Clarifying what the purchase price includes
When you’re looking at buying a business, the term goodwill is one you’ll hear frequently. Specifically, goodwill represents the difference between the purchase price and the combined value of all of the physical assets of the business. The elements that make up goodwill consist of aspects such as the reputation of the business, its loyal customers, its brand identity, its systems, and possibly its staff or any proprietary technology.
The purchase price of a business includes not just goodwill, but also assets such as equipment, furniture, inventory and, in some cases, debtors. In other words, the purchase price of a cafe includes not just the goodwill but the tables, chairs and crockery also, or the purchase of an accounting practice includes not just goodwill but also computers, software, desks and debtors.
When looking at a business that’s for sale, ask the seller to break down the purchase price into the individual components and, as soon as this breakdown is in place, home in on the details:
Are you paying for any assets you don’t need? If an item is unnecessary or obsolete, don’t cough up a cent for it. (Ask for a copy of the depreciation schedule: The written-down value shown on this schedule usually provides a chillingly realistic second opinion on item values.)
Does the purchase price include debtors? If so, clarify what will occur if a customer is slow to pay, or does not pay at all.
Find out if any of the assets are currently under lease, and consider whether or not you will want to take over these leases.
With this process complete, turn your attention to stock (if that’s relevant for this business). Don’t agree to pay for stock at valuation (otherwise known as SAV), without first nutting out how this valuation is going to be made:
In the contract, place a ceiling value on stock so that you don’t end up paying for a whole load of unwanted deliveries.
State in the contract that the stock has to be good, usable, current stock. If a stock item is unlikely to sell within six months, based on current sales trends, refuse to pay for it. The last thing you want is a warehouse full of obsolete stock.
If a disagreement about the value of stock is a possibility, employ a registered valuer.
Agree on a valuation method for stock. This could be the last price paid or the average price paid, and may or may not include the cost of freight.
Ask for supplier invoices to verify the wholesale cost of stock and the date the stock was supplied. (Any stock bought more than a year ago is likely to be obsolete or overpriced.)
The sale price of a business doesn’t attract GST if the following conditions are met:
Both you and the seller are registered for GST
The business is actually for sale and money is changing hands
The seller carries on the business, right up until the day of sale
Everything that you need for the continued operation of the business is supplied
Both parties agree in writing that the business is a going concern
As the buyer, if you’re registered for GST, whether GST is charged or not doesn’t matter because you can claim the GST back. However, if you’re not registered, the seller usually adds the value of GST to the purchase price, and you can’t claim this GST back. (Most purchase agreements specify that the price is ‘plus GST if any’.)
The conclusion? Unless your accountant advises otherwise, register for GST before the sale of the business takes place.
Calculating the ‘True’ Earnings of a Business
When you buy or sell a business, sooner or later you’ll hear the term EBITDA, short for Earnings Before Interest and Tax, Depreciation and Amortisation. (People sometimes talk about EBIT instead, a simpler version that means Earnings Before Interest and Tax.)
You may even hear people say things like: ‘Did you hear that Sam got five times EBITDA when he sold his business?’ What they mean is that when Sam sold his business, he received five times his average annual profit, after adjusting this profit for amortisation, depreciation, interest and tax.
Although calculating EBITDA or EBIT is kind of technical, you don’t need a degree in commerce. Here’s how the whole deal runs:
1 Ask the owners for copies of Profit & Loss statements for the last three to five years.Five years is ideal, three years is often all you get. Make sure these Profit & Loss statements are final statements certified by an accountant, and not print-outs generated by the owners themselves.
2 Go through each Profit & Loss report and summarise key totals, finishing with the final net profit (or even loss) before income tax.I recommend you use a spreadsheet, as I do in Figure 3-1. I like to include sales, cost of sales, gross profit and key expenses. If you’re working with company financials, remember to write down the net profit before income tax, not after income tax.
3 Add any amortisation, depreciation or interest back into the profit.The amount of interest paid depends on how much equity the owner has in the business. You’re best to ignore interest when calculating average net profit, so add any interest expense back onto the bottom line to increase the profit.Amortisation is a bit of an obscure one, and refers to writing off goodwill or borrowing expenses. If you can’t see this item on the Profit & Loss report, don’t worry — it probably doesn’t exist.
4 Add back any expenses that seem downright excessive.You know, things such as the single owner-operator who puts three cars through his business (one for him, one for his partner and one for the teenage child) or puts all the expenses for the latest, most expensive four-wheel drive through the business. Other likely culprits include voluntary superannuation contributions, overseas holidays or unrealistically high wages paid to relatives.Refer to Figure 3-1 for how this whole deal works.
5 If the business is a sole trader or partnership, deduct a reasonable amount for the time the owners spent working in the business.If the business is a sole trader or partnership, the Profit & Loss doesn’t include wages for the owners. Find out how many hours the owners work in the business, multiply these hours by a reasonable hourly rate (either for you or for employees), and then deduct the total from the profit. One of my clients wanted to purchase a milk bar. The figures looked good, with hefty profit year after year. Then my client figured that the owner, her husband and her son all worked in the milk bar — up to 150 hours a week combined. My client was single and didn’t want to work any more than 50 hours a week. This difference meant she had to factor in 100 hours additional employee labour every week. After she made this adjustment, the calculations for the goodwill of the milk bar came up as worthless.
6 If the business is a company, look at the wages paid to the directors and, if necessary, adjust the profit for what you think are reasonable wages for the time spent.If you think the directors’ wages were too high, add the amount of
