INTRODUCTION

Are you part of the 10%?

Statistics show that out of every 10 buyer's enquiries received by business brokers, only 1 in 10 buyers (10%) will actually ever buy a business. This Guide is designed to help you to decide if you are part of the 10%.

Given the complexities of the purchase process, the stress of business ownership, and the discipline and dedication required for ongoing business success it is understandable that only a small number of “Potential” Buyers become “Actual” Buyers.

This Buying Guide pulls no punches. If the buying process seems complex, it’s because it is. Buying a business is not something you do on a whim. You need to be fully committed to the process and your learning curve will be steep. The rewards for those willing to commit are vast; buying an already successful business and growing it further is rewarding both financially and emotionally. But if not done right, you can end up stuck in a business that may be near-on impossible for you to exit from.

“Wise men say only fools rush in” - Elvis

This Guide is written for two main groups; first-time business buyers who are committed to buying a business; and second, people who may just be interested in finding out more about buying a business. I hope to educate people about the business buying process, so they can make better, more informed decisions.

As a Business Brokers, I want to deal with educated business buyers; it saves me time when a buyer already knows what type of business they want and has an understanding about their budget and likely borrowing capacity.

This Guide is not exhaustive. Many others have written on this topic, and I encourage you to explore these resources. Above all, be educated and aware of what you are getting yourself into, since once you are in, its not easy process to get out.

BEFORE YOU START

It’s important that you have some clear ideas in your mind about the type of business you are looking for and the price you are prepared to pay before speaking to brokers.

You need to remember that approximately nine out of every 10 business buyers will never actually buy a business. Business brokers know this statistic, and as such they have developed processes/ questions to quickly identify serious buyers.

Below are a selection of questions I ask potential buyers when assessing whether a buyer is serious or not.

Why?

• Why do you want to buy/own a business? (Identification of credible motivation)

• Why have you decided that buying a business is good for you?

• Have you considered the pressure and stress that comes with business ownership?

• Are you prepared to work seven days if necessary to ensure your business is successful?

What?

• What type of business do you want?

• Industry type (retail, wholesale, services etc.)

• Structure (owner operated, under management, franchise, non-franchise etc.)

• What picture comes into your mind when you imagine yourself owning and operating a business?

• What budget do you have?

• Have you spoken with a business finance broker/banker regarding your capacity to borrow?

• Do you understand the process banks go through when assessing the viability of the business loan? (This guide will assist you)

• Have you made a list of your assets and liabilities, living and loan expenses and other relevant factors?

• What minimum Return on Investment are you prepared to accept?

• What is your current occupation?

• Are you between jobs, between businesses, currently employed full-time etc.?

• Do you have particular trade skills/job experience in particular industries?

When?

• When do you want to buy a business? (Now, next month, next year etc.)

How?

• How are you expecting to finance/pay for the business you are looking to buy?

• How are you expecting to operate/manage the business once you have purchased it?

• Do you understand the process of how businesses are bought and sold? (This guide will assist you)

If you can adequately have answers for each of these questions then I would consider you to be a serious buyer.

THE BUYING PROCESS

HOW IS THE SALE PRICE OF A BUSINESS CALCULATED?

There are a number of valuation methods and ‘rules-of-thumb’ which have developed over time for the valuation of businesses, and particular business industries may even have their own specific methods of valuation. This can be very confusing, particularly if you are comparing businesses from different industries.

To cut through this confusion, a single consistent valuation method has been developed allowing all businesses to be valued on the same consistent basis. This method of valuing is known as the Return On Investment (R.O.I.) Method of Valuation.

The R.O.I. Method of Valuation analyses the income stream of a business, and then assesses the Risk of this income stream continuing on into the future. This risk is expressed as a percentage (%) and is known as the R.O.I% . The higher the percentage, the higher the perceived risk of the ongoing income stream.

A prudent buyer will ask “Is the current income from the business sustainable and on-going?” The R.O.I% used in calculating the value of the business is a reflection of this risk. It is important to note that the R.O.I% is determined by supply and demand. If a business is in a sought after industry then a purchaser may be prepared to pay more for a business, thus lowering the R.O.I%.

The R.O.I% changes over time as business cycles ebb and flow. It is, therefore, important not to rely on “rules of thumb” when valuing businesses. The advantages of using one single method to value businesses is that it allows for different businesses across various industries to be compared to each other on the same basis. A wholesale business can be compared with a manufacturing business, even though the industries are completely different.

HOW IS THE BUSINESS VALUE CALCULATED?

Let’s consider an example in our business buying guide.

Jenny has a successful wholesale/retail business which has an Adjusted Net Profit of $200,000 per annum.

An R.O.I% of 40% is deemed to be appropriate in this instance. With these two pieces of information the potential sale price of the business can be calculated using the formula shown below:

HOW IS THE R.O.I % CALCULATED?

The R.O.I% is derived by dividing the Sale Price of a business by the Adjusted Net Profit of the business (Please see formula below). For example, if Jenny sells her business for $500,000 to Robert, and at the time of sale the business was producing an Adjusted Net Profit of $200,000 per annum, then the R.O.I% for that business will be calculated as:

Note that this is a reversal of the formula show on page 5.

An example has been provided below on three different businesses, all with the same Adjusted Net Profit of $100,000. The hypothetical businesses are compared with each other, and note the effect on the overall value that the R.O.I.% has:

As you can see, the lower the R.O.I.%, the higher the value of the business. Remember that the R.O.I.% is derived from the Business Sales Market, to calculate up-to-date R.O.I.%’s on businesses which have recently sold.

WHAT IS ADJUSTED NET PROFIT?

