chapter 5 buying a business copyright 2006 prentice hall publishing company 1 buying an existing...

Chapter 5 Buying a BusinessChapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 11

Buying An Existing Business


Buying a BusinessBuying a Business

AdvantagesAdvantages Business may continue to be Business may continue to be

successfulsuccessful Can use experience of previous ownerCan use experience of previous owner ““Hit the ground running”Hit the ground running” Business may have best locationBusiness may have best location Employees and suppliers are in placeEmployees and suppliers are in place



AdvantagesAdvantages Equipment is installed Equipment is installed Inventory is in place and trade credit Inventory is in place and trade credit

existsexists Easier time finding financingEasier time finding financing It’s a bargainIt’s a bargain



DisadvantagesDisadvantages It’s a loserIt’s a loser Possible “ill will” from previous Possible “ill will” from previous

ownerowner Employees may not be suitableEmployees may not be suitable Location may be unsatisfactoryLocation may be unsatisfactory Equipment may be obsoleteEquipment may be obsolete



DisadvantagesDisadvantages Change and innovation can be Change and innovation can be

difficultdifficult Inventory may be obsoleteInventory may be obsolete Accounts receivable may be worth Accounts receivable may be worth

less than face valueless than face value


Valuing Accounts Valuing Accounts ReceivableReceivable

Age of Accounts

(days)

Amount

Probability of Collection

Value

0-3031-6061-90

91-120121-150

151+

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



DisadvantagesDisadvantages Change and innovation can be difficultChange and innovation can be difficult Inventory may be obsoleteInventory may be obsolete Accounts receivable may be worth less Accounts receivable may be worth less

than face valuethan face value

Business may be overpricedBusiness may be overpriced


How to Buy a BusinessHow to Buy a Business

Analyze your skills, abilities, Analyze your skills, abilities, and interests.and interests.

Develop a list of criteria.Develop a list of criteria. Prepare a list of potential Prepare a list of potential

candidates (Remember the candidates (Remember the “hidden market”).“hidden market”).

Ray’s Market


How to Buy a BusinessHow to Buy a Business

Investigate and evaluate Investigate and evaluate candidate businesses candidate businesses and select the best one.and select the best one.

Negotiate the deal.Negotiate the deal. Explore financing Explore financing

options.options. Ensure a smooth Ensure a smooth

transition.transition.Ray’s Market


Five Critical Areas for Five Critical Areas for Analyzing an Existing Analyzing an Existing BusinessBusiness

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

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

3.3. What is the potential for the company's What is the potential for the company's products or services?products or services?

Customer characteristics and composition.Customer characteristics and composition. Competitor analysis.Competitor analysis.

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


The Legal Aspects ofThe Legal Aspects ofBuying a BusinessBuying a Business

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

Bulk transfer - protects Bulk transfer - protects business buyer from the business buyer from the claims unpaid creditors might claims unpaid creditors might have against a company’s have against a company’s assets.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 the Buyer and seller must prepare a list of the property included in the sale.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 notice of the sale to each Buyer must give notice of the sale to each creditor at least ten days before he takes creditor at least ten days before he takes possession of the goods or pays for them possession of the goods or pays for them (whichever is first).(whichever is first).


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

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

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

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


Restrictive covenant - contract in Restrictive covenant - contract in which a business seller agrees not which a business seller agrees not to compete with the buyer within a 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, and premises, product liability, and labor relations.labor relations.

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


Five Critical Areas for Five Critical Areas for Analyzing an Existing Analyzing an Existing BusinessBusiness

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

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

3.3. What is the potential for the company's What is the potential for the company's products or services?products or services?

Customer characteristics and compositionCustomer characteristics and composition Competitor analysisCompetitor analysis

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?


Determining the Value of a Determining the Value of a BusinessBusiness

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 Balance Sheet TechniquesTechniques

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

= $266,091 - = $266,091 -

$114,325$114,325= = $151,766$151,766

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

= $266,091 - = $266,091 -

$114,325$114,325= = $151,766$151,766

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

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

$114,325$114,325 = = $160,313$160,313

Balance Sheet Balance Sheet TechniquesTechniques

Earnings Earnings ApproachesApproaches

Variation 1: Excess Earnings Variation 1: Excess Earnings Method.Method.


