Business PurchaseBusiness Purchase

• Purchase may not solely be for Purchase may not solely be for business entry, but for expansion business entry, but for expansion purposespurposes– Achieve breakeven level of salesAchieve breakeven level of sales

– Scale economiesScale economies

– Hire professional managersHire professional managers

Business PurchaseBusiness Purchase

• Selection of industrySelection of industry– Personal interest and skillsPersonal interest and skills– Growth prospects for industryGrowth prospects for industry

• Develop screening criteriaDevelop screening criteria– Acceptable priceAcceptable price– LocationsLocations– Financial condition of companyFinancial condition of company

• Identify specific companiesIdentify specific companies• Evaluate companies against criteriaEvaluate companies against criteria

Finding OpportunitiesFinding Opportunities

• Known candidate - Ask themKnown candidate - Ask them– May be available in futureMay be available in future

– Everybody has a priceEverybody has a price

• Trade journals and publicationsTrade journals and publications

• Business professionalsBusiness professionals– Lawyers and accountantsLawyers and accountants

– Investment brokersInvestment brokers

• Industry networkingIndustry networking

Business ExperienceBusiness Experience

• Helps identify industries of interestHelps identify industries of interest

• Credibility with potential sellersCredibility with potential sellers

– May have other buyersMay have other buyers

– Interested in continued success of Interested in continued success of their businesstheir business

• Provide contacts with customers and Provide contacts with customers and supplierssuppliers

Evaluating the OpportunityEvaluating the Opportunity

• Why is the owner selling?Why is the owner selling?– Owner will often have legitimate Owner will often have legitimate

reasonsreasons

– Evaluate legitimacy of reasonsEvaluate legitimacy of reasons

• Evaluating the businessEvaluating the business– Owner will present in most Owner will present in most

favorable lightfavorable light

– Seller financing or contingent Seller financing or contingent payments can reduce riskpayments can reduce risk

Form of TransactionForm of Transaction

• Stock acquisitionStock acquisition– Assumption of liabilitiesAssumption of liabilities

– Basis in stock is what you paidBasis in stock is what you paid• No “step-up” in basis of underlying No “step-up” in basis of underlying

assetsassets

For this reason, purchaser will For this reason, purchaser will normally prefer to purchase assetsnormally prefer to purchase assets

Form of TransactionForm of Transaction• Acquisition of assetsAcquisition of assets

– Purchase price allocated to individual Purchase price allocated to individual assets based on FMVassets based on FMV• Results in “step-up” in basisResults in “step-up” in basis

• Higher asset values will lower taxable Higher asset values will lower taxable incomeincome

– Don’t necessarily have to purchase all Don’t necessarily have to purchase all assetsassets

– Most valuable assets may not be tangible Most valuable assets may not be tangible in naturein nature

Example of Step-up in BasisExample of Step-up in Basis

• Seller A holds fixed asset with cost of Seller A holds fixed asset with cost of 10,000 and FMV of 20,00010,000 and FMV of 20,000

StockStock AssetAsset

PurchasePurchase PurchasePurchaseBasisBasis $10,000 $20,000 $10,000 $20,000DepreciationDepreciation (5 years) 2,000 4,000(5 years) 2,000 4,000

Tax savings at 40% 800Tax savings at 40% 800

Valuing the BusinessValuing the Business

• Value is FMV, but don’t have Value is FMV, but don’t have well-established marketwell-established market– Potential purchasersPotential purchasers

– Seller and purchaser time frameSeller and purchaser time frame

– Uniqueness of businessUniqueness of business• Some industries have Some industries have fairly standard valuationfairly standard valuation methods, multiplesmethods, multiples

Valuing the BusinessValuing the Business

• Review multiple years financial Review multiple years financial statements and tax returnsstatements and tax returns– Review for trendsReview for trends

– Be alert for sudden improvements Be alert for sudden improvements just prior to salejust prior to sale• May indicate window-dressingMay indicate window-dressing

• Time to sell is on upturnTime to sell is on upturn

– Look for discrepancies between f/s, Look for discrepancies between f/s, tax returnstax returns

Valuation MethodsValuation Methods

• ApproachesApproaches– Balance sheet approachesBalance sheet approaches

– Capitalized earnings approachesCapitalized earnings approaches

– Market comparablesMarket comparables

• Valuation may be done using Valuation may be done using multiple methods, different multiple methods, different methods for different parts of methods for different parts of businessbusiness

Valuing AssetsValuing Assets

• Fixed Assets - Fixed Assets - appraisalappraisal

• Inventory - Inventory - physical countphysical count– Adjust for obsolete itemsAdjust for obsolete items

• Accounts receivableAccounts receivable– Based on estimated percentage collectible Based on estimated percentage collectible

by category or specific accountsby category or specific accounts

– May exclude receivables from purchaseMay exclude receivables from purchase

(days)(days) Acct age Amount % Coll. ValueAcct age Amount % Coll. Value

0 - 30 $60,000 95% $57,0000 - 30 $60,000 95% $57,000

31 - 60 30,000 90% 27,00031 - 60 30,000 90% 27,000

61 - 90 20,000 75% 15,00061 - 90 20,000 75% 15,000

91 - 120 10,000 50% 5,00091 - 120 10,000 50% 5,000

> 120 15,000 20% 3,000> 120 15,000 20% 3,000

Total 135,000 107,000Total 135,000 107,000

Earnings CapitalizationEarnings Capitalization

• Earnings normalizationEarnings normalization– First step is to recast, or “normalize” First step is to recast, or “normalize”

earnings to make them more meaningful earnings to make them more meaningful or comparable to competitorsor comparable to competitors

