I’m Buying A Small Business – What Do I Need To Know?
Buying an existing proven business can be easier than starting from scratch – an established business has brand awareness, a (hopefully happy!!) customer base, regular suppliers and immediate cash flow.
Before signing on the dotted line, the buyer ideally have experience in the industry as well as the actual area & location where the business operates. What is successful in one part of Australia may be a failure in another.
Previous performance is not always an predictor of the future and it is not enough to know that the current owner has made decent profits over the last 3-5 years. The first question that you will need the answer to is “Why are you selling?”
How Much Is A Business Worth? How Do I Value A Business?
If you’re buying a business through a broker, you will have heard the term “due diligence.” A buyer will be given the chance to inspect all aspects of the business – operations, financials, legal & tax compliance, ideally a detailed customer base profile, any physical assets & intellectual property. They can be eye opening to a number of your questions about the business however the due diligence process of a small business purchase will rarely give a buyer a rock solid foundation.
During due diligence your accountant will be able to pour over any financial statements that you provide and can identify any tax risks associated with the existing business/entity, a suggested entity structure for you to move forward with & can help you identify the best way to plan your succession in the future.
Business valuations can be extremely difficult and 10 business valuations will give you 10 different figures – it is not an exact science. We recommend basing your purchase price off your brokers report, however there are a number of factors that you will need to consider;
- number of years in operation
- circumstances of the seller
- the business life cycle stage is this business in
- location, location, location
- terms of rental lease
- the return on investment you’re looking for as a buyer
- market value of similar business that have been recently sold
Bookkept has provided business valuations in the past, and we heavily prioritize the final two dot points above. A business is ultimately an investment, and the market value is a business is simply what someone else is willing to pay for it. If there are a number of similar small business sales in your suburb that are 60% less than what the seller is asking, it may be an unreasonable price!
What Hidden Costs Are There In Buying A Business?
In addition to your business broker fee, any accounting costs associated with your due diligence or entity structure set up, there are a number of costs that a first time buyer would not think about;
- the purchase may attract stamp duty (generally only on real property purchases)
- there may be pending legal proceedings against the business
- there may be outstanding warranty claims
- are the current staffing costs in line with the relevant award? You may be required to give staff a pay rise on day 1 to fall in line with Fair Work Australia
- payroll tax, WorkCover & superannuation costs associated with the above
- staff may leave or become disgruntled with the new owner
What Am I Actually Buying?
There are two options when buying a business, you may buy the business assets only (goodwill, vehicles, stock, lease) or you may buy the entire business entity (shares or units or buy into a partnership).
Buying Business Assets
Buying the business assets instead of purchasing the whole trading entity will shield you from any historical tax compliance risks & will also allow you to start the business in whichever tax entity structure that your accountant feels is most appropriate. This can have great future proofing ability to distribute profits or capital gains and will often mean the difference in thousands of dollars in tax.
There are advantages in the amount of due diligence required also as you will only need to make sure the operations of the business are sound, as opposed to any untrustworthy previous owners.
However, there are disadvantages with the purchase in relation to assets. Each asset is taken to have been acquired at the new purchase date, and will have to be depreciated, GST applied and each asset will have to be valued in comparison to the total sale price.
Buying The Business Entity
Buying an entity is when you purchase every single part of the business – assets, liabilities, legal structure, leases and contracts between this existing business and any suppliers/customers as well as any undisclosed liabilities. This is also sometimes called “walk in walk out.”
There are many advantages to this type of business sale, often revolving around the tax consequences of the existing franking credits & tax losses. The purchaser also has an easier time dealing with any assets of the business because the owner (the entity) remains the same, whereas the owner of the entity has changed instead. This also is true for customer and supplier contracts – they will not have to be renegotiated.
The disadvantages revolve around any historical undisclosed liabilities. Did the previous owner pay wages & superannuation correctly? Did the previous owner file their income tax returns correctly? Are there possibilities of previous customers bringing legal action against the entity?
Can I Pay The Previous Owner To Work For Me? What Is ‘Earnout’?
In business where the owner is a “key person” it is common to have a change over period where both new/old owners work together to ensure a smooth hand over of clients and operations. Often a buyer will tie this process to the business purchase price and make the old owner “earn” his price – this is called an earnout arrangement.
There are financial advantages to using an earnout arrangement due to the number of years an earnout will take place over. The buyer has a number of years to finance part of the sale, and the seller has the proceeds spread over years to help with taxes from their capital gain.
The real world application of an earnout arrangement is to ensure the previous owner can’t dump a failing business on you and high tail it!
The disadvantages of an earnout arrangement come from the leadership of the business going forward. The new purchaser wants full control while the previous owner wants control as their cash received is based on profits. It is often a source of legal action and can be messy if the old/new owners do not have a rock solid agreement on how the business will be managed.
If you are looking for business purchase guidance, entity set-up or thinking it’s time you made a change to an accountant with business experience, please give us a call on (03) 8568 3606. With over ten years of combined experience working with a diverse range of clients, Bookkept is well equipped to assist your business. We offer bookkeeping & tax services, and would love to help you succeed in your new venture.