Buying a Business – Buyer’s Guide


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Recommended to do a valuation of the business you are interested in.Elsewhere on the web / Links
Business Valuation Model (Excel Spread Sheet)
The Business Valuation Model combines relative indicators for future performance with basic financial data (such as revenue, cost of sales, and overheads) to value a business. This valuation method can be used for business purchase, sale, or establishment. This model uniquely applies your intuitive business and market knowledge to provide a three-year performance forecast and a business valuation. It is compact and easy to use, requiring minimal inputs. Outputs are in graphical and tabular form.

Frequently Asked Questions (FAQs) About Buying A Business

Should I buy a business, or simply start my own business?
An existing business has a history which can be used to evaluate the business. It should have detailed financial records. This will enable you to determine exactly what you are getting for your money. If you do a proper due diligence, the risk should be lower than starting a new business. This is the case, specifically because an existing business has usually shown there is demand for its products or services, and you can quantify the demand and growth patterns, before laying out capital.

Sometimes, a seller will agree to stay on for a period and help to train a new owner and to provide seller financing.

On the other hand, there can also be disadvantages to buying an existing business. A buyer will be assuming an established corporate culture and infrastructure which may make implementing changes more difficult. Also buyers will generally have to pay a premium for an existing business. This is where the trade-of lies: the seller can ask a premium because he took the risk of establishing the business; the buyer should decide if he wants to pay a premium for buying something that it already up and running, versus not paying a premium and setting up a new business but running the risk failure before the business becomes profitable.

How is the asking price of the business calculated?
This is a key question, which will drive negotiations. A complete business valuation often provides an objective starting point for both buyers and sellers of businesses. It is important to keep in mind that a price must reflect a fair market value if it is to support the sale of the business. In other words, although certain formulas may provide a certain value, the business will not sell if that price is not in line with market prices for that particular type of business.

Valuing a business is not an exact science, but you should be able to determine a price band within which the final price can be negotiated. The valuation process involves comparing several different approaches and selecting the premium method, or a combination of methods. Some of the methodologies used to evaluate businesses are:

1. Rule-of-thumb methods
2. Asset-based valuation
3. Comparable Company Value Multiple
5. Discounted cash flow.

1) Rule-of-thumb methods
One of the most common approaches to small business valuation is the use of industry rules of thumb. These “rules” are of course generalisations with severe shortcomings, and should not be used for much more than a point of reference. One industry rule of thumb says an Internet Service Provider company is worth $75 to $125 (+-R750 to R1250) per subscriber plus equipment at fair market value. Another says that small weekly newspapers are worth 100% of the gross income of one year. Yet another places the value of an advertising company on 150% gross income for one year.

2) Asset-based valuation
This valuation method is based on the premise that the value of a business can premium be determined by adding the value of all the assets of the company and subtracting the liabilities, leaving a net asset valuation. An asset-based valuation can be further segmented into four approaches: (1) book value, (2) replacement cost, (3) appraised value, and (4) excess earnings. Asset-based valuation methods ignore the importance of  earnings and cash flow. For this reason, this valuation approach is generally not used to determine the market value of a company – especially in the context of an acquisition.

It is a crude method of valuing a company, and should only be used in special circumstances, for example where a company has little or no track record and no certain future earnings, or in cases where the company has been running at a loss.

Book Value – The book value of a company is obtained from the balance sheet by taking the adjusted historical cost of  assets and subtracting the liabilities. Tangible book value is calculated the same way as finding regular book value, except that intangible assets (like goodwill) are excluded in the calculation. Using book value does not provide a true indication of a the value of a company, nor does it take into account the cash flow that can be generated by the assets of a company. It is a crude method of valuing a company, and should only be used in special circumstances, for example where a company has little or no track record and no certain future earnings, or in cases where the company has been running at a loss.

Replacement Cost – Replacement cost reflects the expenditures required to replicate the operations of the company. Figuring replacement cost is essentially a set-it-up-yourself or buy decision.

Appraised Value of Assets – The difference between the appraised value of assets, and the appraised value of liabilities is the net appraised value of the firm. This approach may be most commonly used in a liquidation analysis because it reflects the divestiture of the underlying assets rather than the on-going operations of the firm.

Excess Earnings – In order to obtain a value of the business using the excess earnings method, a premium is added to the appraised value of net assets. This premium is calculated by comparing the earnings of a business before a sale and the earnings after the sale, with the difference referred to as excess earnings. Assuming that the business is run more efficiently after a sale, the total amount of excess earnings is capitalized (e.g., the difference in earnings is divided by some expected rate of return) and this result is then added to the appraised value of net assets to derive the value of the business.

3) Comparable Company Value Multiple
This method involves selecting a group of companies (often listed companies) that, on average, are representative of the company that is to be valued. The financial or operating data for each comparable company  (like earnings or book value) is compared to each its total capitalization to obtain a valuation multiple. An average of these multiples is then applied to derive the value of the company.

