How to analyse the financials when buying a business - Episode 4

One fantastic and I find often overlooked way to achieve financial autonomy is to buy an existing business.  In comparison to starting your own business where cash flow starts at zero and you need to support yourself whilst the business becomes self-sustaining (refer episode 1), when you buy an existing business, you have cash flow and customers from day one. Buying a business is something I can talk about with quite a bit of experience.  I’ve bought two businesses, and for a couple years I was a licensed Business Broker as a side line to my financial planning practice.  The thinking at the time was that my business owner financial planning clients would need to sell their businesses when they retired, and so perhaps offering business broking services was a sensible expansion.  I ended up concluding that the two services weren’t especially complementary, but I picked up some great learnings that make me a better advisor for my business owning financial planning clients, and for those seeking financial autonomy through buying a business. Just as an aside, something that I believe really strongly about business endeavours, but also life more broadly, is that we can’t be afraid to try.  I heard someone trying to sell business coaching recently and their tag line was 98% of business fail within 10 years. What a ridiculous statement. I assume their definition of failure is that the business isn’t around 10 years from when it started. So? Does that equate to failure? I operated as a part time business broker for 2 years and then made the decision it wasn’t sensible for me to continue to devote time and effort into that area.  At the end of that period I had $35,000 sitting in my Business Broking bank account, and had learned an enormous amount.  In fact even if there was no money in the bank account from that business, I’d still say it was a success because I learnt so much. So if you hear people trying to convince you that your plan or idea will never work because most businesses fail – don’t believe it. People start businesses, and people wind up businesses.  Their lives change, new opportunities come up, industries change.  Sometimes people just come to the conclusions that they could make more money doing something else. That’s not failure – that’s having a go and then having the intelligence to reflect and chose a new path.  In Silicon Valley jargon, that’s a “pivot”. Anyhow, sorry for the rant but that’s just something I feel strongly about – you can’t live your life being afraid to try.   So when you look at buying a business, here’s the process: You search the various web sites such as businessforsale.com.au and find a business that looks interesting.  You submit an enquiry to the broker.  The broker will send you a Confidentiality Agreement which you need to sign and send back – most business owners that are selling want to keep it quiet.  They don’t want their customers and staff to know that they are looking to exit. The broker will then send through to you an Information Memorandum (IM).  The level of detail in here will vary depending on the scale of the business and it’s complexity, but the IM will give you some good information about the business, it’s history, and some figures around how revenue and profit have been tracking. Having read through the IM you should be able to determine whether this is a business you really want to look into in a serious way.  Expect to look at quite a few IM’s in your hunt for a business.  They cost you nothing and it’s always useful to see the figures for different businesses. So let’s say you’ve found a business that looks like it may fit your needs.  The next step will be to get the detailed financials – at least 3 years worth.  So what to look for? The Profit and Loss is the most important. First of all, is the business making a consistent profit?  This will be the number at the bottom of the Profit and Loss.  If it’s losing money it’s tough to see how it’s worth anything, so let’s assume it is showing a profit. Is that profit after the owner has received a wage? There should be a wages or salaries item in the Expenses section, and often in the financials there will be an explanation of what this is made up of.  If it’s not completely clear, go back to the broker and ask for a breakdown of what the wage’s expenses are. It is very common in a small business for the owner not to take a wage, and just live off the profit. Consider this example.  One business you look at shows a profit of $30,000 last year.  The other a profit of $90,000.  At first blush the second business looks more attractive.  But you dig a bit deeper.  You find in business one that in fact the business owner has paid himself a wage of $80,000, and also paid super of $25,000.  In business two however, you learn that the business has paid nothing to the owner, and in fact in this case the husband works on the business 6 days a week and his wife does the book work one day a week.  $90,000 rewards for all that effort is starting to sound less attractive. So you need to get an understanding of what is the actual return to the owner. It wouldn’t be unusual to find the business owner running his car through the business.  I’ve seen instances where the entire families’ mobile phones all go through the business.  