I'M THINKING OF BUYING A BUSINESS
4. How much should I spend on a new business?
Once you’ve arrived at a value for the business, you also need to be sure you can afford to make the purchase.
You’ll probably already have a financial limit in mind based on:
- The cash you have available.
- The amount you’ve been able to secure as a loan.
- The amount partners, invest investors and venture capitalists are prepared to put in.
- Or any combination of these.
It’s a mistake to think this means you can spend the full amount you have available 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.
- To tide you over during any unexpected delays and teething problems.
- To keep the business running until it reaches break-even.
- To cover the finance charges and interest payments (if applicable).
- As a contingency reserve.
The total amount of capital available, less the money you need to keep the business running until it breaks even (including interest payments and loan repayments), defines the top purchase price you can afford to pay.
Work out how much money you will need to set aside to cover operational costs by using an annual cash flow chart.
Is the return on investment attractive?
Another critical factor to consider is whether you’ll earn a reasonable return on your investment. Work out how much profit you expect to make each year for the next five or 10 years. Is the annual net profit you anticipate earning a worthwhile return on the amount of money you’ll need to invest in the business?
A surprising number of small business owners would be better off financially if they put their money into an attractive fixed-term, high-interest-bearing deposit and headed off with their fishing rods, rather than toiling long hours in their low-profit business.
Unless this is a lifestyle purchase, you’ll want to make sure your investment is likely to earn you a significantly better return than your money could earn sitting in a bank or medium-risk investment, earning interest.
What is the risk?
The amount you’re prepared to invest buying a business will also depend on the level of risk involved. If you’ve done a thorough investigation and the business is in good shape, and in a growing market, you’ll be prepared to pay a higher price. On the other hand, if it’s a new business or a new product, in a low-growth or untested market, the risk involved means you’ll only be prepared to buy the business at a lower price.
One other point to consider is: how easy would it be to get your money out if your situation changes? Would you be able to sell the business easily if you needed to? If you can answer yes, you’ll be prepared to pay more for the business. But if your answer is no, you’ll probably only be prepared to buy the business at a lower price.
Other factors to consider
There are a number of other factors you might want to consider when deciding how much to spend. If the business is a lifestyle purchase or a way for you to make money while also contributing to your favourite cause, this could increase the value of the business to you – and the amount you’d be prepared to pay.
If you need financing to buy the business, you’ll need to consider whether it’s still a worthwhile investment. You might have to give over control of the business to an investment partner or provide security for the finance, possibly risking your family home if the venture fails. The business will also have to generate enough additional revenue to cover the related finance costs. In some cases, this additional financial burden can make the purchase a far less lucrative option.
If you’re buying or selling a small business, it’s critical to know what the business is worth. The challenge is that what you think a business is worth, and what the person on the other side of the fence thinks it is worth, are usually two different figures.
In the end, the motivation for both buyers and sellers is always the belief that they’re getting a good deal.
If you’re selling your business, you’re likely to be disappointed if buyers don’t see the potential you do. For example, a café up for sale at $300,000 included a purpose-built wooden floor with the café’s name etched in the middle. The floor alone cost $100,000 – but nobody else saw any value in the floor.
The worth of a business hinges on how much profit it will make, balanced by the risks involved. But past cash flow, profitability, and asset values are only the starting points. It’s often the hard-to-measure factors such as key business relationships and goodwill that provide the most value.
If you need support with determining how much to spend on a new business, please get in touch.1 We can assist you with working out what is within your budget, so you have every chance of success.
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