In our business valuation calculations (pg7) we use the business Adjusted Net Profit to determine value.

So just what is Adjusted Net Profit?

In its most simple form, Adjusted Net Profit is the true underlying profit of a business after allowances have been made for the owners’ personal structure and any abnormal income or expense events. In accounting terms it is known as E.B.I.T.D.A (Earnings Before Interest, Tax, Depreciation, and Abnormals).

People buy or start businesses in order to have access to an income stream from the services or products that the business produces. The R.O.I. Method of Valuation calculates the value of a business based on the income it produces.

The income stream of a business is shown in the Profit and Loss statements prepared by the business accountant. Financial statements of privately held businesses are usually prepared to report income taxes. These financial statements serve the purpose for which they were intended, however they rarely show the economic reality of the business’s earnings or assets.

To determine the appropriate Adjusted Net Profit to value a business, it is usual practice to work on the figures from the current financial year, as this is usually the most up-to-date picture of how the business is performing.

Adjusted Net Profit is “adjusted” to remove accounting changes

and the owners personal structure from the business profits.

Adjusted Net Profit = Business Operating Profit before Tax, Depreciation, Interest & “Add-Backs”

WHAT ARE ADD-BACKS?

The financial statements of privately owned businesses rarely portray the true assets and earnings they generate. Pro-forma adjustments, often referred to as “Add-Backs”, are used to adjust an historically reported financial statement for a truer picture of the underlying cash-flow of the business.

Add-backs help portray the true.

underlying cash-flow of a business.

Adjusted Net Profit = Business Operating Profit before Tax, PLUS Depreciation, Interest & “Add-Backs”

The type of Add-Backs that are relevant depend on the circumstances unique to each individual business. The underlying goal is to adjust the historically reported profit to the economic reality of the business by adding or subtracting amounts to individual financial statement components.

Typical Addbacks can include:

• Donations

• Bad Debts

• Rent Adjustments

• Adjustment for Owner’s Wages & Superannuation

• Hire Purchase and Leasing charges

• Loss on sale of Fixed Assets

• Interest (Both expense and income)

• Depreciation

Add-backs are an important tool for adjusting financial statements to show the economic reality of the business, but they are not tools that can alter history. Add-backs are not appropriate to depict how a business could have performed had the owner taken a different strategic direction or captured an opportunity that was missed. Add-backs are used to properly depict the earnings and assets of the business as it was actually operated and not how the owner should have or could have operated the business.

The importance of properly identifying Add-Backs shouldn’t be overlooked as they directly impact the Business Value when using the R.O.I Method of valuation.

ADD-BACKS EXPLAINED

WHY DO WE ADJUST FOR MANAGEMENT WAGES?

In most small businesses (less than 100 employees) the business director(s) work actively in the business in an operational capacity. Depending on the business structure and taxation structure recommended by the business owner’s financial adviser, the directors salaries may be above or below fair market remuneration.

The Wage Adjustment is made to ensure that a full charge is made for the costs of operating the business under full management, and hence full charges made for owners’ wages for time engaged in the working in the business.

WHY DO WE ADJUST FOR RENT?

Another income statement adjustment often involves occupancy cost or building rent. Some businesses own the premises they operate out of, thereby not needing to pay Fair Market Rent.

An adjustment to the historical rent expense for the business may need to be made to reflect the earnings of the business as if it had been paying Fair Market Rent all along, since an incoming buyer of the business will have to incur this expense themselves in the course of their normal business activity.

WHY DO WE ADJUST FOR DEPRECIATION?

The Return on Investment Method of Valuation relies on E.B.I.T.D.A (Earnings Before Interest, Tax, Depreciation, and Abnormals). The income of the business is valued before depreciation has been taken into consideration.

In the accounts, the depreciation is determined by taxation laws. This may or may not have any relevance to the actual market value of the plant and equipment. For example say a machine is bought for $990 on the 30 June. One day later, on the 1 July, this item will have no book value as it has been completely written off for tax purposes. To say that this item has no real value to the business owner the next day is illogical. If that person was selling the business, he would want to get more than $0 for this new piece of equipment. Many items of plant and equipment can be written off completely on the books, but are still used by the business for many years thereafter. Experience has shown that in the vast majority of times, the asking value of the plant and equipment exceeds the written down value and in many cases by large amounts.

EXCEPTIONS

Depreciation should not be added back for video stores and companies that hire out plant and equipment. Video tapes have a 100% depreciation rate. Thus the purchase of these should be treated as an expense. Hired out plant and equipment is the “stock” of the business and should be considered as an expense.

HOW IS GOODWILL CALCULATED?

WHAT IS GOODWILL (Intangible Asset)?

Goodwill is the value of a business to a purchaser over and above its net asset value. It reflects the value of intangible assets such as strength of the on-going income stream, reputation, brand name, contracts, good customer relations, high employee morale and other factors that improve the company’s business.

The correct method of deriving Goodwill is very simple and accurate.

Goodwill = Total Business Value less Net Asset Value (See example below)

The first step to calculating Goodwill Value is to determine the Total Business Value, using the R.O.I Method of Valuation outlined in the preceding pages. Once the Total Business Value has been determined it is a simple matter of deducting the Net Asset Value (plant, equipment, stock, vehicles etc.) of the business from the Total Business Value, to arrive at the Goodwill Value, or intangible asset value.

Using our example of a Wholesale / Distribution business, the Total Business Value is calculated at $370,000, as determined using the R.O.I method of valuation.

The value of the Goodwill is directly determined by the overall value of the business, which in-turn is derived by the R.O.I. Method of valuation as outlined earlier in the report. Thanks for reading our Business Buying Guide - if you have any questions, feel free to get in touch!