So go through the expenses, ask lots of questions, and get to a point where you know how much the current owner is actually making out of this business. So as an example you might find a business that made: $30,000 profit $80,000 in owners wages $25,000 in owners super contributions $15,000 in owners vehicle expenses that aren’t essential to the operation of the business $5,000 in other expenses related to the owner. So add this all up and the total return to the owner for this business is $155,000. There may also be depreciation in the expenses.  This is a non-cash item reflecting the value of equipment wearing out.  You may want to add this amount to the return the owner receives as well. This is less clear cut because at some point that equipment will need to be replaced.  If depreciation is a large amount, you’ll need to dig a bit deeper into this and it may be something to discuss with your accountant. However you decide to best treat depreciation, you will have arrived at a total return to the owner in the most recent year. Now run this same calculation across the previous year’s financials so you can see how stable this is.  Was last years $155,000 earnings a typical year, or abnormally high or low? You won’t get it from the financials, but once you understand the total return to the owner, ask the broker how many hours the owner is putting into the business.  Earning $155,000 might be acceptable to you if she’s putting in 40 hours per week, but perhaps, if to earn this, the owner is working 7 days a week and 12 hours a day, maybe that return isn’t so attractive.  In reverse you might come across a business that only returns $30,000 to the owner each year, but if it only takes up 2 hours a week of the owners time, maybe that’s a really good business. Okay, so you’ve now got a good sense of what the current owner is making from this business, and how stable that is.  The next thing I’d go to is trends. Start with the total revenue and total expenses items.  I’d put them in a spreadsheet myself but it’s up to you.  You’ve got 3, maybe more years of data.  What is the trend?  Now we’d all like to see a trend of rising revenue.  In my experience though, business owners are just like elite sports people – rarely do they get out at the top.  So don’t be surprised if you see declining our plateauing sales.  Whatever the trend, you need to understand what is going on as this will definitely have an impact on whether you want to buy this business, and how much you would be prepared to pay. Often at the revenue level income will be broken up into several sub-categories – what is that telling you?  Is one area of the business dying?  Perhaps another is growing. Similarly at the expenses level.  What is happening there?  Have input costs or wages been rising faster than revenue? Having gone through the process you should have a whole bunch of really intelligent and insightful questions to ask the owner.  You also have a good basis upon which to talk price. You could ask all your questions to the broker, but I would suggest you ask for a meeting with the owner at this point so you can get the answers straight from the horse’s mouth.  A direct discussion is likely to give you far more detail, plus you can gain a lot in the non-verbal cues. On price, don’t be surprised if, having gone through the financials, you struggle to make sense of the price being asked.  For many business owners their business represents their life’s work and in their mind it is a gold mine worth millions.  Do your own numbers, determine what you as the owner could make out of this business, and from that what is a sensible price for you to pay.  Typically that will be 1 to 3 times what the business will make for you each year depending on the trend of revenues and profits, and the industry.  If you come up with a price that makes sense to you of say $300,000, and the owner is asking $900,000, don’t be afraid to tell the broker that based on the numbers and information provided, it only makes sense to you to pay $300,000.  Don’t throw in a ridiculous low ball offer just to play games, because that will just piss people off, but if you say “look, from the numbers you’ve provided I think I’d make “x” per year, and so as a result it would make sense to me to pay “y” for this business, the broker will understand and the business owner will come around, or perhaps furnish you with additional information to show why the business is actually worth more. Very often the business owner’s expectations are way off the mark, and as much as the broker can try and advise them of that, it’s not until genuine offers start coming in that the reality hits. Also, keep in mind that most business owners, by the time they decide to sell, are well and truly ready to exit.  They’re already thinking of the retirement holiday or what they will do next with their life.  So make an offer that makes sense for you and be patient.  If the owner won’t come around, there’ll be other businesses.   Important Information: This information is of a general nature only and has been prepared without taking into account your particular financial needs, circumstances and objectives. While every effort has been made to ensure the accuracy of the information, it is not guaranteed. You should obtain professional advice before acting on the information contained in this publication.