Due diligence

Don’t make these mistakes when buying into a business

Owning a business is a goal for many people and being a business owner can be an incredibly rewarding experience both professionally and financially. It’s very common for prospective business owners to be attracted to the prospect of buying a business either by acquiring the whole business themselves or by purchasing a share of the business from the existing owners. The advantage of this path is that the prospective owner can eliminate the start-up period inherent in any new business and leap straight in with a profitable business (hopefully). This article will focus on the common mistakes people continue to make when buying an existing business.

To begin, the value of any business is determined by the future profits that you expect to receive in the future. Critical to this are two important aspects:

  1. The business performs in line with your expectations after you have made the acquisition; and
  2. There are no issues arising from the past that result in unexpected cash outflows or costs.

Developing a clear understanding of both aspects is paramount to determining the value of any business and whether the investment in the business is a sound decision whilst mitigating the risks of any unforeseen issues that can lead to losses in the future.

Future performance

It’s important to ensure that the investment delivers an appropriate return when buying a business. While the rates of return on investments vary widely across different industries, an important consideration for any prospective business purchase is whether the business will be able to continue to deliver a favourable return into the future. To put this another way, will the business make profits in the future that justify the price being paid to acquire the business? If the performance of the business fails to meet expectations, then the money may be better of invested in other businesses or asset classes.

Key to this is the ability to accurately forecast the future performance of the business. A fatal fall in many business purchases is simply relying on the vendors projections and/or historical results without conducting any form of analysis or verification to ensure that the projections are a reliable indication of the performance in the future. When looking at the projections for any business, it’s important to consider a range of factors such as:

  • Nature and timing of revenue streams
  • Contracts with key customers
  • Reliance on key customers, what is the customer base
  • Competitive forces and industry trends
  • Sales trends and seasonal forces
  • Potential for disruption
  • Gross margins
  • Relationships with suppliers
  • Benchmarking to industry norms
  • Staff levels and mix
  • Analysis of fixed and variable costs
  • Inventory levels and turnover
  • Level of involvement in the business by the current owner/s
  • Remaining life and condition of existing plant and equipment
  • Bad debts and current debtors
  • Warranties and refunds

The items listed above are just a sample of the things that need to be considered when forecasting the future performance and the list is not exhaustive and will vary from business to business. Correctly identifying and understanding the key factors that will determine the success of any business is imperative and requires the skills of a qualified accountant. Failing to identify and understand a single factor can determine the success or failure of purchasing a business.

As an example, Kerry wishes to sell his plumbing business to Charles. Over the last 3 years, the business has made profits of $100,000, $115,000 and $125,000 respectively and Kerry is projecting that the business will make a profit of $130,000 in the next year. The historical results match the profits shown in the tax returns that Kerry has provided so Charles decides to purchase the business without undertaking any further due diligence. Immediately after purchasing the business, Charles realises that 80% of the sales are made to the government under a contract that ends in 3 months’ time. Once the contract ends, Charles will be required to submit a tender as part of a competitive tender process if he wishes to win that contract back again for another 3 year period. There is no guarantee that Charles will win the tender plus he doesn’t have any experience with the tender process, so he may need to engage with specialists to assist him along the way which could be an added expense he didn’t plan on incurring.

In this example, Charles failed to identify that a significant portion of the income for the business came from a single government contract. Having a single customer like the government contract leads to the risk of over reliance on a single source of income and creates a big problem should have customer leave or in this case the contract ceases. An matter such as this would have been identified during due diligence and steps could have been taken to mitigate the associated risks (i.e. negotiating a reduced purchase price or making some of the consideration paid contingent upon the contract being successfully renewed).

Clearly understanding the current business operations and the impact of that on the future performance of the business is critical. It’s not uncommon for vendors to overestimate the likely performance of the business in the future and/or not disclose important information about the business unless specifically asked by the purchaser.

