12 Risks To Avoid When Buying a New Business

by Ivan on September 26, 2010

Cien Pesos
Creative Commons License photo credit: Alex E. Proimos

Oscar Wilde warned us that ‘experience is the word men give to their mistakes’. Instead of starting a business and all the risks involved, maybe you should buy one instead? Sounds good? Neil Patel, over on Quick Sprout, identifies three business categories and why he prefers the third when buying a business.

David Garfield on Rise To The Top takes up the same subject with Neil and identifies seven mistakes that nearly broke his business. The bottom line? How do you identify the true value of a company before you buy it. No one wants to buy a lemon, right?

7 Advantages Of Buying a Business

Most business articles on Entrepreneurs focus on starting up a business. And this makes sense as many new business owners are concerned with getting their product off the ground. Expand the product, finding partners and making acquisitions are further down the road.

What if buying a new business was a smarter move?

Instead of putting your energies into getting funding, finding employees, and looking for distribution partners, taking over an existing business may be more rewarding… and less stressful.

Neil outlines why buying an existing business may be a smarter move. Instead of starting from scratch look for an under-performing business and see if you can turn it around.

The advantages of buying an existing company include:

  1. Using its existing customer base to upsell other products.
  2. Enter new markets, especially it has an overseas office and presence in the local market.
  3. Re-engineer its technology to link in with your products; develop new applications; upsell services/consultancy.
  4. Use the company’s track record and assets to secure larger bank loans.
  5. Increase your purchasing power. Buying PCs for 10 employees is one thing but if you buy 500, you can get a heavy discount from the supplier.
  6. Consolidate office space and reduce overheads. Instead of having several small team in different locations, you can take advantage of existing office space. This reduces costs and, in theory, should see greater collaboration between teams.
  7. Bid for larger government contracts by pooling your resources.

Risks When Buying a Business

If buying an existing business is so attractive, why don’t more do it?

It’s a combination of factors.

# 1 Culture

Working at a small startup is often less formal, more fluid, and sometimes slightly on the edge. Company cultures are very different as are the age profiles. Consider the difference between Google’s famed pool tables against more conservative firms. Merging different cultures can have negative effect on the new company as cultures clash and management struggle to impose a new unified identify.

#2 Employees

You need to meet the key employees in the company and decide how much value they provide and where they fit into your long term plans. Gauge their feelings towards the merge/takeover and how this will impact the new business.

  • Does the Sales Manager have a strong set of contacts?
  • How many large contracts has he landed in the last 12 months?
  • What type of commissions or profit sharing exists?
  • Are employees offered special benefits, e.g. expensive company cars that you’ll want to trim.

Identify those you want to keep and see if you can offer them incentives to stay. Incentives may be financial but also a new role in the company reorg that’s always appealed to them. Of course, you also have to calculate the cost of laying off staff and terminating contracts.

#3 Customers

Arguably the most important ‘asset’ you’re buying is its customers. Research the industry and look for new trends, downturns, consolidations that could influence your customers. Examples may include new legislation, other mergers (eg better deals elsewhere) or new product launches from your competitors.

Can you compete with your competitors in the next 12-24 months and retain your customer base? Look for ways to determine what customers think of your target business. Just because they use its product doesn’t mean they’re happy. For example, do you like the anti-virus software the came bundled with your PC? Would you switch if you could? How about your cable or phone company? Market research, surveys and brand monitoring on social media channels can be very rewarding.

#4 Debts Hidden off the Balance Sheet

From the outside you see the tip of the iceberg only. You may have an idea how successful the product is, but other variables will less visible and harder to determine. Smart accountants can bury debt is very sophisticated ways; remember Enron. So, don’t look just at the P&L and cashflow, look at loans, debts etc. This is where many an acquisition goes wrong – you don’t actually know what you’re buying!

#5 Transfered Losses

Another consideration when buying a company is to see if you can transfer the main assets to your own company (or a new entity) and leave the outstanding loses with the former company.

