8 Red Flags When Buying a Business
Throughout our lives, we make several big purchases that require common sense, research, and expert opinion or insight. These purchases might include purchasing a car, a home or an investment. Buying a business is no different. A decision that shouldn’t be made lightly, there are several factors that should be considered when purchasing a business. Here is a list of red flags we’ve identified for anyone looking to buy a business.
1. Experience, experience, experience!
The idea of owning a country cafe with its idyllic setting alongside the river with tables adorned with flowers sounds delightful, but have you ever made a cup of coffee? Have you ever worked an 8-hour shift on your feet serving customers?
If the answer is no, it’s a good idea to give it a go before committing to purchasing the business. Time to back-pedal and get a job at your local cafe before you invest $100,000+ as you might find it was just a dream you created from the latest Netflix film. The experience you have in the industry is important. Going in blind is possible and the seller will usually allow you to purchase, but is it the best business strategy?
Ask yourself this very important question… Is this a good business to buy FOR ME?
If you have this #1 priority covered, and you have previous experience, onto the next step!
2. Meet the Owner
With any business you are strongly considering, it is extremely important you meet the owner. Whether it's a country cafe, online website business or major steel manufacturer, if they are serious about selling their business, you need to meet them face-to-face.
I know it sounds like common sense, but I’ve heard too many horror stories of people committing to businesses for it to all come crumbling down after the money was paid. You should know who you are dealing with by getting a sense of the current owner. After all, they own the business, it is their reputation you are taking over, it is their hard work that will become yours. If they want your money, they need to also invest their time.
Visiting the business and seeing how it operates will also give you an advantage. Visit the business at different times and observe how busy it is. See if the sales they are claiming match what you estimate based on the clients walking into the business. Ask the owner if you can spend some time in the business to see how it operates, how the staff performs, and client interactions.
Are there any similarities between you and the owner? The moment you walk into any business I'm sure you can see ‘what can be fixed’ - it's at the heart of all business owners. We have that critical eye that leads to innovation and change. You will find by meeting the owner whether they are similar to you and if you share the same values. Whilst not vital, it will tell you a lot about how the business operates and how it relates to its clientele.
3. Don’t fall for the sales pitch
It's that old saying “he could sell ice to Eskimos”. There are some very talented salesmen and saleswomen whose main objective is to get the business sold. They are ready to move on and they want you to purchase. That is their end game. Whether it is a private seller, franchisee or a broker, it’s important you see beyond what you are being told. Being analytical and checking all areas of the business will be your best defence when buying a business. Strict due diligence will save you a lot of heartache down the track.
4. Do your due diligence
It’s your right and you should take full advantage of this. It is the only way you can be confident that the business you are purchasing is exactly what they are claiming it is. If you are a first-time buyer, due diligence is the process in which you get to investigate the business in full before completing the purchase. The amount of information you will have access to varies with each business sale, there may be some limitations due to confidentiality. This is to protect the seller in the instance that the business sale falls through but you have been given privileged information such as client lists, profit and loss statements or sales history. Often you will find a deposit is required before a full due diligence can be performed.
AND don’t do it alone….
You may have been in business for many years and think you understand all the moving pieces, but two pairs of eyes are better than one1, three pairs are better than two.. And so on.
If you are investing your hard-earned money into a business you want to be as confident as you can be that the information you are being told is accurate. It is so easy for a business to go backward; some mismanaged accounts, bad cash flow, poor marketing, new shop fit-out, and suddenly you could find yourself sinking money into your newly bought business that wasn't in any of your budget or cash flow projections.
5. Understand the financials
Reading a profit and loss statement may come second nature to you, or maybe you’re the ‘idea’s person’ who can see the potential, or perhaps you’re the Chef with bundles of talent. Whichever category you fall under, getting external advice to help analyse the financials is important. Figures can tell a lot about a business, they can also hide a lot of things.
Typically, three years of financial information is analysed when buying a business. Obviously, some businesses will have more, some will have less, but three years tends to be the number professionals advise to see when buying a business. The size and type of business will also play a big part in this.
