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Buying a business – How much should you invest?

The factors you should think about

We can all find our hearts ruling our heads. But if you let this happen when you’re buying a business, and you don’t research the opportunity properly, you may come to regret it. You need to make sure you establish the worth of the business and whether its returns are going to be worth your time and money.

This depends on a number of factors, including current market conditions, how many competitors there are in the marketplace and how many buyers are in the market.

What's the business worth?

The first thing you need to do before you think about buying a business is work out how much it’s worth. This can be tricky. The market value can be quite subjective. The amount you’re willing to pay will also be based on what the business is worth to you, as well as the market value. You might only want the land the business currently occupies, or a database that the business owns.

It’s not as simple as looking at the amount the current owner has invested. Maybe they’ve over-capitalised in some areas or invested in refurbishments that you wouldn’t. There might also be intangible assets — like an exclusive licence — or future orders that lower the risks of buying the business.

To avoid paying more for the business than it is worth, you should:

  • Take a look at the company’s history — you can get copies of their statutory returns from Companies House.
  • Speak to your advisers — their financial and legal due diligence could save you making a costly mistake
  • Investigate the industry and future trends if it’s one you’re new to
  • Find out about any future developments and plans in the area that could affect you

How much can you afford?

After you’ve worked out a value for the business, you need to make sure you can afford to buy it.

Your financial limit will be based on:

  • Your available cash
  • How much you can borrow
  • How much your partners, investors or venture capitalists are prepared to put in

It’s possible that the current owner will accept a deferral of some of the purchase price, perhaps for several years or linked to future profits – an ‘earn-out’.

But don’t think that you can spend the full amount you have on the business purchase. You’ll need to work out how much additional money you’ll need to:

  • Cover additional purchase, transfer and set-up costs
  • Tide you over during any unexpected delays and teething problems
  • Finance growth in stocks or debtors, ‘working capital’ or to fund the business while you return it to profit if it is a ‘turnaround’ case
  • Cover the finance charges and interest payments if applicable
  • Hold as a contingency reserve

The total amount of capital available, less the amount you need to run it (including interest and loan repayments), indicates the maximum price you can afford to pay.

An annual cash flow chart will help you work out how much money you’ll need to set aside to meet operational costs.

Is the return on investment attractive?

It’s also important to ensure that you’ll be able to make a reasonable return on your investment. Calculate how much profit you think you can make each year for the next five or ten years. Then look at whether the annual net profit gain is worthwhile compared to the amount you need to invest in the business. Make sure you’re realistic in your assumptions, and always look at the worst-case scenario.

A surprising number of businesses would be better off financially if they put their money into a fixed-term, high-interest-bearing deposit account.

If you’re buying the business as a lifestyle choice, there will be other factors that influence your decision. But if it’s simply for investment, make sure it will give you a better return than you can earn on lower risk investments.

What is the risk?

The amount you’re prepared to pay for a business also depends on the risks involved. A business that’s in good shape and operates in a growing market is usually worth paying more for. However, a new business or product, in a low-growth or untested market means you’ll probably only be prepared to pay a lower price.

Another thing you should consider is how easy you can get your money out if your own situation changes? Could you sell the business easily if you had to? If you can, then you’ll probably be prepared to pay more for that business. If you can’t, then the purchase price offered will be lower.

Other factors to consider

There are many other factors to consider when you’re deciding how much to spend on a business. If it’s a lifestyle purchase, or a way to contribute to your favourite cause as you make money, this could increase the amount you’ll be prepared to pay for the business.

If you buy the business using finance, think about whether it’s still a worthwhile investment. You might have to give up some control of the business to an investment partner or provide security for the finance, possibly putting your family home at risk if the venture fails.

Remember you’ll have to pay any borrowings back, and pay interest on them until you do. Sometimes this extra financial burden can make the purchase a less appealing option.

This guide is intended as general advice only, and not intended to cover specific circumstances and needs. The information in this article is also not linked to any of the products offered by Clydesdale Bank PLC.

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