copyright © 2011 pearson education, inc. publishing as prentice hall buying an existing business...

Copyright © 2011 Pearson Education, Inc. Publishing as Prentice Hall

Buying An Buying An

Existing BusinessExisting Business

Buying An Buying An

Existing BusinessExisting Business

CHAPTER CHAPTER 77

Copyright © 2011 Pearson Education, Inc. Publishing as Prentice Hall 7 - 2Ch. 7: Buying an Existing Business

Key Questions to Consider Key Questions to Consider BeforeBefore Buying a Business Buying a Business

Is the right type of business for sale in the Is the right type of business for sale in the market in which you want to operate?market in which you want to operate?

What experience do you have in this What experience do you have in this particular business and the industry in which particular business and the industry in which it operates? How critical is experience in the it operates? How critical is experience in the business to your ultimate success?business to your ultimate success?

What is the company’s potential for success?What is the company’s potential for success? What changes will you have to make – and What changes will you have to make – and

how extensive will they have to be – to realize how extensive will they have to be – to realize the business’s full potential?the business’s full potential?


Key Questions to Consider Key Questions to Consider BeforeBefore Buying a Business Buying a Business

What price and payment method are What price and payment method are reasonable for you and acceptable to the reasonable for you and acceptable to the seller?seller?

Will the company generate sufficient cash to Will the company generate sufficient cash to pay for itself and leave you with a suitable pay for itself and leave you with a suitable rate of return on your investment?rate of return on your investment?

Should you be starting a business and Should you be starting a business and building it from the ground up rather than building it from the ground up rather than buying an existing one? buying an existing one?

Copyright © 2011 Pearson Education, Inc. Publishing as Prentice Hall 7 - 4Ch. 6: Franchising and the Entrepreneur

FIGURE 7.1 Types of Business BuyersSource: Darren Dahl, “Meet the Buyers,” Inc., April 2008, pp. 98-99.


Advantages of Advantages of Buying a BusinessBuying a Business

It may continue to be successfulIt may continue to be successful It may already have the best locationIt may already have the best location Employees and suppliers are Employees and suppliers are

establishedestablished Equipment is already installedEquipment is already installed Inventory is in place and trade credit Inventory is in place and trade credit

is establishedis established


Advantages of Advantages of Buying a BusinessBuying a Business

New owners can “hit the ground New owners can “hit the ground running”running”

New owners can use the previous New owners can use the previous owner’s experienceowner’s experience

Financing is easier to obtainFinancing is easier to obtain It’s a bargain!It’s a bargain!

(continued)(continued)


Disadvantages of Disadvantages of Buying a BusinessBuying a Business

It’s a “loser”It’s a “loser” Previous owner may have created ill willPrevious owner may have created ill will ““Inherited” employees may be Inherited” employees may be

unsuitableunsuitable The location may have The location may have

become unsatisfactorybecome unsatisfactory Equipment and facilities Equipment and facilities

may be obsolete or inefficientmay be obsolete or inefficient



Change and innovation can be Change and innovation can be difficult to implementdifficult to implement

Inventory may be Inventory may be outdated or obsoleteoutdated or obsolete

Accounts receivable may Accounts receivable may be worth less than face valuebe worth less than face value


Copyright © 2011 Pearson Education, Inc. Publishing as Prentice HallCh. 7: Buying an Existing Business

Valuing Accounts ReceivableValuing Accounts Receivable

Age of Accounts

(days)

Amount

Collection Probability

Value

0-3031-6061-9091-120121-150151+

Total

$40,000$25,000$14,000$10,000$7,000$5,000

$101,000

.95%88%70%40%25%10%

$38,000$22,000$9,800$4,000$1,750

$500

$76,050

7 - 9

Table 7.1



Changes can be difficult to implementChanges can be difficult to implement Inventory may be staleInventory may be stale Accounts receivable may be worth Accounts receivable may be worth

less than face value less than face value The business may The business may

be overpricedbe overpriced



Acquiring a BusinessAcquiring a Business

Study: 50 to 75% of all business sales Study: 50 to 75% of all business sales that are initiated fall through.that are initiated fall through.

The The rightright way: way: Analyze your skills, abilities, and Analyze your skills, abilities, and

interests.interests. Prepare a list of potential candidates.Prepare a list of potential candidates. Investigate and evaluate candidate Investigate and evaluate candidate

businesses and select the best one.businesses and select the best one.