This practise of moving assets, such as Intellectual Property, is not uncommon in business and allows you to separate assets that you can develop from loses, such as debts and loans. Look at how large organization re-structure and you’ll see how it’s done. While this isn’t a risk for most M&As, it does need consideration if you’re the transfer of losses/debts is one of the reasons you’re attracted to the price.

#6 Tax Relief

You may be entitled to tax relief if you start-up a new company in under-developed area. These tax breaks allow you to setup operations at a low cost, claim the tax relief, and direct your finances into areas where you get higher returns. Government bodies and local agencies offer these tax credits to stimulate regions that may have fallen behind or are suffering economically. Contact your local Chamber of Commerce to ensure you are entitled to these. Don’t assume that you’ll get the credits just because others have received them.

#7 Management Skills

Buying and running businesses require different skills. Business owners who have built their companies from scratch has a passionate commitment to their own business. Running a new organization, with new clients, new customers may be a bridge too far.

Mergers/buy-outs often fail as the founder of the target company is pushed out resulting in an employee exodus. Also, the buyer may not have the skills to motivate the newer staff who may resent the buyout.

If you want to evaluate a business, at minimum you need to prepare a checklist and work through what the target acquisition offers.

#8 Facilities

These do not appear on the balance sheet yet can be an immense hidden liability.

Why?

Let’s say the company produces material that requires waste treatment. There may be costs associated with cleaning up spills, waste and disposals that may have damaged the soil and/or water tables.

Costs to clean up these need to be factored into your value of the company. Also, see what agreement is in place with the landlord so you are not tied into a long-term lease.

#9 Inventory

Another place where the value of assets can be fudged. If the goods are perishable (e.g. foods) or are now out of fashion (e.g. clothes ranges or children’s toy), then you need to re-adjust their value on the balance sheet. Most firms are slow to write down goods or write them off as obsolete.

IT companies need to be wary as the value of servers, hardware, printers etc all may be out-dated and require an overhaul. You also need to check if they’re compatible with your IT Strategy.

#10 Competitors

While competition is a fact of life, be cautious if the buyer is willing to sell the business at a cut price. Determine why they are willing to take this loss. Has a new competitor entered the market? Has a competitor won large government contracts that will marginalize your firm. Consultancy firms need to be very careful here as they can get locked out if the major players become deeply entrenched with Government agencies.

#11 Currency Exchanges

One that often gets overlooked! Companies with offices in different countries may report earnings n their parent company’s currency (e.g. USD) but the sales from different regions may be in Euro, Yen, and RMB.

The value of the currencies fluctuates through-out the year. A good year in one country – with an attractive currency exchange – may not be easy to see in the balance sheet. You need to be wary of FOREX as changes in rates and performance will skew the true value of the company.

#12 Financial Statements

Anyone who has worked in accounting knows that there are different ways to present the same data to the IRS and still stay compliant. Debts can be hidden in partnership, loan repayments can be staggered over a 5 or 10 year period. Likewise, audits should be taken for what they are. Again, remember Enron and how Arthur Andersen ‘audited’ the company’s books.

Conclusion

Warren Buffett talks about the level of detail required to fully analyze a company before he would make a bid. He covers this in his first biography, not The Snowball, where he would spend weeks and sometimes months analyzing a firm’s performance before making a bid. It took him over a year before he decided to buy Coke, but when he did invest, the returns were staggering.

To recap, when buying a company look at:

  1. People – is it their talent you’re after?
  2. Product – how well does it align with what you have or fit another project you have in mind
  3. Customers – can you use this to sell new products and/or offer complimentary services
  4. Financials – can you use their existing cash reserves to stimulate more growth. And can you write off some of their debts? Can you determine the true value of the company?

Try to estimate the net positive cash flow for the next five years and then determine the multiple of earnings to work out a fair value.

Remember, making the bid is the start of the negotiating process.

What other mistakes do you see people make when buying a new business?

Related Articles:

Ivan Walsh, Internet Business ExpertAbout Ivan Walsh Got a question about running an online business? Contact me on Google Plus, @IvanWalsh, and Facebook

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