Essential guide to buying a business

When you're looking to buy a business, identifying the right one to buy is only a first step. Approaching the business purchase methodically is key to making the most of the opportunity and avoiding potential pitfalls. Careful checking, due diligence and skilful negotiation are essential.

Buying a business - the initial approach

Preliminary due diligence on your business purchase

Professional business purchase advisers

Making an initial purchase offer

Signing heads of terms

Detailed due diligence on your business purchase

Negotiating the final terms of sale

After the purchase completion

1. Buying a business - the initial approach

From the outset, your aim is to make the vendor of the business want to sell it to you.

Establish your credibility

• Formally register your interest in buying the business. The target business will usually have instructed professional sales advisers to sell the business. Approach the advisers, rather than the management.
• Explain what your background is, why you are interested in buying the business, and how you will finance the purchase. Your integrity and your future plans for the business are usually extremely important to the vendor.

Work out the vendor's objectives

For example:

• Does the vendor need to sell? If the answer is yes, what time pressures are they under?
• Does the vendor wish to sell assets or a company which holds assets?
• Is money the prime motivation for selling?
• Does the existing management aim to stay involved in the business?

2. Preliminary due diligence on your business purchase

You must be sure that the business you are buying has no major problems. Preliminary due diligence must be completed before you make a firm offer to buy. Be aware that the vendor's sales memorandum will usually gloss over weak areas.

It is unusual to have much access to a business before an offer has been accepted. Wait until you have agreed heads of terms to do a more thorough investigation.

Get a feel for the business

• Research its market and main competitors.
• Meet the vendor in person. Try to visit the business.
• Assess the key risks associated with future trading.

Ask industry experts for their views

• What is the future demand likely to be for the business' products or services?
• Are prices and margins rising or falling?
• How is competition in that market changing? For example, which new competitors are entering it? Are new competing products or services being introduced to market?

3. Professional business-purchase advisers

Choose advisers with appropriate experience

You may need experts in several different areas, at different stages of your purchase. For example, specialists in:

• market research, accounting, tax and legal due diligence
• financing the purchase
• employee terms - for example, pension fund provisions
• negotiating the deal

Ask about the last four deals that the adviser worked on. Ask to speak to the clients involved about their experiences. This approach quickly reveals which advisers are good. You can also pick up useful tips on buying a business.

Draw up specific remits for your advisers

• Agree in writing what your advisers should and should not do. For example, you could ask a financial adviser to analyse projected margins for orders over £5,000.
• Coordinating more than one adviser can become complicated. Agree to use planning documents, such as a completion checklist.
• Give advisers a timetable for the work.

Agree fee levels as clearly as possible

• Professional advisers normally charge by the hour. Agree a target number of hours for each stage of work, and a system for keeping you regularly informed of costs. Negotiate a limit on the maximum fee.
• Advisers may charge by the job.
• The final fee may depend upon the deal completing, or on the purchase price. For example, you might pay an adviser a percentage of any reduction achieved in the price as a result of their work.

4. Making an initial purchase offer

Take professional advice to help you value the target business

• Do not rely on the vendor's figures. Question any optimistic projections or unsupported claims.
• Identify where savings can be made, and where there is scope to increase profits. For example, can your existing business also grow by selling to the customers of the business you want to buy?

Consider your level of risk

Risk is higher if the target business:

• Has assets worth less than your offer price.
• Relies on one or two major customers (or contracts, or suppliers, or key employees).
• Is currently unprofitable, or has a history of losses. You may have to fund losses for some time to come.

Heavy borrowing to finance the purchase may also increase your risk. Conversely, the lack of adequate finance may have been all that was holding the company back.

Calculate your initial offer and your maximum offer

Take into account:

• your initial valuation
• what competition you are up against
• the vendor's objectives

Assess what you are prepared to pay and be able to articulate why. Be prepared to amend the basis for your offer if necessary.

Submit your purchase offer

• Use a concise, formal letter. Head it SUBJECT TO CONTRACT, so that you are not committed.
• Detail the specifics of what you are prepared to pay, and what you expect to receive for it.
• Emphasise the positive aspects of your offer. For example, that you can pay in cash, or that you are prepared to keep all employees on.

Chase up a decision on the offer

• Clarify any outstanding issues.
• Listen carefully to feedback on your offer, and be prepared to revise terms if necessary.

5. Signing heads of terms

The heads of terms agreement sets out the main terms of the sale. It is also called heads of agreement.

Specify what you have agreed to buy

• This may be the business, or just its assets. For example, you might buy the fixed assets (equipment and so on), stock, debtors and order book - and re-employ the people.
• By buying just the assets, you may avoid potential legal liabilities, such as disputes over previous contracts.

