Diana Clement: Things to know when buying a business

Financial returns from a good business will eclipse those from other investments. It is not surprising that many thousands of Kiwis choose to plough their capital into a business instead of investments.

It is an excellent asset class - returning on average 27 per cent on investment, says business broker Clyth MacLeod. Yet there are risks aplenty and buying well is essential.

The last thing I want to do is to put people off buying a business. Some potential owners, however, go into the equation with blinkers on.

British ex-pat Larry Banks looked at more than 45 businesses to buy when he came to New Zealand 15 years ago. Despite having turned a number of businesses around in the corporate world, the one he bought turned out to be a mistake.

On paper the PE (price/earnings) ratio suggested it was reasonably priced. Yet key information about existing contracts was not fully disclosed because the owner Banks was negotiating with was desperate to sell. "When people are desperate they do desperate things and I was a victim of that," he says.

"Vendors want to sell and different people have different levels of ethics," says Banks. "You have to go in with your eyes open and when you are not sure, get specialist advice."

Banks has since picked up the pieces and begun a franchising business from scratch. ReloCrate will rent polypropylene removal crates as a cost-effective and convenient alternative to cardboard boxes.

He compares the process of buying an existing business to that of buying an old villa, which could have problems lurking beneath the surface.

"Buying a business should be a fun and positive experience," says Banks. "But you need to have a good understanding of what you are buying."

The downside for the owner of starting a business from scratch instead of buying one is that the start-up doesn't come with an established name or cashflows.

It is essential to get a valuation when buying a business. Either a business valuer or accountant can assist. Valuations are an opinion based on a long list of tangible and intangible factors such as machinery and debts on the tangible side and goodwill, trademarks, databases, brand recognition and even physical location on the intangible side.

There are three different approaches to valuing a business, which are asset, earnings, or market-based. It is important to use more than one approach to come up with a range of value.

An adviser should be looking for more than just value when they examine the business.

"There is a whole heap of stuff an accountant can flush out," says Tom Davies, New Zealand Institute of Chartered Accountants (NZICA) spokesperson. They will look at factors such as:

* How long the lease has to go.

* Details of staff employment contracts.

* How good the suppliers are.

* What the terms of supply are.

* How good the customers are or if they are in financial difficulty.

* Are there claims against the company?

* Has too much "personal" expenditure been removed from the books?

* Is the plant nearing the end of its life?

Some of these factors can be brought in at the negotiation stage.

As well as relying on advisers, business buyers should use their own investigative skills to uncover any irregularities in a business deal. One small overlooked factor can be enough for a business to fail.

Buyers also need to realise that the financial accounts of a business aren't always honest.

There may be one-off sales that cannot be sustained, discretionary expenses or historic figures/financial forecasts that cannot be supported.

As a result it is always worth paying for a Bizstats report, which is a bit like a QV report for a business. Whether you want to buy a funeral parlour, a dry-cleaning business or a local newspaper, there is a sales history that can be accessed through Bizstats.

The report gives buyers a ballpark figure for what the business might be worth.

The Franchise New Zealand website has more than 250 questions to ask when buying a business or franchise.

"Don't skimp on this research," says Simon Lord of Franchise New Zealand.

"[Franchising] offers a huge number of benefits, but there is still a risk involved - it's up to you to satisfy yourself that this is a genuine opportunity."

Those questions include how the franchisor makes money, says Lord. "Is there a large initial franchise fee, an ongoing royalty fee which is fixed or based on turnover, or a mark-up on products sold to you by the franchisor?"

Beware large initial fees - franchisors who only make money from selling franchises may not be interested in you once you've bought your franchise.

Other questions can include:

* Who is the competition? What advantages does the franchise have to offer its customers?

* Do you have to buy products or services from the franchisor? If so, are these at the same or a lower price than you could buy elsewhere?

* What training will you receive initially? How long is it, what does it cover, and is there an additional fee for initial or ongoing training?

* What level of support can you expect?

Business deals aren't black and white. Many factors can affect the price a business sells for. While a valuation gives one value, businesses of that nature might be selling for a very different amount on the open market, says MacLeod. Factors such as the inclusion of vendor financing or long-term consultancy in a deal may change the price.

Getting to a "yes" in the negotiation process can be difficult. One buyer of a Hamilton manufacturing business struggled to get the seller to see sense. The seller's business broker had ratcheted up the potential price by about 30 to 40 per cent over what the buyer's analysis and the Bizstats report suggested was reasonable.

When the buyer suggested a third-party valuation the broker stuck his ground. It left both buyer and seller in a difficult position because the goodwill of the business was going to be important and there would be a three to four-month handover period in which the seller needed to train the new owner.

The buyer felt like he was dealing with a real estate salesperson who employed obvious standard closing phrases to manipulate them into accepting the asking price.

Banks saw this approach many times. when he was buying.

"Like a real estate agent, business brokers are reliant on commissions," he says. "Their opinions and advice are not unbiased."

Ironically some business brokers are licensed under the Real Estate Agents Act 2008.

That's a good thing, however. It gives buyers and sellers more legal protection than they would have otherwise.

It is not always the adviser's fault if an owner is asking too much for the business. Sometimes, says MacLeod, sellers have inflated ideas of the value of their business.

"You're buying the future income stream", says MacLeod, "not today's profit. There may be risks of sustaining that cashflow."

What you pay for a business isn't everything. It's what you make of it. Many a good small or medium-sized business has been ruined by an inappropriate buyer. MacLeod says it usually boils down to not working hard enough or having personality defects.

"They don't have management skills or the sense to recognise their weaknesses and employ people to make up for their lack of skills."