Diligent investigation the only way to safeguard your business purchase decision

Caveat Emptor. Look before you leap. Let the buyer beware.
And never more so when you are looking to purchase a business.

As a purchaser it is your responsibility to comprehensively establish what the assets and liabilities of the business are, and to evaluate its commercial potential. This will obviously involve checking out the financial, taxation and legal aspects including leases, contracts, and proprietary information. But there are more aspects to due diligence that may not be so obvious. We explore some of these here.

Explore the business environment
Due diligence should also include the business environment, local council regulations and legislation. Has there been recent changes in local council regulations or legislation? For instance, if the business is a café reliant on foot traffic for customers, any changes to roading, or the upgrading of infrastructure requiring road closures or major road works, could severely impact business.

Consider historical trends in trading patterns
Businesses usually have busy and quiet periods. Look at historical trends over several years to determine the seasonality of the business. Ideally you want to purchase the business before the busy season to maximise the return and to help with cashflow.

For example, a retail business is likely to be busy in the lead up to the Christmas festive season; the best time to purchase is shortly before this time period, although this may be reflected in a higher purchase price. Alternatively, if you purchased in March, you would have most of the year trading before the busy retail season. In contrast, a manufacturing business is likely to have a different seasonality trend; businesses can close down over the Christmas festive period, so the ideal settlement will be different to a retail business.

Understand the cash flow requirements of the business
Having enough cashflow is imperative for a successful business. You need to understand the cashflow requirements of the business as you may have to borrow more funds to meet working capital requirements.

  • You need to understand how the business derives income and when the cash is received. You should review the terms of trade with customers as well as when they traditionally pay. If clients are paying deposits in advance this will be favourable for your future cashflow.
  • You also should factor in when you need to pay suppliers and employees.
  • If the business sends invoices with payment terms due 20th of the following month, then it can be up to six weeks before any cash starts to roll in. In the interim you will likely have employees to pay.
  • With a new business there is often additional expenses required in the first few months, including paying the advisors who assisted with the business purchase, insurance, and set up costs.
  • Are there any asset replacements required soon? This will increase the cash requirements.

Purchasing assets, stock and Work in Progress
Buying the business assets and any stock is generally part of the transaction. The business may also have Work in Progress such as in the construction / building or manufacturing industries. At settlement these business assets, stock and Work in Progress will need to be agreed in terms of both existence and value.

The value of the Work in Progress can be very difficult to determine so it’s important to understand the method of the value. Has the value been determined on a percentage complete or has it been determined based on the costs incurred to date? If the value is determined based on percentage complete and if the costs do not match the percentage complete, there will be a mismatch, impacting your profitability.

Taking over the team
Taking over the employees with the institutional knowledge can be very advantageous, ensuring continuity for clients and in how work is done.  You may agree to take over the accumulated holiday pay and checks on the accuracy of those calculations will be needed.

Accuracy of recording expenses
Take care to check the consistency of expenses recorded each month. A month’s worth of telephone expenses either not accounted for or recorded in the wrong period, for instance, can make a hole in your monthly profit. Lower expenses overstate the value of the business, meaning you pay too much. Plus, it can negatively impact your cashflow.

How accurate are cash sales?
It can be hard to verify the accuracy of money taken that is not deposited into the business bank account. Ask the question and record the answer.

Perhaps the most telling question to ask though is the one to ask first. Why are they really selling? We encourage you to drill down on this as your understanding will inform your decision making.

These are just some of the areas to explore in your due diligence process, whether you are buying or selling. We would be happy to discuss more with you. Contact a Moore Stephens Markhams advisor here.

Prepared by Jess Gilmour, a Moore Stephens Markhams director. Jess has specialist expertise to assist clients through the sale or purchase of a business or property; including due diligence, structuring advice and preparing budget and cashflow reports. She works with clients from a broad range of industries including farming, investment, consultants and retail.

Published winter 2019.

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