5 Common Mistakes People Make When Purchasing A Business

Going into business, whether it’s the first time or the tenth, can be exciting and terrifying all at the same time. What if it works? What if it doesn’t?

Reflecting on some of the transactions we’ve been involved in over the years, we’ve identified the following 5 mistakes purchasers often make when buying a business. Many of these issues mirror problems we see in reviewing a buy-sell agreement, or other types of business contracts and data sharing agreements during transactions.

1. Poor or Non-Existent Due Diligence

Due diligence is your opportunity to verify whether or not the business will work for you. You don’t get to have a full inside look at how everything works, but you certainly get to test the numbers. We’ve prepared a brief and simple Due Diligence Checklist to help you identify the areas where you could be asking questions.

It is important in your due diligence to work with a management accountant. The reason you want a management accountant is that they should be able to help you with cashflow forecasting in anticipation of completion. Cashflow forecasting looks at all the costs and expenses you will need to cover once the purchase is complete, as well as covering any loan repayments you will be making after completion and ensuring you have working capital available when you get started.

Profits look good on paper, but cash is king and if you don’t have the cash to keep the business running after completion, you may need to renegotiate the purchase price or consider a different business. These are the same types of risks we flag when reviewing a data protection agreement, data processing agreement, data contract, or distribution agreement that affects the business operations.

2. Understanding What Stock You Need

Not every business will have stock that needs to be transferred to you as the purchaser and not every agreement deals with it adequately. Things we have seen go wrong with stock usually arise because no one thought about it too much before the completion day.

Representations about a business in the advertising pre-sale are not always accurate. This is especially the case if the seller tells you they have never done a stocktake in their life. If the seller doesn’t really know what stock they have, how can you determine what stock you need to maintain the same profitability of the business after completion?

If you see a stock estimate in advertising, ask for the verification behind it. Once you’ve entered into the due diligence phase you should be permitted to access what information the seller has about existing stock, even if the specific stock items are de-identified.

Compare the stock levels you are purchasing against the sale levels at the same time the previous year. Will there be enough stock on hand to meet demand, and if not, how are you going to get it quickly?

If the stock is unfamiliar to you, or a large volume, consider hiring a professional stocktake firm to come in and complete the stocktake in the days before completion. It is worth the money to properly identify what you are and are not buying. You shouldn’t be paying for stock that is obsolete, or which cannot be sold to the existing customer base, or which is about to expire. It’s going to cost you to get rid of it.

On the other hand, if the stock is only $100,000 in a $10,000,000 purchase, you might consider fixing an agreed price with the seller rather than doing a stocktake. The contract should have specific provisions around what can and cannot be done with that stock during the contract period, and what happens if it’s missing at completion, but losing $5,000 in stock is probably less expensive than completing a formal stocktake in that scale of transaction.

If you’re not taking over premises, you also need to consider moving the stock and what that will entail. $760,000 worth of $50 widgets is a lot of stock. As the purchaser, you are going to be responsible for packing it and moving it in a fixed timeframe. How many people, how much equipment and how much time will you need to do that?

3. Not Getting Lease Advice

You can negotiate an assignment of a lease. You don’t have to agree to the same terms the seller had with the landlord.

If the seller has been in the premises for a long time, it is possible there is quite a bit of maintenance due before your occupation of the premises will be compliant. You also need to consider whether the building has been properly maintained.

For example, fire safety obligations now are a lot different to what they were 20 years ago. If the landlord hasn’t brought the premises up to date, make sure they do before you take over. If there are other compliance obligations you have to meet to store the stock on the premises, make sure all compliance is up to date. As a new tenant you won’t get the benefit of obsolete provisions.

If there are make good provisions in the lease, you want to ensure your assignment doesn’t make you liable. It can cost as much to de-fit a building back to bare walls and clean paint as it can to complete a fit-out. If your lease only lasts another year after you take over, you could be up for huge costs in the short term.

4. Not Getting Proper Contract Advice

If you are going to invest $3,000,000 in buying a business, why wouldn’t you get proper advice? Yes, it costs money. The seller is prepared to pay 15% of the purchase price to the broker, yet we’ve had buyers begrudge 3–5% of the purchase price for proper advice?

Addressing potential issues early and before you spend a lot of money is better than ending up with unending costly problems after completion.

Your lawyer and your management accountant need all the information you have about the business, not just what you think is important. It also helps if we know your plans for the business in the next 3–5 years. With better context, we can provide better advice. It is a false economy to say “just look at this for me” or “I just want advice about this” without providing all the information your advisers need.

We worked with a purchaser after they had signed the contract and who only wanted a “red flag” advice about the contract and were prepared to do the rest of the work on their own to “save money”. They hadn’t even thought about moving stock before completion and hadn’t advised us they wanted our support in that area. When it became an issue on the day of completion, they needed our help.

They had not asked us to advise about or be involved in completion previously. There was significant frustration on all sides. We no longer offer limited services for business sales. These situations frequently involve reviewing key documents such as a contract for the sale of business , copyright agreement, exclusive distribution agreement, exclusive distributor agreement, or even a buyer’s agent agreement that is tied to the transaction.

5. Being Emotionally Tied to the Purchase

Savvy business advisers will always tell you to buy on the numbers and not on the emotions. Not everyone can be that clinical.

For many people purchasing their first business it is very emotional. It’s a new relationship and as a purchaser you might have rose coloured glasses on. You might be so focused on getting the purchase complete you forget to look too closely at some of the important details. Some people will actively refuse to hear anything negative about their new acquisition.

Most contracts have points at which you can walk away as the purchaser without significant losses. No matter what you have spent in the lead up, it will be less than what you could lose after the purchase if there is something wrong with the business. Work with your advisers to understand those triggers and use them if it turns out the transaction is not right for you.

We’ve worked with a buyer who told us “I’ve spent $500,000 already on this transaction, there is no going back now.” Hindsight showed that he would have been far better off walking away at that point than proceeding. He ended up losing over $20,000,000.

We’ve also worked with purchasers who have gone through all the steps to get advice and then walked away before the contract is signed, when the problems we helped them identify couldn’t be resolved before the deal was completed. One client did it three times. For the first three potential transactions the businesses they were looking at had all effectively stopped operating and the client would have been purchasing the right to occupy premises under a lease only, with no immediate revenue. You need deep pockets if you are going to invest in re-launching an already failed business.

There are many benefits to buying existing businesses, especially if you can consolidate with an existing business and save some costs, or promote the new business to your existing clients, and vice versa, to increase sales. Be confident you understand what you are taking on and get help before you reach the point of no return. Reviewing every buy-sell agreement, data sharing agreement, distribution agreement, or copyright agreement template that impacts the business will protect you from costly surprises later.

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