Last week, I wrote about the best business buying practices of Warren Buffett, Berkshire Hathaway’s CEO and Chairman.  Mr. Buffett emphasizes that he doesn’t make quick business buying decisions.  He studies them carefully with a healthy “buyer beware” mindset.  He’d rather wait a long time to find one great business than leap at sexy-sounding opportunities that can falter later. 

This week’s column will introduce some “due diligence” considerations to help two women assess the value of a retail coffee and wine shop.  The stated purchase price is $750,000 including a building.  At this price, the buyers will also need $100,000 from investors

Here’s where potential buyers have to do their homework. Investors will ask tough questions about (i) the strength of the base business and (ii) if the purchase price is low enough to give all investors and owners considerable upside.  If investors ask too many unanswered questions, they will assume new management is not capable of buying a business successfully. Investors back management teams that “look at the numbers” just as much as they do.

Let’s face it.  Most companies are put up for sale at a price that exceeds true value.

To determine the right number, start by verifying the value of the building and inventory. 

Pay considerable attention to inventory value and turnover rates because the information can provide meaningful clues to business health. Ask for an inventory report including original purchase prices, purchase dates and how the owner values the inventory today.  Most goods should be valued at original cost, but the owner may seek to boost the company’s purchase price by raising wine values to some loose estimate of “market” value.

Also investigate if the inventory is in good, salable condition. How was the wine stored over the years?  Are any cartons or bottles damaged?  Did you count all the bottles and cases to make sure all the stated inventory is really there?  As you go through your investigation, consider every problem as an opportunity to lower the purchase price.   

Accountants who audit financial statements typically discount inventory that has not been sold within 12 months of purchase. But wine can be tricky.  Be wary if inventory has been sold at prices below original cost or if there is too much of any single type of product.”

My best tip is this:  Don’t buy other peoples’ mistakes. If there is no market for any of the wine or coffee, don’t buy it. Let the owner keep merchandize that you can’t sell at a profit.  No exceptions! 

Your next area of investigation is the business itself.  Look at the company’s monthly and annual results during the last 3 years.  Have revenues and profits grown every year?  Ask what causes monthly revenue fluctuations.  Ask to sit in the store for several days to monitor customer traffic.  What and why do they buy? Can customers buy the same merchandise in Safeway or Costco?  What will it take to improve the business?  What will it cost to do it? 

Now here’s the acid test.  Can you put together a similar retail shop for less than $750,000, preferably without a real estate purchase?  Remember, if you finance a business purchase with variable interest debt, as interest rates rise (and they will), the cash cost of buying and operating the business also rises.

Researching a business acquisition involves many more considerations than this column can reasonably cover. To help, I posted a lengthy list of potential due diligence considerations at www.insideentrepreneurship.com.  Click on “Other Information.”   Next week we’ll review how to approach potential co-investors to help finance a business acquisition.  Cheers.