What price to pay is foremost in any potential purchaser’s mind. The thoughts usually revolve around what funds I currently have, what funds can I borrow and ultimately what is my total maximum price that I have available to negotiate with. Stating the obvious, knowing your maximum price is essential but sometimes taints the buying process with the mindset that if I can afford it, it’s good to go. The price you pay is not a function of affordability but a function of viability, a function that quite often is given superficial attention. Further, more often than not, inexperienced players can allow their emotions and funds availability to rule their buying decision, resulting in an overpriced acquisition that creates cash flow problems from day one.
Although there are many, many factors that need to be considered when buying a business, too little weighting is given as to whether the business can sustain the buyers intended lifestyle, service any acquisition borrowings and provide sufficient cashflow to support the operation. The central theme that needs to be addressed is “after repayment of acquisition borrowings” can the business meet the needs of both operational funding and lifestyle requisites.
Many buyers merely make this determination based on historical profitability. This measure, although important, does not reflect the outflow of funds that are not profit based, which are largely debt repayment and taxes. The ultimate test of affordability is simply cashflow. What money comes in less what money goes out, nothing more than that. Businesses can be profitable yet struggle to make financial commitments and fail to fund borrowings.
A major effect on the cashflow of your business is the servicing of the debt used to fund your operations. Largely, this includes any debt undertaken for the business purchase. Clearly the purchase price has a bearing on your future cashflow and subsequently it’s survival.
It is important to note that your business should derive sufficient funds from trading throughout the year to fund the business, fund the borrowing and fund your personal needs.
And cashflow needs to be considered after payment of appropriate taxes.
Do I consider the potential sale price of a business in my calculations?.
Of course you need to. Generally all business acquisitions involve borrowings. Borrowings comprise two component; the amount of the borrowings or principal, and the interest you pay each month. Profit and loss figures only reflect the cost part of the borrowings being the interest. The principal component is not considered in the determination of profit and loss and is a major consideration in determining cashflow requirements.
For instance, you’ve borrowed $500,000 to fund your business over five years. Put simplistically, this means that from a cashflow perspective your business needs to fund $100,000 per year out of it’s profits to make the loan repayments. Consider a business that traded well and made $150,000 profit for the year. Take 33% tax out, $50,000 and you are left with $100,000. Payback your annual loan repayment of $100,000 and you are left with a big fat zero to help grow your business and to provide and return to the business owner. Buy price is important as it has a direct bearing on the borrowings you will need to undertake.
Do I consider taxes? Your surplus cashflow is determined after consideration and provision for taxes. Too often those buying or commencing a business, fail to consider taxes until the shock of that first income tax return materialises. Always be aware that in every dollar your business earns you must make a donation to the government. Real cashflow is what’s left after your taxes are paid.
Do I consider loan repayments? When borrowing to purchase your business you must consider the term of the loan and whether interest only or principal and interest repayments are suitable. I'm not a fan of interest only loans. They do have their use for short term speculation or some guarantee that your business will be readily sellable for a decent price at some time in the future. You need to understand one thing - at some point the loan needs to be repaid. As a common sense rule a principal and interest loan should largely be structured around the belief that there could be a point where the business is worth nothing. That could arise from a number of factors but if I have a five-year property lease, with no guarantee of renewal, then there could be a good chance that I will have to quit the operation after 5 years. And yes of course there are other options to continue the business, but I imagine a fair chunk of goodwill value could dissipate in any move. The last thing you want is to have an interest only loan with the principal intact and you have to cease operations. The term and components of the loan are important.
You’re all smiles. You’ve found “the” business. You’ve just borrowed $500,000 to fund your business over five years. Put simplistically this means that from a cashflow perspective your business needs to fund $100,000 per year out of it’s profits to make the loan repayments. Consider a business that traded well and made $150,000 profit for the year. Take 33% tax out, $50,000, and you are left with $100,000. Payback your annual loan repayment of $100,000 and you are left with a big fat zero to help grow your business and to provide a return to the business owner. Buy price is important as it has a direct bearing on the borrowings (and hence, cashflow) you will need to undertake.
Do I consider fluctuations in trading? From sales dollars to margins you must consider the effect on profitability and cashflow if trading fluctuates. As a minimum you should do a bit of a “what if”, that is; what if my sales decline, what if my margin declines, what if my volume declines, what if my overheads increase, what if my wages increase and the resultant impact on profit and cashflow. You need to be aware of the dark side to manage and evaluate. Conversely you should also evaluate the impact of positive measures and reflect on that outcome.
Do I consider business efficiencies when reviewing your purchase proposal?
Everyone operates differently and although any efficiencies achieved on acquisition should be considered for your own future operating analysis it should not have an impact on the price you are paying for the current business as it stands today. You are paying for “what is” currently on the table not evaluating a price on what you are going to do to improve the operation. Stick to what’s on the table and determine a price accordingly. You don’t pay a premium for a car now because you are going to install leather seats in three months time.
Do I consider wages to myself?
An often overlooked cost in evaluating purchase price for business acquisition is the wages of the owners. There seems to be a general mind set that the profit flow from operations determines the rewards to the owner. Quite often the costs of the current owners’ work efforts in the business are understated. Owners efforts in running a business are a cost to the business, profits are what’s left after that.
A brick wall needs to be built to separate the function of the business from the function of the owner undertaking employment roles. One day you might get sick, one day you might scale back, one day you might sell; by factoring in owners’ wages you’ll be covered. You will also determine more accurate base level breakeven sales.
Wages should represent market value. That is what price would you pay for someone of similar expertise to undertake those duties. It’s not necessary that you take the cash but it is necessary that the profit calculations take this into consideration.
Do I consider new equipment?
Evaluate the expected life of existing equipment and plan accordingly. Don’t undertake a business purchase without being aware that you may need $100,000 of replacement equipment in 12 months time. The requirement to purchase additional equipment will impact cashflow and business funding. And also your purchase decision and buying price.
Do I need to know my breakeven?
Know it, memorise it and sleep with it. Bring the number down to a useable scale. Depending on your business you should always be aware of your daily, weekly or monthly breakeven sales. Know this and plan your marketing accordingly. Be aware there are two breakeven sales numbers. One that’s based on profit and one that’s based on cashflow. Remember the first, live off the second.
Cash flow rules Would you buy an investment that produces a negative result?, then why would you buy a business that does the same. And the quantum is so much bigger. Your purchase price needs to be something that is affordable if you pay too much unless you get additional funding you won’t last long. The numbers don’t lie, do the homework, work out cashflow and ensure due diligence.
READ: Why do I need to invest on Business Acquisition Tool?