• Typical adjustmentsTypical adjustments– Excessive owner salaries and perquisitesExcessive owner salaries and perquisites

– LIFO inventoryLIFO inventory

– Non-recurring sales or expensesNon-recurring sales or expenses

– Other temporary “window-dressing”Other temporary “window-dressing”

WeightedWeightedYear Earnings Weight EarningsYear Earnings Weight Earnings

1999 $100,000 5 $500,0001999 $100,000 5 $500,000

1998 80,000 4 320,0001998 80,000 4 320,000

1997 70,000 3 210,0001997 70,000 3 210,000

1996 90,000 2 180,0001996 90,000 2 180,000

1995 60,000 1 60,0001995 60,000 1 60,000

Total 15 1,270,000Total 15 1,270,000

Weighted earnings 1,270,000/15 = $84,667Weighted earnings 1,270,000/15 = $84,667

Earnings CapitalizationEarnings Capitalization

• Capitalization rate = 1/rate of returnCapitalization rate = 1/rate of returnex. Required return = 20%ex. Required return = 20%

Capitalization factor = 5Capitalization factor = 5

Weighted earnings $84,667Weighted earnings $84,667

Capitalization factor Capitalization factor x 5 x 5

Estimated value $423,335Estimated value $423,335

Capitalization FactorCapitalization Factor

RiskRiskCo. ACo. A Co. BCo. B

Multiple 6 4 Multiple 6 4

Which business is riskier (other things Which business is riskier (other things being equal)? being equal)?

Capitalization FactorCapitalization Factor

RiskRiskCo. ACo. A Co. BCo. B

Multiple 6 4 Multiple 6 4

Return Rate 16.7% 25%Return Rate 16.7% 25%

(1/Cap. factor)(1/Cap. factor)

Co. B is riskier Co. B is riskier

Capitalization FactorCapitalization Factor

GrowthGrowthCo. ACo. A Co. BCo. B

Multiple 8 5 Multiple 8 5

Which business has higher growth Which business has higher growth prospects (other things, such as prospects (other things, such as earnings and risk, being equal)? earnings and risk, being equal)?

Capitalization FactorCapitalization Factor

GrowthGrowthCo. ACo. A Co. BCo. B

Multiple 8 5 Multiple 8 5

ReturnReturn 12.5% 20%12.5% 20%

Co. A has higher growth prospectsCo. A has higher growth prospects

((Reflects that future earnings will be higher, Reflects that future earnings will be higher, rather than a difference in returns)rather than a difference in returns)

Capitalization FactorCapitalization Factor

Risk Cap. Factor ValuationRisk Cap. Factor Valuation

Growth Cap. Factor Valuation Growth Cap. Factor Valuation

Market ComparablesMarket Comparables

Business is valued using P/E ratio of Business is valued using P/E ratio of comparable publicly-traded companycomparable publicly-traded company

• Care should be exercised in selecting Care should be exercised in selecting comparable companies to obtain close matchcomparable companies to obtain close match

• Earnings need to be standardizedEarnings need to be standardized

• Liquidity discount of 30-50% is applied to Liquidity discount of 30-50% is applied to reflect lack of liquidity.reflect lack of liquidity.

A business is not profitable, and has A business is not profitable, and has little tangible assets. Can it still little tangible assets. Can it still have value?have value?

A business is not profitable, and has A business is not profitable, and has little tangible assets. Can it still little tangible assets. Can it still have value?have value?

Sure, intangible assets or sales Sure, intangible assets or sales volume may be valuable to volume may be valuable to another businessanother business

Allocating Purchase PriceAllocating Purchase Price

• To minimize taxes, maximize allocations to:To minimize taxes, maximize allocations to:– Inventory and receivablesInventory and receivables

• Immediately deductible as cost of sales Immediately deductible as cost of sales (inventory), or write-off if not (inventory), or write-off if not collectible (receivables)collectible (receivables)

– Assets with relatively short livesAssets with relatively short lives• Noncompetition agreementNoncompetition agreement

• Minimize allocation to land, real estate, and Minimize allocation to land, real estate, and other long-term assetsother long-term assets

• Allocation issues are applicable whether a Allocation issues are applicable whether a balance sheet or earnings approach is usedbalance sheet or earnings approach is used

Other Purchase IssuesOther Purchase Issues

• Consulting agreement - Consulting agreement - Purchase will Purchase will often provide to keep seller on for a period often provide to keep seller on for a period to assist with transitionto assist with transition

• Noncompetition agreement - Noncompetition agreement - Seller will Seller will generally agree to not enter into a generally agree to not enter into a competing business for a specified time and competing business for a specified time and geographical areageographical area

• Notice to creditors - Notice to creditors - Creditors must be Creditors must be notified of salenotified of sale

Payment TermsPayment Terms• Collect on DeliveryCollect on Delivery

– May apply if seller has other buyers, May apply if seller has other buyers, need for cash, etc.need for cash, etc.

– Bank financing can usually be obtained Bank financing can usually be obtained for part of purchase pricefor part of purchase price

• Installment saleInstallment sale– Purchase paid over several yearsPurchase paid over several years– Transfers risk to sellerTransfers risk to seller– May require life insurance on buyerMay require life insurance on buyer– May provide tax deferral for sellerMay provide tax deferral for seller

Payment TermsPayment Terms

• Contingent PayoutContingent Payout– Agreed upon downpaymentAgreed upon downpayment

– Balance contingent on future earningsBalance contingent on future earnings

– Allows balance of payments to be Allows balance of payments to be financed from earnings of businessfinanced from earnings of business

– May require seller involvement, audited May require seller involvement, audited financial statements, etc.financial statements, etc.