Buying a business? You need to read this first.

(buying a business – 5 minute read)

Comic Sam is standing in front of a shop that is named 'Business Co. Ltd'. He is throwing a bunch of money in the air. On the shop there is a tag saying 'SOLD'. Comic Sam has just completed buying a business.

As the global stock market tanks, the property market slows down and cryptoassets fail to live up to the hype, investors are looking for different ways to grow their finances. A growing class of investments are business investments. Instead of investing in shares in a publlicly listed company, you buy a small business and run it as your own.

Some investors are just looking to diversify, some are looking at changing their careers to build something of their own. Whatever your reason for buying a business, here are some things you need to think about first:

What is your time commitment to the new business?

There are a lot of businesses up for sale that advertise themselves as ‘passive income‘ earners. Be very careful when buying a business that claims to give you all the money with none of your time needed. At some level, your input is required to run the business. This means that you will have to set aside some time to run the business.

There are examples of businesses that you can run with less oversight, like an automated laundromat or a storage shed. But you still need to make time to check the equipment, deposit the cash, open/close the business and make sure that your customers aren’t wrecking your stuff.

In most cases, buying a business is a career change. You will likely have to give up your full time job to pursue this business dream. If you’re unwilling to commit full time to your new business at some stage, you may not be ready to buy a business. Make sure you understand what your your time commitment will be to the new business.

Businesses need time and money to become successful. So, you need to be prepared to invest both.

Always check the financial statements.

Never buy a business without first looking at their financial statements. Ever.

The financial statements will give you a good idea of:

  1. How much profit the business can generate
  2. What its ongoing costs are
  3. If the business owes anyone money (this is particularly important if you are undertaking a share purchase – more on this later)

You should be able to get access to the most recent financial statements from the business prospectus. Also, insist on having the financial statements up to two prior years as well. If you can get more prior year information, even better. When examining the financial statements, keep an eye out for:

Salaries

Check if the salaries are wages paid to employees and/or any wages paid to the owners of the business. If there are no owner salaries, then what you, as the new owner will make is the profit (income minus expenses).

Fixed Assets

Fixed assets will affect the price you pay for the business. We’ll discuss this later in the article.

Commitments

The business may be locked into a lease or may have an ongoing subscription that they need to pay. This will impact your overall return.

Buying a business via Asset Sale or Shares Sale?

There are two ways to buy a business. You’ll have to check with the vendors how they intend to sell the business to you. Let’s take a look at both of them:

Asset Sale

Asset sales tend to be the easier method. You (or your company) are buying over the physical and intangible assets of the business. That’s all. Asset sales are usually made up of:

  1. Remaining fixed assets in the business
  2. The Business’s goodwill – the intangible ‘asset’ that consists of the customer base/branding of the business

For example, Ben’s Barbers is on sale with a purchase price of $200,000. This is made up of $100,000 worth of barber equipment and furnishings and $100,000 worth of goodwill. From a tax point of view, you can claim depreciation expenses on the fixed assets acquisition. Goodwill however cannot be depreciated or claimed as a tax expense. Note that other types of intangible assets like patents and trademarks may be depreciable.

Be careful of vendors who try to overinflate their business’ goodwill and underprice their assets. This is because in Aotearoa, goodwill counts as a capital gain and is non-taxable. Gain on the sales of assets on the otherhand, count as income and are taxable. Ensure that you are getting the fixed assets sold to you at market value. In fact, insist on it, as this will allow you to maximise your tax claims on the depreciation of the fixed assets.

Shares Sale

Shares sales tend to be trickier. On paper it sounds simple: You pay money for shares in the business. Then you operate the business as the new owner. You don’t have to set up a new company.

In practice it can be more complicated. What is happening is that you are taking over the business in its entirety. This also means taking over the company’s liabilities as well. Keep an eye out for any money owed to the tax department/IRD and outstanding bank loans. This will become your debt once you buy over the business. You can (and should) insist that the debt values be subtracted from your purchase price of the business.

You may even have to pay an additional ‘working capital’ fee to reimburse the current owners for relinquishing current assets of the business to you. This is on top of the purchase price for the shares. Working capital is calculated as current assets minus current liabilities. Current assets is made up of cash in the business, amounts owing to the business by customers and any retail stock. Current liabilities can include amounts owing to suppliers, taxes and employee payments.

The advantage of a Shares Sale is that any trademark, licenses or copyright held by the company now automatically belong to you. In an Asset Sale, this isn’t usually the case, unless you ask for it.

What is the right price for buying a business?

This is the trickiest bit. The sales price of a business is made up of the value of their physical assets and the value of their intangible assets (goodwill). The vendor will calculate Goodwill using an earnings multiple. The lower the risk to future earnings, the higher the multiple. Some vendors may use a projection of future earnings and include one to two years’ worth of earnings in the sales price.

Let’s go back to Ben’s Barbers again: Ben’s has assets worth $100,000 at market value. Over the past 12 months, Ben made $50,000 worth of profit from the business. In selling the business, he uses an earnings multiple of 2 to derive his goodwill figure of $100,000. Note that $100,000 also represents his potential future earnings from the business over the next 24 months (assuming sales remain the same).

When buying a business, ask for a breakdown of the sales price. What portion relates to fixed assets and what portion to Goodwill. Getting the asset values are easy if you have access to their financial statements. Also ask for a breakdown of the calculation for Goodwill. You’d be surprised how many business sellers just pull a number out of thin air to calculate this.

What price is a good price? That depends on you and the business you are buying. If the vendors are not being forthright with their information, it’s better to walk away and look for a better deal.

Talk to an accountant before buying a business

At the very least you’re looking at sinking $10,000 to $30,000 in a venture that isn’t a sure thing. You will want an accountant on your side who can evaluate the purchase. Yes, accountants can be pricey. But you know what else is pricey? Spending half your life’s savings on a dud of a business.

If you have the funds to buy a business, you can afford that extra few thousand dollars to get an accountant to advise you on the financial side of things.

Oh, and you’ll want a lawyer to handle the legal stuff as well.

Happy business buying!

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