Past issues

When purchasing a share of an existing business or purchasing a business entirely by acquiring it’s critically important to know and understand that you’re also purchasing the history and all the associated “baggage” of the business for the better or worse. In some instances, people can use this to their benefit. For example, a business may have carried forward losses that the new owners believe can be utilised by turning the business around and making profits in the future. On the flip side, unforeseen issues can arise from the conduct of the previous owners that can come back to significantly hurt the new business owners and in extreme cases, cripple the business to the point of failure.

To use a practical and simplistic example, Samantha is interested in purchasing a 50% share in a business that Katherine owns. The business is consistently making a profit after tax of $100,000 p.a. and Samantha believes that the business will continue to make those same profits into the future. Businesses in this industry are typically valued at 3-3.5 times their earnings so that would mean that the whole business is worth around $300,000 to $350,000. However, Katherine has offered to sell 50% of the business to Samantha for $200,000 which consequently values the whole business at $400,000 (or a multiple of 4 times) which is higher than the industry average. Samantha believes that his new business partner has an edge over the competitors and the historical profits of the business lead Samantha to believe that paying a higher purchase price is justified. The premium that Samantha is paying to acquire his share is between $25,000 to $50,000. Samantha and Katherine agree that Katherine will continue to be responsible for managing and operating the business going forward.

In the first year after Samantha purchases his share, the business performs well and makes a profit of $100,000 so Samantha is happy that his new investment is performing well. However, in the second year Katherine has informed Samantha that the ATO has conducted an audit of the business and found that staff have not been paid superannuation for the last 3 years. As a result, the business is required to pay the unpaid superannuation owed to the employees, plus interest and penalties which totals $150,000. In addition, there will be an ongoing cost of $25,000 in superannuation payments each year which will reduce the profit expected each year to around $75,000.

The consequence of this is three-fold. Firstly, the business will make a loss of $50,000 in the second-year post acquisition and may require an injection of cash to pay that unpaid superannuation liability to the ATO. Secondly, the it’s likely that the competitive advantage that Samantha believed Katherine had wasn’t the result of any operational matters but rather due to under paying the employees. It’s highly probable that the valuation of the business has fallen back to industry norms both in terms of the multiple used to value the business plus the expected earnings in the future. The indicative valuation of the whole business has likely fallen to around $225,000 to $262,500 and Samantha’s share is worth between $112,500 and $131,250. Finally, the profit that Samantha will receive each year going forward has fallen from $50,000 p.a. to $37,500. To summarise, the loss for Samantha is:

  • Loss of between $68,750 and $87,500 in the value of his investment (34% to 44% reduction); and
  • Loss in recurring profits from the business of $12,500 p.a. (25% reduction).

The loss that Samantha has incurred is very significant in terms of the overall amount of money he has invested but also not unusual. Trusting that the previous owner/s have complied with all legal obligations and that they’ve disclosed all relevant information to the prospective purchaser is fraught with danger but an incredibly common occurrence. In this example, the loss was the result of only one past issue but frequently more that one issue may arise that compounds the losses even further. In the worst case, the issues maybe so significant that business is crippled and ceases to operate.

The importance of adequate due diligence

A comprehensive legal and financial due diligence process will cover many areas including, but not limited to understanding:

  • Nature of the business being purchased
  • The motivations of the person/s selling
  • Contractual liabilities to creditors, employees, lenders and other parties
  • Undisclosed liabilities
  • Past and future financial performance and cash flows
  • Current balance sheet position
  • Working capital requirements
  • Whether any investment is required in new stock is required
  • Compliance with tax obligations including income tax, GST, FBT, payroll tax etc
  • Lease obligations
  • Ownership and valuation of buildings, plant and equipment
  • Ownership and valuation of intangible assets such as patents and other intellectual property

Failure to conduct proper due diligence is the most common issue that we see that leads to material issues arising for the new owners of existing businesses. It’s critical that any prospective business owner engages with a qualified accountant and solicitor who will work side-by-side with the client to guide them through the business acquisition process and ensure that thorough due diligence is undertaken before any investment decision is made. Doing this will reduce the risk of common mistakes being made and improve the likelihood that the business will succeed into the future.

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