Because the comparable companies will have different characteristics than the firm undergoing the valuation, premiums or discounts may be applied to the target company. Unlike listed companies, privately held firms do not have an actively traded market for their shares. This will result in private companies almost always being valued at a discount to their listed company peers.

4) Discounted Cash Flow
Discounted cash flow is the preferred tool to value businesses. What sets this approach apart from the other approaches is that it is based on projected, future operating results rather than on historical operating results.

Discounted cash flow analysis consists of
1) projecting future cash flows
2) deriving a discount rate and
3) applying this discount rate to the future cash flows and terminal value.

This detailed analysis depends on accurate financial projections and discount rate assumptions. The resulting company valuation is the sum of discounted future cash flows and the discounted terminal value.

1) Projecting Future Cash Flows – The first step in conducting a discounted cash flow analysis is to project future operating cash flows over a projected holding period, generally five years. These projections are generally done before debt (but after taxes) to obtain an accurate indication of future free cash flow. The future free cash flow is the cash left over after operating the business and investing in necessary property, plant and equipment, but before servicing debt or paying out any cash to owners.

2) Discount Rate – The second step in the discounted cash flow analysis is to develop a discount rate. The discount rate is also referred to as the weighted average cost of capital (WACC) and is premium thought of as a percentage which represents the return expected by an owner of the company commensurate with the risk associated with the investment. For example, a risky Internet start-up with little in the way of a demonstrated track record, would receive a higher discount rate than a company with a long history of growth and profitability and more obvious future prospects. Discount rates are generally calculated by deriving the cost of equity capital and the after-tax cost of debt (note that although the cash flows are projected on a debt free basis, it is important to derive a WACC based in part on the expected cost of debt, since this reflects the level of risk for the company). These financing costs are weighted and result in a WACC percentage, or discount rate. The cost of equity capital is generally determined using the capital asset pricing model (CAPM), which is based on three inputs: (1) the risk free rate (the expected return on long term government bonds , (2) the beta, which is a measure of the relative riskiness of the company (compared to the market), and (3) the equity risk premium (the expected rate of return on common stocks in the long run). The derived discount rate is applied to the projected future cash flows to determine the present value of the future cash flows.

3) Terminal Value – The next major step involves calculating a terminal, or residual value. A terminal value calculation combines assumptions used to derive future projections and the discount rate to obtain a current value for a  long term future cash flows. The assumption underlying this step is that a company is a going concern and that its value is imbedded in its ability to generate value not just today, but well into the future. A terminal value is calculated by determining the cash flow in the period beyond the last projected period. This predicted future cash flow is then capitalized by a percentage (represented by the discount rate of the company less the predicted long term growth rate) and this capitalized figure is then discounted back to the present using the discount rate.

Although these methodologies can indicate a value band for your business, the results should be viewed with a degree of caution. There are a large number of additional factors which impact the value of a business. Some of these factors which are often overlooked, include:

  • The true profitability of a business in the eyes of a buyer (book profit adjusted for extraordinary expenses, excess compensation for the owner, etc.)
  • Strong growth (using past performance as an indicator of future returns to the buyer)
  • Competitive climate (market share of the firm, entrant of new players)
  • Regional/national economic climate
  • Unique/proprietary products, data, processes
  • Favourable lease terms in a desirable area
  • Tax loss carry-forwards a buyer may be able to use to offset profits
  • Advantageous supplier relationships that a buyer can leverage
  • Rapidly changing industry dynamics
  • Desire to immediately exit or stay with the business
  • Customer concentration
  • Recurring nature of cash flow/financial performance

Why is confidentiality so important to the seller?
Confidentiality is very important to a seller. Be sure to treat all negotiations and information confidential. Customers may not be interested in buying from a business that is up for sale, competitors could use the information to their advantage, and employees generally experience anxiety and often leave.

What should I be looking for in a business?
Generally, you should not purchase a business unless you can improve it. Since you pay a price for the current value of the business, you would want to improve the value of the business to “profit” from owning it.

The time and effort which will be required is an important consideration as is how much the buyer can afford to pay for the business. The amount of cash the buyer hopes or needs to regularly take out of the business is very important, especially if the business is to be the only source of income for the buyer.

What is due diligence?
Due diligence is a systematic process for acquiring and analyzing information to help a buyer or seller to determine whether or not to proceed with a proposed business transaction. Typically you would verify information supplied by the seller, such as turnover.

How much cash do I need in order to purchase a business?
In most cases, a portion of the total consideration paid for a business is paid in some sort of deferred payment – whether in the form of a seller note or payments contingent on the performance of the business.

Lenders are also available to make acquisition loans, including financial institutions and private individuals.

Therefore, a cash investment of 1/3 to 1/2 of the purchase price may be sufficient to complete a transaction.

What are the main reasons for the failure of a business after it is bought?
– The price paid was significantly over market value.
– The due diligence was not carried out correctly.
– A previously dependent asset was unable to function/survive without the support it received in the previous owner environment
– A change in business environment created unexpected problems.