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

$160,$160,

313313

Step 1Step 1: Compute adjusted tangible net : Compute adjusted tangible net worth:worth:




$160,$160,

313313


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


$160,$160,

313313


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

Salary Salary $25,000$25,000 Total Total

$65,078$65,078

$74,000$74,000


(Continued)

EEP = Projected Net Earnings - Total EEP = Projected Net Earnings - Total Opportunity CostsOpportunity Costs

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

= $74,000 - 65,078 = $8,922= $74,000 - 65,078 = $8,922

Excess Earnings Excess Earnings MethodMethod

(Continued)

EEP = Projected Net Earnings - Total EEP = Projected Net Earnings - Total Opportunity CostsOpportunity Costs

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

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*

= $74,000 - 65,078 = $8,922= $74,000 - 65,078 = $8,922

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

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

Excess Earnings Excess Earnings MethodMethod

Value = Tangible Net Worth + Value of IntangiblesValue = Tangible Net Worth + Value of Intangibles

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

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

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

Excess Earnings Excess Earnings MethodMethod (Continued

)

Variation 2: Capitalized Earnings Variation 2: Capitalized Earnings Method:Method:

Value Value = =

* Rate of return reflects what could be * Rate of return reflects what could be earned on a similar-risk investment.earned on a similar-risk investment.

Net Earnings (Net Earnings (AfterAfter Deducting Owner's Deducting Owner's Salary)Salary)Rate of Return*Rate of Return*

Capitalized Earnings Capitalized Earnings MethodMethod

Variation 2: Capitalized Earnings Variation 2: Capitalized Earnings Method:Method:

Value Value = =

* Rate of return reflects what could be * Rate of return reflects what could be earned on a similar-risk investment.earned on a similar-risk investment.

Net Earnings (Net Earnings (AfterAfter Deducting Owner's Deducting Owner's Salary)Salary)Rate of Return*Rate of Return*

Value Value = =

$74,000 - $74,000 - $25,000$25,00025%25%

= = $196,0$196,00000

Capitalized Earnings Capitalized Earnings MethodMethod

Variation 3: Discounted Future Earnings Variation 3: Discounted Future Earnings Method:Method:

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 Earnings Discounted Future Earnings MethodMethod

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

(Continue(Continued)d)

Year Pess ML Opt Year Pess ML Opt Weighted AverageWeighted Average$65,00$65,00

00

$74,00$74,0000

$82,00$82,0000

$88,00$88,0000

$88,00$88,0000

$74,00$74,0000

$90,00$90,0000

$100,0$100,00000

$109,0$109,00000

$115,0$115,00000

$92,00$92,0000

$101,0$101,00000

$112,0$112,00000

$120,0$120,00000

$122,0$122,00000

$75,50$75,5000

$89,16$89,1677

$99,00$99,0000

$107,3$107,33333

$111,6$111,66767

11

22

33

44

55



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

Present Value Present Value Factor = Factor =

11

(1 +k) (1 +k) ttwhere...where...

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

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


(Continued(Continued))

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

11

Rate of Rate of ReturnReturn

Weighted Weighted Average Earnings Average Earnings in Year 5in Year 5

xx ==

= $111,667 = $111,667 x x

112525

%%

= = $446,668$446,668



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

11

Rate of Rate of ReturnReturn

Weighted Weighted Average Earnings Average Earnings in Year 5in Year 5

xx ==

= $111,667 = $111,667 x x

112525

%%

= = $446,668$446,668

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

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



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

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

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

Value Value ==

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

++ Discounted Discounted

earnings in earnings in yearsyears6 through ?6 through ?


Market Market ApproachApproach

Company P-E Ratio Company P-E Ratio 1

2

3

4

3.3

3.8

4.7

4.1

Step 1Step 1: Compute the average Price-Earnings : Compute the average Price-Earnings (P-E) Ratio for as many similar businesses as (P-E) Ratio for as many similar businesses as possible:possible:

Average P-E Ratio = Average P-E Ratio = 3.9753.975

Company P-E Ratio Company P-E Ratio 11

22

33

44

3.33.3

3.83.8

4.74.7

4.14.1

Step 1Step 1: Compute the average Price-Earnings : Compute the average Price-Earnings (P-E) Ratio for as many similar businesses as (P-E) Ratio for as many similar businesses as possible:possible:

Average P-E Ratio = Average P-E Ratio = 3.9753.975

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

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

Market Market ApproachApproach


Exit StrategiesExit Strategies

Straight business saleStraight business sale Family limited partnership (FLP)Family limited partnership (FLP) Sell controlling interestSell controlling interest Restructure the companyRestructure the company Use a two-step saleUse a two-step sale Establish and employee stock Establish and employee stock

ownership plan (ESOP) ownership plan (ESOP)


The Five Ps of Negotiating.The 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 voice

or 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 thefirst 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 sucha hurry to close the deal that

you end up giving up much of what you hoped to get. Impatience is

a major weakness in a negotiation.