Acquiring a BusinessAcquiring a Business

Explore financing options.Explore financing options. Potential source: the sellerPotential source: the seller

Ensure a smooth transition.Ensure a smooth transition. Communicate with employeesCommunicate with employees Be honestBe honest ListenListen Consider asking the seller to Consider asking the seller to

serve as a consultant through serve as a consultant through the transitionthe transition



Critical Areas for Critical Areas for Analyzing an Existing BusinessAnalyzing an Existing Business

1.1. Why does the owner want to sell ... Why does the owner want to sell ... what is the what is the realreal reason? reason?

2.2. What is the physical condition of the What is the physical condition of the business?business?

Accounts receivableAccounts receivable Lease arrangementsLease arrangements Business recordsBusiness records Intangible assetsIntangible assets Location and appearanceLocation and appearance



3.3. What is the potential for the company's What is the potential for the company's products or services?products or services? Product line statusProduct line status Potential for company’s products or Potential for company’s products or

servicesservices Customer characteristics and compositionCustomer characteristics and composition Competitor characteristics and compositionCompetitor characteristics and composition

4.4. What legal aspects must I consider?What legal aspects must I consider?



The Legal Aspects of The Legal Aspects of Buying a BusinessBuying a Business

Lien - creditors’ claims against an asset.Lien - creditors’ claims against an asset.

Bulk transfer - protects business buyer Bulk transfer - protects business buyer from the claims unpaid from the claims unpaid creditors might have creditors might have against a company’s assets.against a company’s assets.


Bulk TransferBulk Transfer Seller must give the buyer a sworn list of Seller must give the buyer a sworn list of

creditors.creditors. Buyer and seller must prepare a list of Buyer and seller must prepare a list of

the property included in the sale.the property included in the sale. Buyer must keep the list of creditors and Buyer must keep the list of creditors and

property for six months.property for six months. Buyer must give written notice of the sale Buyer must give written notice of the sale

to each creditor at least ten days before to each creditor at least ten days before he takes possession of the goods or pays he takes possession of the goods or pays for them (whichever is first).for them (whichever is first).



Lien - creditors’ claims against an Lien - creditors’ claims against an asset.asset.

Bulk Transfer - protects business buyer Bulk Transfer - protects business buyer from the claims unpaid creditors might from the claims unpaid creditors might have against a company’s assets.have against a company’s assets.

Contract Assignment - buyer’s ability Contract Assignment - buyer’s ability to assume rights under seller’s existing to assume rights under seller’s existing contracts. contracts.




Covenant not to compete (restrictive Covenant not to compete (restrictive covenant or noncompete agreement) covenant or noncompete agreement) contract in which a business seller agrees contract in which a business seller agrees not to compete with the buyer within a not to compete with the buyer within a specific time and geographic area.specific time and geographic area.

Ongoing legal liabilities - physical Ongoing legal liabilities - physical premises, product liability lawsuits, and premises, product liability lawsuits, and labor relations issues.labor relations issues.




3.3. What is the potential for the company's What is the potential for the company's products or services?products or services? Product line statusProduct line status Potential for company’s products or Potential for company’s products or

servicesservices Customer characteristics and compositionCustomer characteristics and composition Competitor characteristics and compositionCompetitor characteristics and composition

4.4. What legal aspects must I consider?What legal aspects must I consider?

5.5. Is the business financially sound?Is the business financially sound?



The Acquisition ProcessThe Acquisition Process

Negotiations

1. Identify & 1. Identify & approach approach candidate candidate

2. Sign the 2. Sign the nondisclosure nondisclosure statementstatement

3. Sign 3. Sign letter of letter of intentintent

4. 4. Buyer’s due Buyer’s due diligence diligence investigationinvestigation

5. Draft the 5. Draft the purchase purchase agreementagreement

6. Close the 6. Close the final dealfinal deal

7. Begin the 7. Begin the transitiontransition

1. Approach the candidate. If a business is advertised for sale, the proper approach is through the channel defined in the ad.Sometimes, buyers will contact business brokers to help them locate potential target companies.If you have targeted a company inthe “hidden market,” an introduction from a banker,accountant, or lawyer often is thebest approach. During this phase,the seller checks out the buyer’s qualifications, and the buyer beginsto judge the quality of the company.2. Sign a nondisclosure document. If the buyer and the seller are satisfiedwith the results of their preliminaryresearch, they are ready to beginserious negotiations. Throughout thenegotiation process, the seller expectsthe buyer to maintain strict

