When it comes to entrepreneurship, there is a lot to be said for purchasing an existing business.
An existing business has established customers and revenue streams. This limits the uncertainty of starting from scratch. There are also systems and employees in place, which often leaves the business owner in a better position to focus on growth rather than securing funding for setup.
With that said, the benefits of acquisition come with their own set of challenges. An inefficient or financially unhealthy firm can be more difficult to turn around than simply building from the ground up. To ensure that buying a business is the best course of action, keep reading as we go through a checklist of what to review prior to purchasing an existing firm.
Standard Financials
No one knows what goes on behind closed doors.
A business may appear to be the portrait of health to the public, but a review of its standard financial documents will tell the true story. Balance sheet. Income statement. Cash flows.
These key accounting documents will reveal the financial strength of the business. It will make prospective buyers privy to red flags such as declining revenue and excessive debt to make the most informed purchase decision possible.
Cash Flow Quality
Circling back to the aforementioned financial documents.
They aren’t all created equal.
Cash remains king in the business world. Is the business creating more free cash than it’s burning?
Aggressive accounting practices can’t hide poor cash flows. A huge one-time payment from a client may help the business look highly profitable. However, the ability to generate ongoing cash flows should be scrutinized further.
Customer Concentration
Where are revenue streams coming from? Does the business have a diversified client base? High customer concentration can:
- Significantly put ongoing revenues at risk if a key client defects
- Give clients too much bargaining power when they realize your business is highly dependent on them
It is far more favorable to see businesses with low customer concentration. It represents a more stable and resilient revenue base.
Operations
Efficiency.
It’s the name of the game in the business world.
Are day-to-day operations sustainable?
An operational audit is critical prior to buying a business. It can unearth weaknesses and process gaps. It may also indicate that the company is highly dependent on a few key people, who would be irreplaceable should they leave post-purchase, significantly undermining the value you thought you were obtaining.
Staffing
More on key people.
You are only as good as the people you associate with. It’s one of life’s age-old aphorisms.
Therefore, ensure that the target company has a quality team ready and waiting. Is the right talent in place to support growth and efficient operations? Understanding the workforce can be an early indicator of turnover risks and cultural challenges.
Contracts
Know what you’re getting into.
That’s pretty sound advice.
By reviewing contracts, you can identify legal obligations that may cloud ongoing operations. You can get a bead on unfavorable terms that may undermine profitability.
A thorough review of outstanding contracts uncovers risks associated with long-term commitments. It unearths over-dependence on specific clients. It gives you a full understanding of what you are getting into and will help you plan and negotiate accordingly.
Growth or Stabilization: Which Route to Take Before Acquisition
Synergy is a word that gets thrown around a lot when it comes to business acquisition. It is often (and sometimes erroneously) assumed that the whole will be greater than the sum of its parts when acquiring a business. However, a turnaround strategy may be necessary to prevent a target company from bringing you down with it. Here are some signs that a target firm needs stabilization prior to acquisition:
- Inefficient processes - it can be too expensive and require too much time to fix inefficient operations post-merger
- Poor margins - diluted profitability can limit the combined company’s ability to invest in growth or cover unexpected costs
- Leadership gaps - culture much? Target firms with significant leadership gaps may present difficulties in strategic realignment and put insupportable strain on the new company’s management team
- Cost restructuring - will restructuring debt and liabilities draw attention away from core operations?
Remember, these are just points to consider. They do not necessarily mean that purchasing the company is a “pass.” Rather, just be mindful of the red flags and prescribe a stabilization plan, if necessary, to give the business the best chance of success post-purchase.
Due Diligence 101: What to Know Before Acquiring a Business
Acquiring a business can be a great entrepreneurial strategy. It can give you a head start over starting from scratch. With that said, there are some red flags to keep an eye on. By performing a thorough review ahead of buying a business--incorporating a turnaround strategy as necessary--you give yourself the best chance for experiencing key synergies that facilitate explosive growth. For more of the latest trends in business and entrepreneurship, head over to California Business Journal for the leading thought leadership in the sector!
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