When reviewing P&L and Balance sheets, it can be difficult to decipher what the owners are withdrawing from the business, and what they’re investing into the business. Often business owners will try to move money around for tax purposes, making it difficult to get a clear view of what’s going in versus what’s going out. This is particularly true if a business is dealing with a lot of cash transactions or has been established a long time; seeing the true cash flow can sometimes be a struggle. It's important you see BAS statements and Tax returns. Analysing the actual bank account can also help see things in black and white.
The tricky part of most business analysis is understanding why and how the money came in and why and how it was spent. Did the business have a good year because it landed a major contract that is about to expire? Did the business hire some more employees that may have driven up expenses? Did the owner work 10 hours a week or 100? What are the outstanding debts and loans? Are there outstanding accounts receivable that may never come? Did the salon lose its best hairdresser and now they have opened up their own salon opened up down the road?
Whilst reviewing finances help paint a picture of the business and is the first place to start, they won’t tell the whole story. Business is about numbers, but it’s also about understanding how those numbers came about.
6. Check the contracts
Businesses often have contracts such as phone bills, stock suppliers, marketing, computer rental, and the list goes on. Sometimes these contracts are in the business owner’s name, especially if they are a sole trader or partnership. When you are performing your due diligence, you may not come across these contracts. They may be posted to the business owner’s home address. But nine times out of ten, when the contract is found, it is the business who is liable not the previous business owner.
I’ve heard stories of cafe businesses who order $100,000 worth of custom-designed cups that are still sitting with the supplier that they are gradually ordering from. The previous owner expected much higher sales. You buy the cafe and realise it will take you 5 years to use all those cups and wonder how you’re ever going to repay it. So have a look at the business expenses and determine if there are any contracts in place.
7. Check the lease agreement
Without a proper lease agreement, most business value decreases, especially in the retail and hospitality sectors. Understanding the lease agreement is important.
These are 10 questions you should ask the landlord or check in the agreement:
How long is left on the lease? What are the terms?
Is the lease transferable?
Are there any fees to transfer the lease?
Are there any fit-outs required?
How is the water and electricity managed?
What are my trade restrictions?
What are my opening hours requirements and restrictions?
Do I require approval from the landlord to become the new owner?
Does the landlord intend to sell the building at any point?
Are there any restrictions on other operators? (If you are in a shopping centre, mall or community location.)
7. Get training
If you have been a barista for 10 years you may think you understand how a cafe works, how to make coffee, how to serve customers, b.. But do you understand how this business you are buying operates? Who handles the bookkeeping? How are orders tracked? Who are the couriers? Who are the cup suppliers? What contracts are in place? Who are your repeat clients? Who owns the other local businesses? So on and so forth. Ensuring training is included in the contract is vital. You don’t want to walk into the business blind - no matter how much you know. If after one1 day of training you think you have a grasp of everything, then you can just advise the previous owner they won’t be needed anymore, but placing it in the contract as a requirement is very important.
If the owner cares about their business and their clients they will want to include training. They will want to ensure their clients and staff are being looked after.
Is This a Good Business to Buy?
At this point, if you have run through the last 7 factors and don't have a definitive ‘yes’ or ‘no’, i. It’s time to start the investigation again, or simply walk away. If your gut instinct is telling you to jump in and go for it - then that is your answer. If you have hesitations, - there may be a reason.
Every business is different, every business owner is different, everybody's skill set is different. There isn’t a no yes/no case for every situation.
There are businesses with massive potential that havent been utilised by the current owner. They just need some fresh ideas to see the business go to the next level. There are some businesses that are beyond repair or need a specialised skill set to see them performing at an optimum level.
At the end of the day, as a business buyer, you need to conduct research, seek professional advice and make the decision that is right for you, your goals, and your family.
ABOUT THE AUTHOR
Vanessa is the CEO of Bsale Australia. She has been the managing director for the past 9 years. With extensive knowledge in online marketing and the business for sale industry. Vanessa is a huge supporter and advocate for small business in Australia.