confidentiality of all of the records,documents, and information he or shereceives during the investigation andnegotiation process. The nondisclosure document is a legally binding contract that ensures the secrecy of the parties’ negotiations.3. Sign a letter of intent. Before a buyer makes a legal offer to buy the company, the buyer typically will ask the seller to sign a letter of intent. The letter of intent is a non-binding document that says that the buyer and the seller have reached a sufficient “meeting of the minds” to justify the time and expense of negotiating a final agreement. The letter should state clearly that it is non-binding, giving either party the right to walk away from the deal. It should also contain a clause calling for “good faith negotiations” between the parties. A typical letter of intent addresses terms such as price, payment terms, categories of assets to be sold, and a deadline for closing the final deal.

4. Buyer’s Due Diligence. While negotiations are continuing, the buyeris busy studying the business and evaluating its strengths and weaknesses.In short, the buyer must “do his or her homework” to make sure that the business is a good value. 5. Draft the purchase Agreement.The purchase agreement spells out the parties’ final deal! It sets forth all of the details of the agreement and is the final product of the negotiation process.6. Close the final deal. Once the parties have drafted the purchase agreement, all that remains to making the deal “official” is the closing. Both buyer and seller sign the necessary documents to make the sale final. The buyer delivers the required money, and the seller turns the company over to the buyer.7. Begin the Transition. For the buyer, the real challenge now begins: Making the transition to a successful business owner!

FIGURE 7.2Sources: Adapted from Buying and Selling: A Company Handbook, Price Waterhouse,( New York: 1993) pp.38-42;Charles F. Claeys, “The Intent to Buy,” Small Business Reports, May 1994, pp.44-47.

7 - 20


Determining the Determining the Value of a BusinessValue of a Business

GoodwillGoodwillThe difference in the value of The difference in the value of an established business and an established business and one that has not yet built a one that has not yet built a solid reputation for itself. solid reputation for itself.


Determining the Determining the Value of a BusinessValue of a Business

Balance Sheet Technique Balance Sheet Technique Variation: Adjusted Balance Sheet Variation: Adjusted Balance Sheet

TechniqueTechnique Earnings ApproachEarnings Approach

Variation 1: Excess Earnings ApproachVariation 1: Excess Earnings Approach Variation 2: Capitalized Earnings ApproachVariation 2: Capitalized Earnings Approach Variation 3: Discounted Future Earnings Variation 3: Discounted Future Earnings

ApproachApproach Market ApproachMarket Approach


Balance Sheet TechniquesBalance Sheet Techniques

““Book Value" of Net Worth = Total Assets - Total Book Value" of Net Worth = Total Assets - Total LiabilitiesLiabilities

= $266,091 - $114,325= $266,091 - $114,325

= $151,766= $151,766

Variation: Adjusted Balance Sheet Technique:Variation: Adjusted Balance Sheet Technique:

Adjusted Net Worth = $274,638 - $114,325Adjusted Net Worth = $274,638 - $114,325

= = $160,313$160,313


Earnings ApproachesEarnings Approaches

Variation 1: Excess Earnings MethodVariation 1: Excess Earnings Method

Step 1Step 1: Compute adjusted tangible net worth:: Compute adjusted tangible net worth:Adjusted Net Worth = $274,638 - $114,325 = Adjusted Net Worth = $274,638 - $114,325 = $160,313$160,313

Step 2Step 2: Calculate opportunity costs of investing:: Calculate opportunity costs of investing: Investment $160,313 x 25% = Investment $160,313 x 25% = $40,078$40,078 Salary Salary $25,000$25,000

Total Total $65,078 $65,078

Step 3Step 3: Project earnings for next year:: Project earnings for next year: $74,000$74,000


Excess Earnings MethodExcess Earnings Method

Step 4Step 4: Compute extra earning power (EEP):: Compute extra earning power (EEP):

EEP = Projected Net Earnings - Total Opportunity CostsEEP = Projected Net Earnings - Total Opportunity Costs = $74,000 - 65,078 = $8,922= $74,000 - 65,078 = $8,922

Step 5Step 5: Estimate the value of the intangibles : Estimate the value of the intangibles (“goodwill”):(“goodwill”):

Intangibles = Extra Earning Power x “Years of Profit” Intangibles = Extra Earning Power x “Years of Profit” Figure*Figure*

= $8,922 x 3 = $26,766= $8,922 x 3 = $26,766

* * Years of Profit Figure ranges from 1 to 7; for a normal risk Years of Profit Figure ranges from 1 to 7; for a normal risk business, the range is 3 to 4.business, the range is 3 to 4.