Set out the payment structure

• The amount may depend on the profit figures in the next set of audited accounts.
• Parts of the payment may be deferred.
• Payment can be complex. For example, it might involve shares in your own business.

Agree a period of exclusivity

• For example, you might want to restrict the vendor from speaking to other buyers for a ten-week period.
• Try to negotiate that your professional advisers' fees will be reimbursed if the vendor pulls out of the deal.

List any preconditions you insist on

• For example, achieving a particular result (eg a minimum level of audited profits or firm orders, or the sale of an asset).
• You are only committed to purchase the business if these preconditions are met.

Agree which warranties and indemnities will be provided by the vendor

• Warranties are written statements which confirm certain key information about the business. For example, information on business assets, audited accounts, order book, debtors, creditors, employees and legal claims.
• An indemnity is a commitment to reimburse you (the buyer) for costs incurred in a specified situation. For example, you usually receive a tax indemnity to cover any undisclosed tax liabilities relating to transactions before the date the business was sold.

6. Detailed due diligence on your business purchase

After signing the heads of terms, you should make a thorough examination of the business. This is the second stage of due diligence.

Seek out customer opinions

Ask them:

• How long they have been customers.
• Who their main contact at the business is. If this is the owner, his or her continued involvement will be more valuable.
• What is good and bad about the business' products or services.
• Whether they also use competitors, and the reasons for this.
• What their future demand will be for the business' products or services.

Ask suppliers for their views

• Does the business pay on time?
• Is it an efficiently run business?
• How does it compare with competitors?

Analyse historical information and trends

• Look at sales growth, profit margins, overheads and working capital (debtors, creditors, stock and work-in-progress). What is the scope for improvement?
• Check for inconsistencies. For example, the business may recently have changed its accounting policy to increase the book value of stock (and therefore profits).

Compare the financial projections with other evidence you have

• Do they tally with historical trends? For example, are the debtor period and the bad debt provisions realistic? 
• Is the sales forecast achievable, given the current order book and the statements by customers? Does it reflect the general outlook for the industry and the economy?

Revise the projections if they are out of step with these indicators.

Check up on major balance sheet items

• When was the last full audit? If it was more than six months ago, do another one.
• Are stock levels steady? Rising stock levels may be a dangerous sign, especially in manufacturing, seasonal or fashion industries.
• How large are the bad debts?

Consider doing an employee audit, if you are allowed access

This involves looking at:

• Who the key employees are, so you can plan how to run the business.
• General skill levels, employee turnover and pay, compared with industry averages.
• How employees feel about a change of ownership. Would you expect any to leave? If so, would the key people stay?

Complete legal due diligence

• Confirm legal ownership of all key assets. This might include property, equipment, vehicles and intellectual property (eg registered patents or design rights).
• Check for any past, current or pending lawsuits.
• Examine all contractual obligations. This includes employment contracts, pensions, and contracts with third parties such as customers and suppliers.
• Look for contingent liabilities, such as potential claims from lawsuits or product warranties.
• Consider what effect a change of ownership will have. Some contracts may be nullified as a result.

7. Negotiating the final terms of sale

If your due diligence checks have been thorough, you should be in a stronger negotiating position. The problems and weaknesses you have uncovered may lead you to lower your offer, or to ask for stricter warranties and indemnities.

Be reasonable but firm in making requests

• Explain the reasons behind your requests.

Keep the dialogue going, even if the process becomes awkward

• The vendor is unlikely to withdraw at this late stage. Brinkmanship and all the other aspects of negotiation come into play.

Close the deal

8. After the purchase completion

To ensure a smooth transition, there are two priorities.

Quickly announce the change of ownership, in a positive way

• Agree how it is to be announced, and the wording, with the vendor. Make the announcement positive.
• Meet with employees in person, and individually, if possible. It is important to make them feel settled and motivated from the outset.
• Businesses with more than 50 employees have to notify and discuss with their employees any changes likely to affect their jobs.
• Write to the major customers, explaining the advantages for them.

Implement your action plan

This plan will have evolved during the whole buying process. Complete it before you make the final offer, including a timetable. The plan outlines all the steps necessary to achieve key objectives such as:

• Establishing trust and confidence among employees.
• Securing and then improving customer relationships.
• Focusing the business, to improve cash flow and profitability. For example, by closing (or turning round) any loss-making operations or by selling under-used assets.

Make clear to employees your determination to carry through your plans

Expert quote

"Using inexperienced advisers will, at best, impede the process. At worst, you will lose the deal, pay too much or get landed with unforeseen liabilities." - Paddy MccGwire, Silverpeak