The following are a few non-financial due-diligence considerations a business buyer must account for:
Establish Customer Concentration
An important element of business due-diligence is to determine customer concentration. Customer concentration may be defined as the percentage of revenues coming from a single customer. For example, a business may have five large customers responsible for 60% of its revenue.
Customer concentration is directly correlated with the purchase price and the cash at close component of the deal structure. Let’s say there are two similar companies with equal revenues, margins and net income. The business with lower customer concentration will demand higher price and higher cash at close as compared to a business with lower customer concentration. A business buyer should always model the business losing a few customers when ownership changes. If customer concentration is high, losing large customers when the business changes hands can hurt the business significantly.
When a business changes hands the former business owner still has a relationship with all customers. This relationship becomes a critical element of the due-diligence process if the customer concentration for the business is high. It is possible that after selling a business the former owner may restart the same business in the same area. The business buyer can protect himself from such behavior through non-compete agreements. If the former business owner could be a competitive threat, the business buyer must work with his lawyer to draft a non-compete agreement and get it signed as a part of the deal.
Determine Baseline Deal Structure
The buyer should determine his budget and come up with a baseline deal structure prior to shopping for a business. There are several elements that constitute a deal including cash at closing, seller financing, mezzanine financing, seller retained equity, and earn-out.
Cash at close is the actual cash that will be transferred from the business buyer to the business seller when the deal closes. Seller financing is a loan provided by the business seller to the business buyer. Mezzanine financing is a hybrid between debt (loan) and equity financing. It is a variation of debt financing where the lender has the right (option) to convert the loan to an equity interest if the company defaults on the loan. As the name suggests, Seller Retained Equity is the equity retained by the seller in the business after the owner (management) of the business changes. Once a business buyer has determined the baseline deal structure and cash on close amount he should get approved for financing before approaching a business broker or business seller.
It is getting harder and harder to get credit in the current environment. Therefore most business brokers and businesses sellers require the business buyer to verify their ability to purchase a business before getting into lengthy due-diligence process. The buyer should be clear on what the sources of financing are. The average first time buyer is an experienced professional in the mid 40’s, so a large portion of financing may come from personal savings or home-equity. Additionally, the buyer should be clear on how much of his funds he can use for down payment. In some cases there may be an option to ask for seller financing. The buyer should be clear on the terms for seller financing before approaching the seller.
Build a Team
Purchasing a business is a complex transaction, so the business buyer should engage a business broker to assist him with the process. TheBuySellBusinessess.com website can help buyers and sellers connect, but businesses then need to engage a broker to complete the transaction. In addition to business brokers the buyer may also need to engage an attorney to evaluate the term sheet, stock purchase agreement, leases, franchise agreements etc. The buyer should engage an accountant to review the books for structure the business deal.
Typically, purchasing a business implies purchasing the operating assets only. That said purchasing a business can be extended to include the corporation and fixed assets. In some cases buyers may not want to purchase account receivables (AR). The buying party can include or exclude any assets in the agreement. The buyer should know upfront the industry he wants to focus and if he is in the market to buy an operating business or to buy an operating business with fixed assets.
Find a Business
There are many sources buyers can use to find a business. http://www.buysellbusinesses.com/ and similar Websites are one source. Business brokers play a crucial role in finding businesses as well.