Buying a Business? Ask these 3 important questions.

Thinking about buying a business? Sometimes it is better to buy an existing business, rather than to create your own. And sometimes buying a business can help in the growth of a business you've already started.

Buying a business is an undertaking that is both potentially expensive and complex. Businesses have a lot of moving parts, and there's only so much a person outside the business can know with confidence. But sellers may not be willing to fully disclose everything about their business to an uncommitted buyer.

So, if you're in the early stage of considering purchase of a business, how can you make the best use of your time? What are the most crucial pieces of information that you can get, information that the seller should be willing to give you, but without feeling like he or she is having to disclose all the secrets of the business?

Chad Simmons, in his "Business Valuation Bluebook", says there are three quick, but important questions a buyer can ask the seller:

1. How much is the average revenue per month?
2. What is the average markup on goods sold?
3. What are the average cash expenses, per month, excluding salary for the owner?

These questions will help you estimate the cash flow being generated by the business, which is often one of the first steps you'll take in deciding how to value the business you're thinking of buying.

Here's how the questions work:

Average monthly revenues allows you to calculate the yearly revenues. Some businesses trade on multiples of the yearly revenues (for example, the price of the business is equal to one times sales). However, there are tricks in using a price to sales multiple approach in valuing a business; be sure you know them. In general, higher price to sales multiples can be justified by higher net profit margins and/or higher growth rates. So we don't stop at revenues. We're after cash flows generated by the business, so let's press on.

Knowing average monthly revenues and the average markup allows you to calculate the cost of goods of the business: revenues / (1 + markup) = cost of goods.

For example, if average monthly revenues are $20,000 and the average markup is 40 percent, then cost of goods for the business is: $20,000 / (1 + .40) = $14,286.

You can then calculate gross profit: revenue - cost of goods = gross profit. In our example, $20,000 - $14,286 = $5,714.

With the gross profit, you can then use the average monthly expenses to calculate the business operating profit: gross profit - average monthly expenses = operating profit (before taxes and owner's salary). In our example, $5,714 - $3,000 = $2,714 per month.

Converting the monthly operating profit to a yearly figure gives 12 x $2,714 = $32,568.

You can then use these results to calculate any number of ratios that you want: gross margin, operating margin, and so on.

Remember that this amount is before owner's salary and income tax. Under our example, if the owner has to work full time in the business, the business is generating only enough to pay for a modest wage for the owner's work as an employee, which means little return on the owner's investment in the business as owner.

Simmons goes into much more detail on how to value a business. The book is a worthwhile for both buyers and sellers.

INC Business Lawyers has acted for buyers and sellers of many different kinds of businesses. If you're considering the sale or purchase of a business, or part of a business, please call or e-mail us.