Just as consumer goods are bought every day, people can buy an entire business. Every stock investment is essentially a purchase of a small fraction of a business. Index funds spread ownership into even more minuscule fractions of many businesses. Here, the focus will be on what to consider before buying a business in whole. Some factors to consider include any discrepancy between asking price and enterprise value, the business model that generates cash flow, business history and ability to weather economic storms, branding/goodwill, and the dynamics of business costs, investments and revenue sources.
Price and Enterprise Value
As with any purchase, it helps to start with the cost involved. A straightforward evaluation of a business would be its effective market capitalization. This is the cost of buying every share at a given market price if the business is public. Private businesses such as sole proprietorships or LLCs would focus on the negotiated or evaluated value of total equity. Remember, equity is synonymous with ownership. It behooves the interested buyer to look at not just total equity, but the net debt a business has on hand at time of purchase.
Net debt is given by the formula: total debt – cash & cash equivalents. The reason for the “cash and cash equivalent” deduction is that, in terms of accounting, cash can neutralize debt. For example, if a business has $50,000 in total debt and $60,000 in total cash, an owner/manager can pay off the entire debt and be left with $10,000 in cash. Though this is not always done, in terms of assets vs liabilities, the net debt adjustment is important in valuing a business. Buying a business that has no cash cushion and relies exclusively on anticipated revenues to stay ahead of the debt is a risky venture compared to a similar business that has cash on hand to weather tough times and meet obligations without stretching its debt or equity holdings further. The enterprise value calculation helps buyers pinpoint these crucial differences.
Of course, a buyer should look into the business model and customer base involved. Typically, a business will attract a high number of customers that generate a small profit margin per customer, per the Walmart business model. On the other hand, it may focus on a smaller number of clients, each of which generates impressive margins, like a corporate law firm or a defense contractor.
On a related note, a buyer has to evaluate current and likely core competencies of a business in the near future and anticipate any change in ability to monetize those competencies. For example, if competencies don’t match demand as well as expected, or if there are little barriers to entry for competitors to move in and out-brand or out-price the business, the buyer should request a lower price to offset this kind of risk.
Enterprise Durability and Time
A new, recently formed business is generally a greater risk than an established enterprise. The reason is that time spent competing in the market shapes and molds a successful business to better withstand future market shocks and continue to generate profit, or at least mitigate loss, for a buyer. Past responses to external stressors like recessions, competitors, lawsuits as well as internal stressors such as talent drain, cost overruns and bad management decisions can help a buyer understand the scope of responses and adaptive measures a business can realistically generate in a given situation. Business models or bureaucracies that are too rigid and dependent on any one set of customers or market conditions should be properly discounted on account of the greater risk they represent to a buyer.
Branding and Goodwill
Regarding brands: for better or worse, marketing is king. If a business has the talent and resources to generate substantial brand recognition and goodwill, it can climb above the rest and become an industry leader. Note that this is better achieved in B2C sectors that are more susceptible to advertising and public relations campaigns. B2B deals with representatives and buyers that are tasked to squeeze out the best deal for their employers; time crunches and impulse purchases are not par of the course in a B2B environment.
On the other hand, note how apparently everyone “has to have the latest iPhone” without being able to justify the extra expense. Why? There is no real answer other than because Apple’s product development and marketing divisions hit the right public relations buttons that catapulted the company from just another phone provider to a corporate celebrity. The same phenomenon can be seen with Starbucks, Michael Kors, and others “got to have” products/services that are industry leaders. Again, note how natural it is to answer a tough inquiry with “just Google it.” In principle, “just Bing it” would work just as well, but it sounds “off.” This is not an accident, it is precisely what a buyer should be looking for when assessing a business’s PR, goodwill, and advertising strategies.
Product/Service Cost Dynamics
Evaluate if the business depends on a product or a service. The relevant difference is that each sector requires different kinds of expertise, different investments, and different business valuation measures. For example, a small silver mining company and a headhunter/recruitment firm with several offices may have the same costs and even profit margins. However, the nature of costs for mining operations and its associated legal/regulatory environment will be very different than that of a recruitment office. Exceedingly better and more expensive mining equipment may pay for itself even though the initial equipment purchase can demolish margins in the short term. Exceedingly better and more expensive pens and folders are unlikely to have the same effect in such a human-focused field such as headhunting to fill temporary job openings. On the flip side, if the market price of silver plummets, the headhunter firm won’t be at risk of bankruptcy while the silver miner prays for a miracle. Though “common sense”, these types of evaluations sometimes get lost in the clutter of financial documents, consultant presentations and other exceedingly complicated metrics that gloss over the essential “bumper-sticker explanation” of how a business intends to turn investments into profits.
This article hopes to drive home a critical point: buying a business is 99 percent doing homework, 1 percent “buying.” Such decisions as buying/selling businesses are not easily reversible for most people. While a great purchase can catapult the buyer into wealth and comfort, the downside can leave a buyer facing a tremendous loss. Note that the market, customers, investors (including yourself), lenders, and laws are not strictly rational. Buying and selling is influenced by egos, psychology, persuasion, background, beliefs, and other human-factor intangibles. Do not neglect those variables when deciding which business to buy.
Author: Stan Aberdeen
Stan Aberdeen is an accomplished business writer who has worked for numerous clients in many facets of personal finance, investing, debt management, business valuation, product development, accounting, and similar topics.