What to Know Before Buying a Local Small Business
Buying an established business that has already proven its worth can be easier than starting a new venture from scratch.
An established business typically has brand recognition, a (hopefully satisfied!) customer base, regular suppliers, and a steady cash flow.
Before committing, the buyer should ideally have experience in the sector and the geographic region where the business will operate. What works well in one area of Australia might not succeed in another.
Knowing that the current owner has made respectable profits over the past three to five years is not sufficient, as past performance is not always a reliable indicator of future results.
It’s crucial to approach the process with thorough preparation and understanding to make an informed decision and ensure a smooth transition.
From valuing the business accurately and conducting due diligence to understanding hidden costs and navigating purchase options, we provide insights and practical advice to help you succeed.
You can confidently step into business ownership and drive future growth with the right knowledge and support.
Let’s get straight to the point
Buying an established business offers benefits like brand recognition, a loyal customer base, regular suppliers, and steady cash flow. However, several critical factors must be considered before purchasing.
Experience and research are essential. Buyers should have experience in the sector and the geographic region where the business operates, as past performance isn’t always a reliable indicator of future success.
Valuing a business is complex. Factors like years in operation, the seller’s situation, the business life cycle stage, lease terms, return on investment, and market value of similar businesses should be considered. It’s advisable to base the purchase price on a broker’s report and market comparisons.
Conduct thorough due diligence to investigate all aspects of the business, including operations, financials, legal and tax compliance, and assets. An accountant can review financials, identify tax risks, and suggest an appropriate entity structure.
Be aware of hidden costs, such as stamp duty, pending legal actions, warranty claims, staff costs, payroll tax, WorkCover, and superannuation.
Buyers have two options when purchasing: buying business assets or acquiring the existing company. Buying business assets offers flexibility and protection against historical tax risks but requires asset depreciation and GST application.
Acquiring the existing company involves purchasing all assets and liabilities and maintaining contracts but considering potential undisclosed liabilities.
Earnout agreements can ensure a smooth transition and financial benefits by linking the purchase price to the previous owner’s involvement. However, be cautious of potential management challenges and legal disputes.
Seek assistance from experienced accountants for entity establishment, business purchase, or management transitions. Bookkept offers extensive bookkeeping and tax preparation support.
Determining the Worth of a Business
You’re likely familiar with the term “due diligence” if you’re in the process of buying a business through a broker.
A prospective buyer will be able to investigate all business areas, including operations, financials, legal and tax compliance, client base profiles, and any physical and intellectual property.
However, conducting due diligence rarely provides a buyer with a rock-solid foundation despite offering enlightening answers to many questions about the business.
During due diligence, your accountant can review financial statements, identify tax risks associated with the existing business or entity, and suggest an appropriate entity structure for moving forward. Additionally, your accountant can assist in planning your future succession strategy.
Valuing a business can be exceedingly challenging, and if you get ten different opinions, you’ll end up with ten different numbers. It is not an exact science.
We advise you to base the price of your purchase on the report provided by your broker. Nonetheless, several factors need consideration:
- Number of years the business has been operating
- Seller’s situation
- Stage of the business life cycle
- Positioning
- Terms of the rental lease
- Desired return on investment
- The market value of similar businesses sold recently
Bookkept has previously offered business appraisals and emphasises the importance of these last two points.
Ultimately, a business is an investment, and its market value is the amount another party is willing to pay.
The price might be unreasonable if similar small businesses in your suburb have recently sold for 60% less than what the seller is asking.
Hidden Costs When Purchasing a Business
In addition to the price you pay your business broker and any accounting fees related to due diligence or setting up the corporate structure, there are costs a first-time buyer might not consider:
- Stamp duty on the acquisition (usually only on real property purchases)
- Pending legal actions against the company
- Pending warranty claims
- Staff costs and potential Fair Work Australia obligations
- Payroll tax, WorkCover, and superannuation costs
- Potential staff dissatisfaction or resignations
What Exactly Am I Buying?
When purchasing a business, a buyer has two choices: buy the business’s assets (goodwill, vehicles, stock, and leases) or buy the entire corporation (shares, units, or partnership stake).
1. Buying Business Assets
Buying a business’s assets rather than the trading entity as a whole can protect you from historical tax compliance risks and allow flexibility in choosing the most suitable tax entity structure.
This approach can offer significant future-proofing benefits in distributing profits or capital gains and often represents a substantial difference in tax liability.
Additionally, you’ll only need to ensure the business operations are sound rather than verifying there were no untrustworthy past owners.
However, this method has some drawbacks. Each asset is considered purchased on the new purchase date, requiring depreciation, GST application, and valuation in relation to the overall sale price.
2. Acquiring Ownership of the Existing Company
Buying the entity means purchasing the entire firm, including all assets and liabilities, legal structure, leases, contracts with suppliers and customers, and any unreported liabilities. This is often referred to as “walk-in, walk-out.”
This type of purchase has several benefits, primarily related to the tax implications of existing franking credits and tax losses. It also simplifies asset management, as the business entity remains the same, though the owner changes. Contracts with customers and vendors don’t need renegotiation.
The downsides include potential undisclosed liabilities. Were wages and superannuation paid correctly by the previous owner? Were taxes accurately paid? Are there potential legal actions from past clients?
What About an Earnout Agreement?
When the business owner is a key person, a transitional period where the new and previous owners work together ensures a smooth transfer of customers and operations.
This is known as an earnout agreement. It ties the purchase price to the previous owner’s continued involvement, requiring them to “earn” their price.
Earnout arrangements can offer significant financial benefits, allowing buyers to finance part of the purchase and sellers to spread capital gains taxes.
However, these agreements can lead to future management challenges, as both new and previous owners may want control tied to their financial interests. Without a solid agreement on business governance, earnouts can lead to legal disputes.
Conclusion
If you need assistance establishing an entity, purchasing a business, or considering switching to an experienced business accountant, call us at (03) 8568 3606.
Bookkept has over ten years of combined experience dealing with various clients and is well-qualified to serve your business needs.
We specialise in bookkeeping and tax preparation and are happy to help ensure the success of your new business.
Frequently Asked Questions
What Should I Research About The Business Before Purchasing?
Look into the business’s financial history, including profit and loss statements, tax returns, and cash flow. Understand its customer base, competitive landscape, and potential for growth. Check for any legal or financial liabilities and confirm that necessary licenses and permits are in place.
How Do I Assess The Business’s Financial Health?
Review audited financial statements for at least the last three years. Look at profitability, expenses, outstanding debts, and assets. Consult an accountant to ensure you understand the financial records and to spot any red flags.
Are There Legal Considerations To Be Aware Of?
Yes, you must conduct thorough due diligence on any existing contracts, leases, and supplier agreements. Verify that the business complies with Australian tax, employment, and environmental laws. Consider hiring a solicitor to review all legal documents and identify any potential liabilities.
What Is Due Diligence, And Why Is It Important?
Due diligence involves a thorough examination of the business’s financials, legal standing, and operations to identify risks or hidden liabilities. It’s essential to protect your investment and ensure there are no unexpected issues post-purchase.
Should I Hire Professionals To Help With The Purchase?
Yes, it’s advisable to consult with an accountant, a solicitor, and potentially a business broker. They can provide expertise in areas like finance, legal, and valuation, helping you make an informed decision and avoid costly mistakes.