Excess Earnings MethodExcess Earnings Method

Step 6Step 6: Determine the value of the business:: Determine the value of the business:

Value = Tangible Net Worth + Value of Value = Tangible Net Worth + Value of IntangiblesIntangibles

= $160,313 + 26,766 = = $160,313 + 26,766 = $187,079$187,079

Estimated Value of the Business = $187,079Estimated Value of the Business = $187,079




Variation 2: Capitalized Earnings MethodVariation 2: Capitalized Earnings Method

Value = Value = Net Earnings (Net Earnings (AfterAfter Deducting Owner's Salary) Deducting Owner's Salary)

Rate of Return*Rate of Return*

Value = Value = $74,000 - $25,000$74,000 - $25,000 = = $196,000$196,000 25%25%

* Rate of return reflects what buyer could earn on a similar-* Rate of return reflects what buyer could earn on a similar-risk investmentrisk investment..



Variation 3: Discounted Future Earnings Variation 3: Discounted Future Earnings MethodMethod

Compute a Compute a weighted averageweighted average of the of the earnings:earnings:

Step 1Step 1: Project earnings five years into the : Project earnings five years into the future:future:

Pessimistic + (4 x Most Likely) + Pessimistic + (4 x Most Likely) + OptimisticOptimistic 66

3 Forecasts: Pessimistic Most Likely Optimistic



Discounted Future Discounted Future Earnings MethodEarnings Method

Step 1Step 1: Project earnings five years into the : Project earnings five years into the future:future:

Year Year Pessimistic Most Likely OptimisticPessimistic Most Likely Optimistic Weighted Weighted AverageAverage

$65,00$65,0000

$74,00$74,0000

$82,00$82,0000

$88,00$88,0000

$88,00$88,0000

$74,0$74,00000

$90,0$90,00000

$100,0$100,00000

$109,0$109,00000

$115,0$115,00000

$92,0$92,00000

$101,0$101,00000

$112,0$112,00000

$120,0$120,00000

$122,0$122,00000

$75,5$75,50000

$89,1$89,16767

$99,0$99,00000

$107,3$107,33333

$111,6$111,66767

11

22

33

44

55




Step 2Step 2: Discount weighted average of future earnings at : Discount weighted average of future earnings at the appropriate present value rate:the appropriate present value rate:

Present Value Factor = Present Value Factor = (1 +k) (1 +k) tt

Where:Where:

k = Rate of return on a similar risk investment.k = Rate of return on a similar risk investment.

t t = Time period (Year - 1, 2, 3...n).= Time period (Year - 1, 2, 3...n).

11




Year Weighted Average x PV Factor = Present Value Year Weighted Average x PV Factor = Present Value

11

22

33

44

55

.8000.8000

.6400.6400

.5120.5120

.4096.4096

.3277.3277

$75,500$75,500

$89,167$89,167

$99,000$99,000

$107,333$107,333

$111,667$111,667

Step 2Step 2: Discount weighted average of future : Discount weighted average of future earnings at the appropriate present value earnings at the appropriate present value rate:rate:

$60,400$60,400

$57,067$57,067

$50,688$50,688

$43,964$43,964

$36,593$36,593

Total Total $248,712$248,712




Step 3Step 3: Estimate the earnings stream beyond five years:: Estimate the earnings stream beyond five years:

Weighted Average Earnings in Year 5 x Weighted Average Earnings in Year 5 x 1 1 Rate of Return Rate of Return

= $111,667 x = $111,667 x 1 1 25% 25%

Step 4Step 4: Discount this estimate using the present value : Discount this estimate using the present value factor factor for year 6: for year 6:

$446,668 x .2622 = $117,116$446,668 x .2622 = $117,116




Step 5Step 5: Compute the value of the business:: Compute the value of the business:

= $248,712 + $117,116 = = $248,712 + $117,116 = $365,828$365,828

Estimated Value of Business = $365,828Estimated Value of Business = $365,828

Value Value ==

Discounted Discounted earnings in earnings in years 1 years 1 through 5through 5

++ Discounted Discounted

earnings in earnings in years 6 years 6 through ?through ?



