1.5 million ($100,000 x 15). If the other business has net earnings of $50,000, it might be worth only $750,000 ($50,000 x 15).
Market-based methods of business valuation share similarities with the housing market. To determine the valuation, you look at comparable home sales in the same neighborhood - or business sales in the same industry. Just as the price per square foot varies drastically between Des Moines and Manhattan, so will the likely business valuations in mature, lower-growth industries like farming or dry cleaning versus younger, higher-growth industries like robotics or ecommerce.
Market-based methods can also involve more qualitative and speculative aspects, such as estimating how evolving industry trends or consumer behaviors will impact the future growth of a business. Again, you could liken this to real estate, where certain demographic, cultural or economic trends make some areas grow more appealing and the homes there start to attract higher prices.
A company’s assets are generally the most predictable part of its valuation. If a company owns a building or a fleet of vehicles, it’s pretty straightforward to determine their present value minus loans or mortgages that are secured against them. The value of the assets, net of any debt, can generally be added to the valuation.
Non-physical assets can be a bit trickier. Imagine a company that owns the patent for a medical device that it has not yet manufactured or brought to market. To understand the value of that asset, it is necessary to model out what it will cost to manufacture and to market — and what the resulting revenue stream will look like.
In assessing the real estate, fixed assets, and inventory of a company, you want to know more than just what each item is worth today. Here are some of the factors to include in your research:
Finally, you will want to understand the type of ownership and maintenance attached to each asset. For example, is it owned outright, is there a loan outstanding, or is it leased? Is there a warranty or service contract or would any repairs be out-of-pocket? Answering these questions might help you anticipate potential expenses and factor that into your valuation of the assets and the company.
Equipment is part of a company’s assets, so it’s important to know what it is worth to you as a buyer. As you evaluate an itemized list of equipment, here are some of the questions to consider:
It is a good idea to have a look at the seller’s equipment and any documentation relating to it as part of your due diligence.
Inventory is another key component of a company’s assets that you much take into account as part of your due diligence and to calculate a valuation. Here are the steps to take when appraising inventory:
Ideally, you will inspect the inventory in person as part of the due diligence process. If this is not practical or possible, you might ask the seller to fully update their inventory records before closing the deal.
Accounts receivable are monies owed to the company, so it’s important to see not just how much money is reflected on sales reports or invoices, but how much is actually collected as revenue. Here are a few questions to ask while reconciling accounts receivable with a potential seller.
If you are concerned about delinquent client accounts, you might ask the seller to let you speak with the client or clients as part of your due diligence process. It’s important to understand if the business has trouble collecting all of the amounts that are owed to it.
If the business has any mortgages, loans, or other debts, it’s wise to examine the documentation pertaining to them, and ideally, to have your lawyer also take a look. You want to understand all the terms and conditions that might affect the business. You don’t want any surprises, such as a debtor having the right to demand early payment or covenants that might limit your choices in the future, such as your ability to seek additional financing or to sell assets that have been pledged as collateral.
After you have completed your due diligence and arrived at a valuation for the business, you might decide that you would like to invest in it without owning it outright. If this is something the seller is willing to consider, a deal like this could allow them to extract some capital from the business while continuing to run it. All the while, you could participate in its future earning potential, either at arm’s length, or with some type of advisory or co-executive role. This is just another option for you to consider when figuring out how to buy a business in a way that will best meet your personal and financial goals.
Whether you’re buying your first business or expanding your empire, let Swoop scan the market for the best business financing options and deliver them to you in minutes. You can get started right now.
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