5 Questions to Consider Before Buying a Small Business
When stock market returns decline, many investors turn to small businesses. And who wouldn’t? While small businesses involve more risk, their rate of return often averages between 15% and 30%. (And we have seen small businesses that do far better). Additionally, owning a small business gives an investor complete control over their investment. Rather than relying on a public company’s management team, small business owners can take their investment into their own hands. For those who live by the mantra, “you eat what you kill”, buying a small business is a growing opportunity for above-average returns. However, with greater returns comes greater risk.
Analyzing small business risk is a skill that develops over time. It is important for you to understand the small business you are considering. It is important to back your investment with a business valuation. At Peak Business Valuation, business appraiser Utah, we have valued thousands of small businesses. Use our experience to understand a small business before you buy. In this article, we explore five questions to get you headed in the right direction when analyzing a small business. Consider them before buying a small business.
1. Why am I buying a small business?
There are many different reasons to buy a small business. These reasons color the lens through which you analyze a small business. They can even change what a business is worth. “Valuing Small Businesses & Professional Practices” by Pratt, Reilly, and Schweihs (pg. 194), gives six different buyer motivations for buying or selling a small business:
- Buy a job
- Realize certain non-financial benefits (e.g., involvement for personal interest)
- Realize a desired rate of return on investment
- Achieve a targeted market position (e.g., eliminate a competitor)
- Achieve critical mass (for cost savings, access to capital, or other reasons)
- Liquidate the business
A company seeking to buy a competitor may be willing to pay more for a small business than someone looking to buy a job. Consider your motivations for buying a small business. Additionally, consider the seller’s motivations. The differences in these motivations may lead to differences in opinions of value. This can work for you and it can work against you. In business valuation, we combat these differences of opinion by arriving at a fair market value. A fair market value looks at what a typical, hypothetical buyer or seller would transact at. Contact a qualified business appraiser, such as Peak Business Valuation, to help you arrive at the fair market value of a small business. Doing so can help you look at the small business from an objective perspective.
2. Is there supporting documentation for the small business?
At Peak Business Valuation, business appraiser, we talk with hundreds of individuals who are buying a small business. We are often surprised at how often a buyer is willing to “take the seller’s word for it” on valuation matters. While maintaining confidentiality in a transaction is important, it is also important that a potential buyer is aware of important facts. Let the question, “is there a document for that?”, guide your entire due diligence process. A question we ask often is, “can you provide documentation for this assumption?” In some cases, documentation may not be available, but this question can help uncover the truth.
For example, a seller may claim that about $50,000 of expenses are personal in nature. Asking for supporting documentation can help verify this claim. The seller could have unintentionally been incorrect. Even if the documents aren’t available, the quest to find them can be enlightening. Additionally, you or a financial analyst can discover more about the small business as you review the documentation. Maybe combing through general ledger reports and credit card statements is not your style. Consider hiring a business analyst like Peak Business Valuation to review the small business you are considering buying. Schedule a free consultation to get started.
3. How reliable is the revenue of the business?
While observing a company’s revenue gives you a good idea of the size and growth of the company, we recommend you take a closer look. The value of a company’s revenue links to how reliable and repeatable its revenues are. Many factors showcase the quality of a company’s revenue, including:
- Customer Concentration
- Level of Customer Quality
- Customer Repeatability
We will explore each of these factors and how to measure them, below.
Customer Concentration
Customer concentration refers to what part of sales is attributable to a single customer. Generally, the more concentrated a business is in one or more customers, the more risky the revenue is. Essentially, the business is tied to the risk that its large customers undertake, which is usually out of the small business owner’s control. You should request an accounts receivable statement for one or more years. Consider any customer that makes up more than 10.0% of revenue. Look at the 5 largest customers. Questions to consider include:
- How long is the business’s relationship with the customer?
- Do contracts secure the revenue? (If so, is there a document for that?)
