Five things you need to look for when buying a small business.
Are you thinking of buying a small business? Then making sure it’s a good investment is crucial. There’s little point in spending loads of money on a venture that will cause you a lot of headaches and could drain you of all your financial and personal resources. There are plenty of examples of when buying the wrong business has had calamitous outcomes for the purchaser.
So, where should you start? What do you want from the purchase? And what features make a company worth the investment? Here we outline five criteria you should consider when searching for the right firm to buy.
1. Is the business owner-centric?
By owner-centric, we mean, does the current business owner run their enterprise on a full-time basis, are all the processes in the business entirely dependent upon the business owner? If the current business owner is busy running the operations 24/7 and everything is centered around them then this is a problem. If so, think twice about the purchase.
If you’re looking to step into their shoes and work in the business full-time, that’s fine, if you have the time and the necessary skill set. But if you buying the business to add to your current business or as an investment then you need a company that you can easily step away from, you don’t want to be involved in the day-to-day running of it.
You could employ a manager, of course, but that’s an additional salary to consider on top of the investment, and you’ll both be learning the ropes simultaneously.
A business that can function well without its owner on-site and fully present is the best type of investment. It leaves you as the new owner full of energy and new ideas but, most importantly, free to grow the business, reinvest the profits or modify your offering.
2. Is there a management structure in place?
Even if the business is owner-centric and you plan to take their place directly, you’ll need to know the organisation’s management structure. Is it hierarchical, divisional or flat? And if it’s divisional, what defines the divisions?
The structure of a business is integral to its functioning, and without one, any venture could quickly become unprofitable and chaotic. Not only does the structure determine who does what and what the main routes of communication are, but the right structure can also make an organisation more efficient and productive. But, if you have the wrong structure in place, it can dampen employee morale and confuse line management responsibilities.
3. What systems are in place?
Systems are an essential component of any self-managing business. Reliable systems can even add monetary value to a business because of the significant benefits they bring. Whether it’s in accounting, production, or sales, systems are measurable ways to support a company achieve its goals. They prevent time and money from being wasted on unnecessary tasks but instead provide a tried and tested method that you can use repeatedly. They ensure outcomes meet a specific standard by outlining the steps that employees should take or that workflows should follow, and they also prevent omissions by defining all the stages of a process.
Systems can support expansion, too. As a business owner, you can quickly and easily duplicate the methodologies used in one location, department, or workflow with minimum fuss. The procedures are already known to work successfully, meaning they won’t need much modification or a period of trial and error.
4. Is the net profit percentage 10% or above?
When looking for a business to buy you’ll often find businesses that are up for sale advertised by business brokers. Business brokers will traditionally use a measure called EBITDA to show how profitable the business could be. EBITDA is calculated by taking the Net Profit and adding back the Taxes, the Interest, the Depreciation, and Amortization. Net profit is net income divided by a business’s total revenue, often expressed as a percentage. The value represents the proportion of a company’s revenue retained as profit.
EBITDA is a very useful measure when used properly. The problem is that you’ll often see ‘adjusted EBITDA’ this is where the people selling the business on behalf of the business owner have added additional items to the EBITDA to make the business look potentially more profitable in the future. This is why you should use a combination of both EBITDA and Net profit to evaluate the business.
You can use the net profit percentage to compare the profitability of two or more businesses, and it’s a mark of how well an enterprise is run. Lower percentages, i.e. 7% or less, indicate lower profit margins and highlight the potential for reducing business outgoings. Values of 10% or higher demonstrate the business is well-run and profitable, though it doesn’t mean there’s no room for improvement!
Bear in mind, however, that net profit percentage varies significantly across different business sectors, with companies in the service sector generally having greater values than those that produce goods. It is perhaps unfair to directly compare two businesses in vastly different sectors without being aware of this caveat.
5. Does the business have debts, and what is its cash position?
Considering the amount of debt, equity, and cash a business has can also give you insights into the management of the enterprise and the liabilities you’ll be taking on. Yet, they can also highlight a company’s vulnerabilities.
Consider debt. How geared is the business you want to invest in, or in other words, what is its debt to equity ratio? A highly geared business (high debt to equity ratio) has a lot of leverage and will reap the rewards during an economic boom. But if sales dip, debts still need to be paid, putting the company in a financially precarious position.
If you are taking on debt, ask how that debt is structured. Find out the repayment schedule and the details of any terms and conditions.
And finally, you should consider the cash position of the business. Although you can have too much cash (leaving it exposed to erosion by inflation), having access to some in combination with other liquid assets gives you agility and flexibility. Could the business operate for a minimum of three months on its cash reserves? Conversely, if there’s more than six months’ worth available, as the new owner, you could put that cash to better use.
Having some liquidity lessens exposure to risk and fluctuations in the market, but it also allows you to take opportunities when they’re available.
Think you’re ready to buy a business? We can help you understand the current situation and the potential of any company on the market and whether it would be a good fit for you. If you’d like to find out more, why not call us on 01482 408585, email us, or book an appointment and visit us at 277 Anlaby Rd, Hull HU3 2SE.