Market ApproachMarket ApproachStep 1Step 1: Compute the average Price-Earnings (P-E) Ratio : Compute the average Price-Earnings (P-E) Ratio

for as many similar businesses as possible:for as many similar businesses as possible:

Estimated Value = 3.975 x $74,000 = $294,150Estimated Value = 3.975 x $74,000 = $294,150

Company P-E RatioCompany P-E Ratio 113.3 3.3

22 3.83.8 Average P-E Ratio = Average P-E Ratio = 3.9753.975

33 4.74.744 4.14.1

Step 2:Step 2: Multiply the average P-E Ratio by next Multiply the average P-E Ratio by next year's year's forecasted earnings: forecasted earnings:


Understanding the Seller’s SideUnderstanding the Seller’s Side

Study: 64% of owners of closely-held Study: 64% of owners of closely-held companies expect to sell their companies expect to sell their businesses within three years. businesses within three years.

Exit Strategies: Exit Strategies: Straight business saleStraight business sale Business sale with an agreement from the Business sale with an agreement from the

founder to stay onfounder to stay on Form a family limited partnershipForm a family limited partnership Sell a controlling interestSell a controlling interest Restructure the companyRestructure the company


FIGURE 7.5 Restructuring a Business for Sale


Understanding the Seller’s SideUnderstanding the Seller’s Side

Exit Strategies: Exit Strategies: Straight business saleStraight business sale Business sale with an agreement from Business sale with an agreement from

the founder to stay onthe founder to stay on Form a family limited partnershipForm a family limited partnership Sell a controlling interestSell a controlling interest Restructure the companyRestructure the company Sell to an international buyerSell to an international buyer Use a two-step saleUse a two-step sale Establish an ESOPEstablish an ESOP

(continued)


A Typical Employee Stock A Typical Employee Stock Ownership Plan (ESOP)Ownership Plan (ESOP)

CorporationShareholders

CorporationShareholders

ESOP TrustESOP Trust

FinancialInstitution

FinancialInstitution

Shares ofShares ofCompanyCompany

StockStock

Stock asStock ascollateralcollateral

BorrowedBorrowedFundsFunds

Funds to Funds to Purchase Purchase

StockStock

Tax-Tax-Deductible Deductible

ContributionsContributionsLoan Loan

PaymentsPayments

FIGURE 7.6 Source: Corey Rosen, “Sharing Ownership with Employees,” Small Business Reports, December 1990, p.63.


Negotiating the DealNegotiating the Deal

Buyers seek to:Buyers seek to: Get the business at the lowest cost.Get the business at the lowest cost. Negotiate favorable payment terms.Negotiate favorable payment terms. Get assurances that they are buying the Get assurances that they are buying the

business they are getting.business they are getting. Avoid putting the seller in a position to Avoid putting the seller in a position to

open a competing business.open a competing business. Minimize the amount of cash paid up Minimize the amount of cash paid up

front. front.


Negotiating the DealNegotiating the Deal

Sellers seek to:Sellers seek to: Get the highest price possibleGet the highest price possible Sever all responsibility for company Sever all responsibility for company

liabilitiesliabilities Maximize the cash they receive Maximize the cash they receive Minimize the tax burden from the saleMinimize the tax burden from the sale Make sure the buyer will be able to Make sure the buyer will be able to

make all future paymentsmake all future payments


The Five Ps of NegotiatingThe Five Ps of Negotiating

Preparation - Examine the needsof both parties and all of the relevant external factors affectingthe negotiation before you sit down to talk.

Poise - Remain calm during thenegotiation. Never raise your

voiceor lose your temper, even if the

situation gets difficult or emotional. It’s better to

walk away and calm down than to blow

up and blow the deal.

Persuasiveness - Know whatyour most important positions are, articulate them, and offer support for your position.

Persistence - Don’t give in at the first sign of resistance to your position, especially if it is

an issue that ranks high in your list of priorities.

Patience – Don’t be in such

a hurry to close the deal thatyou end up giving up much of what

you hoped to get. Impatience isa major weakness in

a negotiation.

7 - 41

In addition to the text


ConclusionConclusion

When buying an existing business:When buying an existing business: Assess the advantages and Assess the advantages and

disadvantages disadvantages Follow the steps to improve your Follow the steps to improve your

chances of successchances of success Determine the value of the businessDetermine the value of the business Appreciate the seller’s sideAppreciate the seller’s side Negotiate wiselyNegotiate wisely


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copyright © 2011 pearson education, inc. publishing as prentice hall buying an existing business...

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