- Is the customer likely to leave if the company’s ownership changes?
- Is the customer a reliable company, such as a long-standing government contract?
Now, it is not necessarily a bad investment if a company’s revenue is concentrated in one customer. Perhaps the customer relationship is long-standing and mutually beneficial. This may indicate an opportunity to grow the small business by diversifying the customer base. Observing customer concentration will help guide your judgment of revenue’s reliability.
Customer Quality
Customer quality can be a subjective judgment to make. You can measure the quality of a customer by whether they pay on time. A good place to start is to request an accounts receivable aging report. This will break down accounts receivable by age. Pay attention to the percentage of accounts that are over 30 days, over 60 days, and over 90 days. Payments can vary based on customer type, but generally, you should investigate why any payments were not received over 90 days. Ask what portion of accounts receivable aged over 60 or 90 days is collectible. Question any bad debt expenses on the income statements. The resulting commentary can be a good indicator of customer quality.
Customer Repeatability
Customer repeatability refers to how often your customers are “repeat customers”. Recurring customers are more valuable than one-time customers. For example, insurance agencies receive revenue each year from the same customers like clockwork. On the other hand, certain services may be one-time purchases and never repeated. When observing customer repeatability, talk with the small business owner about repeat clients. Additionally, observe the accounts receivable aging reports over several years. Which customers repeat year over year? If they have one, you can also dig into the company’s customer relationship management system. Observe how repeatable the revenue is and look for opportunities to increase repeat clients. Contracts are key to creating customer repeatability. Contracts are also more easily transferable to a new business owner. This reduces the risk that the customer will leave with a change of business ownership.
4. What are the risks of buying a small business?
In a rational market, the greater the risk, the higher the potential for profit or loss. In finance, this is called the risk-return tradeoff. Low levels of uncertainty indicate low returns. High levels of uncertainty indicate high returns. The key to achieving high returns is not to blindly take high amounts of risk. When analyzing a small business, you need to identify the key risks. Consciously decide whether you are comfortable taking them. The questions above help you identify some risks. Other key risks to consider include:
- Financial Stability
- Technology Change
- Regulation Level
- Capital Intensity
- Supplier Concentration
- Key-man risk
- And more!
Covering all of these risks in detail is not within the scope of this article. As a general principle, explore scenarios where the small business could fail. What is the likelihood of this occurring? Consider what it would cost to mitigate this risk, if possible. Listing out risks can be a great way to see how comfortable you are with the opportunity. If you are not comfortable with the risk, you should walk away. These risks are also valuable points of leverage when negotiating the price of a business. A business valuation will identify the risks when buying a small business. Discuss these risks with a business appraiser, and ask if there are any you are missing.
5. Can I get another opinion on the value of this small business?
Getting a second (or third, or fourth) opinion will help you maintain objectivity when buying a small business. Buying a small business is undeniably an emotional process. First, large amounts of hard-earned capital are being deployed. Second, your day-to-day life will change to respond to the needs of the small business. Third, the success of this small business will affect your income. And fourth, remaining objective with so much on the line is near impossible. Surround yourself with a team to help you buy a small business. Include a lawyer, an accountant, a business appraiser, and other competent professionals. At Peak Business Valuation, business appraiser, we provide objective opinions of value to banks, management teams, and individuals on a daily basis. We are happy to answer any questions you may have. Schedule a free consultation today!
Summary
Buying a small business is a thrilling investment – and one that must be made wisely. It is important to understand your motivation for buying a small business to uncover your blind spots. Be sure to get proper proof through documentation, and understand the reliability of the revenue. Know if you are willing to take on the risks and if you have the resources to mitigate them. Most importantly, be sure to get a professional opinion of the value through a business valuation.
Peak Business Valuation regularly values small businesses. We are happy to help you understand the value and know the risks before buying a small business. Reach out by scheduling a free consultation! We look forward to working with you and making your dreams of becoming a business owner come true!
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