Looking to buy a business: Know what you're buying...

Before purchasing a business, you need to be sure you understand exactly what you're buying. That can be difficult. Valuating a business is not a simple exercise or an exact science. It simply provides a theoretical figure that will give you an idea of a fair price to pay.

Perform due diligence
The first thing to do when considering purchasing a company is to assess its financial statements, legal status and assets, including inventory, equipment and accounts receivable. You should use the services of in-house and outside experts to do this.

You should also confirm the vendor's good faith and the soundness of the business. If most of its sales are generated by only a few customers, for instance, you will need to confirm that they intend to continue doing business with the firm once you have acquired it.

You must also take into account any changes you intend to make to the company after acquiring it. No matter how essential these changes may be, keep in mind that their cost may substantially reduce the return on the capital you have invested.

Evaluating assets
The vendor should supply you with a detailed list of what is up for sale. These assets may include land, buildings, equipment, inventory, the name of the business, its customer list and any contracts it has with employees and suppliers, as well as prepaid expenses and intellectual property.

When assessing the value of a company's equipment, make sure you have model numbers, dates of purchase and a record of how well the machinery is working, along with maintenance schedules and warranty details. When appraising inventory, check the age and condition of the stock. Are any of these items obsolete? If they're perishable, are they still well within their best-before date? When assessing accounts receivable, you'll need to determine how likely it is the amounts owing will be repaid. Are the receivables old? Are they collectible? Has adequate provision been made for bad debts? Are there any disputes involved?

Company liabilities
Depending on the nature of the assets, a company's loans or unpaid liabilities may become your responsibility as a buyer. A previous lender might even be in a position to seize the company's assets as repayment for an unpaid loan, leaving you with nothing. You need to know if the company has signed agreements that might lower the value of the assets or limit your freedom of action.

Determining fair market value (FMV)
There are a number of ways to determine an asset's fair market value. A specialist's appraisal may be needed for assets such as real estate, major equipment or specialized inventory. Likewise, a collection agency can help you evaluate the true value of accounts receivable, especially when assessing a company with many customer accounts.

Never rely only on the judgment of your accountant or the seller. It's always best to obtain an independent report from an expert specializing in business valuations. This is an unregulated field, but the Canadian Institute of Chartered Business Valuators provides guidelines and a code of ethics.

There are two main methods of valuating a business: one based on assets, the other on earnings and cash flow. An asset-based valuation can be based either on its book value - the company's assets minus its liabilities, as shown in financial statements - or its liquidation value: what a business could expect to fetch if it sold all its assets, paid down all debts including taxes, and then distributed the surplus to shareholders. An earnings-based valuation looks more closely at a company's current and projected future cash flow.

Although it's ideal to try to compare your potential acquisition with a similar transaction, in reality you will rarely be able to do this. In general, little information on such deals is publicly available, and the terms of any deal are often too closely tied to conditions in a particular economic sector to make them truly comparable.

Implications of buying shares
Anyone buying shares in a company takes a stake in the business, together with all of its assets and liabilities, whether they are recorded on the company books or not. A purchase agreement can include a provision that involves a buyer directly in the management of the company, or the purchaser can remain a silent partner. This latter option can smooth the transition between owners, lowering the price paid by the purchaser and allowing existing owners to show buyers how a business is run. The purchaser sometimes has the option of buying out the remaining shares and becoming sole owner later. Such a scenario is more likely if the target business is publicly traded and if the buyer has purchased enough shares to have some influence on how it is run. If a business is privately owned, the owners may prefer an outright sale.

There are always risks. Deals like these can sour if the buyer does not get along with the original owners or if the new and original owners have conflicting strategies. A purchaser may also unwittingly become responsible for liabilities such as unrecorded income tax reassessments, lawsuits and warranty claims that were not recorded in the financial statements. The new owner should also avoid being bound by the previous owner's depreciation schedules, which can be altered based on the purchase price.