For many people buying a small business is their most viable path to a desired life working for themselves, compared with the riskier proposition of starting a business from scratch.
In this article, we’ll outline some of the advantages and disadvantages of buying a small business, the benefits of various entities used to purchase the business, the wisdom of using a consultant during the purchase process, and the importance of the due diligence process both before and after signing the contract.
Discussing these issues with experienced legal professionals is a sensible course of action to check all the necessary steps are taken to make the right decision.
Advantages and disadvantages of owning a small business
Notable advantages to purchasing an existing small business include:
Cash flow: An established, profitable business can produce immediate financial returns and provide records that can be used to attract other investors or partners.
Clients and customers: A well-run business has an established client base which a committed new owner can build on and expand.
Plant and equipment: Depending on the proposed deal, essential equipment used to operate the business can be part of the purchase.
Goodwill: A well-established venture will have a ‘good name’ which becomes part of its value when it comes time to on-sell the business.
Among some of the common disadvantages of purchasing a small businesses are:
It may not be a ‘going concern’: If establishment of the business is incomplete and needs more funds for equipment or fit-outs, for example, this can be an immediate financial drain on the new owner.
Existing debt: Depending on the structure of the deal, a new owner may need to assume the former owner’s debts and other liabilities, and pay existing debtors on time.
Fees and charges: Besides the purchase price, fees for legal and accounting services need to be accounted for, as well as other expenses such as stamp or transfer duty.
Loyalty to former owner: It’s in the nature of small business that some proprietors will develop a loyal following which may not continue with the new owner.
Overstated goodwill: The concept of goodwill is a notoriously difficult concept to value and can be overstated by a prospective seller to inflate the sale price.
Locked-in contracts: Part of due diligence (discussed below) in purchasing a small business is to check whether the enterprise is locked in to long-terms contracts with suppliers, maintenance/cleaning or other services, which might be on unfavourable terms for the business.
Which structure should be used to buy the business
There are also advantages and disadvantages to the different business structures used to purchase and run the enterprise, be it as a sole trader or a company. Business registration, tax, intellectual property and other legal or financial obligations all differ depending on business structure, while the size and type of the business may dictate the best structure for owning the entity.
While operating as a sole trader offers the owner control and nimbleness to make necessary changes in the business, the chief drawbacks are personal liability for business debts and the possibility of losing personal assets if the business fails. Tax will also be charged at the individual’s marginal rate rather than a lower corporate rate. A partnership brings similar benefits and risks.
A company, by contrast, is a separate legal entity and losses will be carried by shareholders in the entity rather than the individual owner. Legal dealings are conducted in the company’s name, shares may be transferred to other people, and the entity is taxed at the lower company rate.
There are a variety of other structures, each of which has its own pros and cons, depending on what buyers are looking to achieve, how much control and protection they’d like, as well as how easily they can exit, to name a few.
The role of consultants
Engaging a consultant at the outset once you’ve decided to purchase a small business can save you time and stress. An experienced consultant can help a prospective owner develop a business plan, assess the financial and operational fundamentals of the business, help re-shape its focus, and create a marketing/public relations strategy and advertising campaign. Consultants may have different skill sets, or combine a number of skills in accounting, financial arrangements and legal obligations in one service.
Importance of the due diligence process
Doing the necessary research on a business that is up for sale is a crucial stage both in the lead-up to signing the contract and afterwards.
Financial records, legal documents and details of how the business operates – including its contracts and leases, existing deals with suppliers, its staffing levels, codes of conduct and human resources records, assets, inventory, licences, permits and liabilities – should all be discovered during this period in order to make an informed decision.
Due diligence helps a buyer to determine whether the business is properly valued and uncover any issues that could affect profitability now or into the future. Having a trusted, independent person examine the business’ financial records is perhaps the most important aspect of due diligence. This step should comprise close checking of the past three-to-five years of the business’ financials including tax returns, BAS, accounts receivable and payable records, balance sheets, profit and loss records, cash flow statements and sales records. This process will help answer the question of whether the business has outstanding debts on assets or to external suppliers.
Buying a small business will attract expenses such as transfer duty on the purchase. The would-be owner needs to budget for this outlay as well as licence or lease assignment fees, bank loan fees (bank guarantee advice), legal fees, accountant fees and set-up costs.
Consult with experienced legal professionals
At PD Law we have helped many people into business ownership by making the processes described above easier to navigate. If you have a small business in your sights, we can assist with the discovery process and ensure the elements discussed in this article are methodically checked off so that a judicious decision is made and the business gets off to a flying start under new management.