Deciding to buy a business is a major financial decision, possibly one of the biggest decisions you’ll ever make. When it comes to buying a small business, it’s easy to feel overwhelmed by the complexities of the process and unsure where to start.
However, if you plan properly, do your research into the legal side, and work with the right people, the process will be a lot smoother.
In this article on how to buy a business, we’ve summarised some of the main factors to consider. Please keep in mind that the points below are suggestions. You should always conduct thorough research and due diligence, and take professional advice where necessary, before entering into a deal.
What are the key factors to consider when buying a business?
When buying a business, there are lots of factors to consider, including timing, financial health, legal and regulatory issues, due diligence, valuation, and financing.
Let’s take a look at each of these factors in more detail.
Is the timing right?
When it comes to buying a business, timing is key, from both a personal and financial point of view.
It’s important not to rush into the decision, especially if there’s anything likely to change in your life that would impact your financial situation or the time you have available to manage the business. When you buy a business there are often new employees to manage, business processes to learn, and a company culture to adapt to. This almost always requires more work than you expect.
In addition to considering your personal circumstances, you should analyse the current macroenvironment and microenvironment. The macroenvironment refers to the broad external factors affecting the business, including social, economic, technological, environmental, political, and legal factors, while the microenvironment comprises factors that are closer to the business, such as suppliers, competitors, and customers. The more informed you are about the industry and broader environment the business operates in, the better the decision you are likely to make.
How do I evaluate the financial health of the business I am considering buying?
Evaluating the financial health of a business before buying it is critical to making an informed decision. This generally involves looking at the company’s financial statements for the past three to five years and analysing them using financial ratios. The financial statements consist of:
1. The balance sheet
The balance sheet provides a snapshot of the company's financial position at a specific point in time, showing what the business owns (assets), what it owes (liabilities), and equity (the value left after subtracting liabilities from assets).
There are several ratios you can apply to the balance sheet to gain insights into the company’s financial situation. Some commonly used balance sheet ratios include:
- Current ratio. This measures the business’s ability to pay its current liabilities using its current assets
- Quick ratio. This measures the business’s ability to pay its current liabilities with liquid assets like cash
- Debt to equity ratio. This compares the amount of debt relative to the amount of equity that is used to finance your company’s assets. We cover this in more depth in our debt vs equity blog
2. The income statement
The income statement, also referred to as the profit and loss (P&L) statement, shows the company's revenue, expenses, and net income over a specific period. Some key ratios using income statement amounts include:
- Gross margin. This measures the amount of revenue retained by the business after deducting the cost of goods sold
- Profit margin. This is the percentage of net sales that a company keeps as a profit after subtracting all expenses
- Operating margin. This shows how much profit a business makes after deducting operating expenses
3. Cash flow statement
The cash flow statement shows the amount of cash that has moved into and out of the business over a specified period of time, helping to show a company’s ability to operate and pay off any debts. Ratios for cash flow analysis include:
- Cash flow coverage ratio. This helps determine what percentage of a company’s total liabilities (usually long-term) are covered by its operating cash flows
- Operating cash flow ratio. This indicates how well a business can pay its current liabilities with its operating cash flows
- Cash flow to debt ratio. This compares a business’s operating cash flow to its total debt
It’s important to look at these three financial statements together to identify any correlations and discrepancies and to gain a comprehensive understanding of the company’s financial performance. Looking for trends over time and comparing performance to industry benchmarks is also key to spotting any financial challenges and evaluating the health of the business.
Consulting an accountant is always a good idea before you buy a business. They can identify any issues with the company’s accounts and provide valuable expertise to help you make the right decision.
What legal and regulatory issues do I need to be aware of when buying a business?
Buying a business requires careful consideration of legal issues. Engaging legal professionals experienced in business acquisitions can help you to navigate the complexities of the process and mitigate any potential legal risks. While each company’s situation is unique, these are a few legal areas to be aware of:
Contracts and agreements: review all contracts and agreements related to the business, such as customer contracts, supplier agreements, leases, and employment contracts.
Intellectual property (IP) rights: determine if the business owns or licenses any intellectual property, such as trademarks, patents, copyrights, or trade secrets. Evaluate the validity, transferability, and protection of these rights, and ensure proper documentation for the transfer of IP assets.
Licenses and permits: identify the licenses, permits, and regulatory requirements applicable to the business. Determine if they can be transferred or if you need to apply for new ones. Common examples include business licenses, health permits, and environmental permits.
Employment matters: understand the obligations related to existing employees. Review employment contracts, benefits, and compliance with employment laws.
What due diligence should I conduct before making an offer when buying a business?
Conducting thorough due diligence is an essential step in buying any business. These are some key areas to consider:
Financial due diligence: this includes reviewing financial statements, as we discussed above, to assess the company’s financial health, and evaluating the company’s assets, including inventory, equipment, and property, to determine their value and condition.
Legal due diligence: examining the legal structure of the business, reviewing contracts and agreements, evaluating intellectual property rights, and identifying any ongoing or potential legal disputes, are a few of the legal aspects to consider.
Operational due diligence: make sure you understand the company’s operational processes, workflows, and supply chain management. Evaluate the quality and reliability of suppliers and distributors, assess the company’s customer base and relationships, evaluate IT systems, and identify any operational risks, such as dependence on key employees or technology vulnerabilities.
Market due diligence: this involves analysing the company’s industry and market position, understanding the target market, assessing market trends and competitive threats, and evaluating the marketing and sales strategies.
Environmental due diligence: assess any environmental liabilities or compliance issues associated with the business, particularly for industries with environmental regulations. Review past or ongoing environmental assessments, permits, and compliance records.
It's important to involve professionals, such as lawyers, accountants, and industry-specific consultants, to help with the due diligence process. They can help you uncover potential risks and ensure that you have a thorough understanding of the business you're buying.
How do I negotiate a fair price when buying a business?
The first step in negotiating a fair price is to determine what the business is worth. The key thing to remember is that there is no such thing as a correct value for a business, only a range of values that are acceptable to both buyer and seller. An advisor can help in determining a range of valuations and support in your negotiations. To find out more about business valuation, read our blog post on valuing an established business.
How can I finance buying a business?
There are several ways to finance the purchase of a business, including seller financing, bank loans, and private equity. The method that’s most suitable for you will depend on factors such as your financial situation, the size of the business, the purchase price, and your preferences. We discuss some common financing methods for buying a business in our blog post, How to finance a management buyout.
If you’re looking for equity finance or a loan to buy a business, get in touch with us. We can provide loans, equity, or a mix of both to support you.