Chapter 5 Buying a BusinessChapter 5 Buying a Business

Chapter ObjectivesChapter Objectives

Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 3939

1. Understand the advantages and disadvantages of buying an existing business. 2. Define the steps involved in the right way to buy a business. 3. Explain the process of evaluating an existing business. 4. Describe the various techniques for determining the value of a business. 5. Understand the seller's side of the buyout decision and how to structure the deal. 6. Understand how the negotiation process works and identify the factors that affect the negotiation process.


Chapter OverviewChapter Overview



1. Understand the advantages and disadvantages 1. Understand the advantages and disadvantages of buying an existing business.of buying an existing business.

The The advantagesadvantages of buying an existing business include: A successful of buying an existing business include: A successful business may continue to be successful; the business may already business may continue to be successful; the business may already have the best location; employees and suppliers are already have the best location; employees and suppliers are already established; equipment is installed and its productive capacity known; established; equipment is installed and its productive capacity known; inventory is in place and trade credit established; the owner hits the inventory is in place and trade credit established; the owner hits the ground running; the buyer can use the expertise of the previous ground running; the buyer can use the expertise of the previous owner; and the business may be a bargain. The disadvantages of owner; and the business may be a bargain. The disadvantages of buying an existing business include: An existing business may be for buying an existing business include: An existing business may be for sale because it is deteriorating; the previous owner may have created sale because it is deteriorating; the previous owner may have created ill will; employees inherited with the business may not be suitable; its ill will; employees inherited with the business may not be suitable; its location may have become unsuitable; equipment and facilities may be location may have become unsuitable; equipment and facilities may be obsolete; change and innovation are hard to implement; inventory obsolete; change and innovation are hard to implement; inventory may be outdated; accounts receivable may be worth less than face may be outdated; accounts receivable may be worth less than face value; and the business may be overpriced. value; and the business may be overpriced.



2. Define the steps involved in the right way to buy a 2. Define the steps involved in the right way to buy a business.business.

Buying a business can be a treacherous experience Buying a business can be a treacherous experience unless the buyer is well-prepared. The right way to unless the buyer is well-prepared. The right way to buy a business is: analyze your skills, abilities, and buy a business is: analyze your skills, abilities, and interests to determine the ideal business for you; interests to determine the ideal business for you; prepare a list of potential candidates, including those prepare a list of potential candidates, including those that might be in the "hidden market"; investigate and that might be in the "hidden market"; investigate and evaluate candidate businesses and evaluate the best evaluate candidate businesses and evaluate the best one; explore financing options before you actually one; explore financing options before you actually need the money; and finally, ensure a smooth need the money; and finally, ensure a smooth transition. transition.



3. Explain the process of evaluating an existing 3. Explain the process of evaluating an existing business.business.

Rushing into a deal can be the biggest mistake a business buyer can make. Rushing into a deal can be the biggest mistake a business buyer can make. Before closing a deal, every business buyer should investigate five critical Before closing a deal, every business buyer should investigate five critical areas:areas:

1. 1. Why does the owner wish to sell? Look for the real reason. Why does the owner wish to sell? Look for the real reason. 2. 2. Determine the physical condition of the business. Consider both the building Determine the physical condition of the business. Consider both the building

and its location. and its location. 3.3. Conduct a thorough analysis of the market for your products or services. Conduct a thorough analysis of the market for your products or services.

Who are the present and potential customers? Conduct an equally thorough Who are the present and potential customers? Conduct an equally thorough analysis of competitors, both direct and indirect. How do they operate and why analysis of competitors, both direct and indirect. How do they operate and why do customers prefer them?do customers prefer them?

4. 4. Consider all of the legal aspects which might constrain the expansion and Consider all of the legal aspects which might constrain the expansion and growth of the business - Did you comply with the provisions of a bulk transfer? growth of the business - Did you comply with the provisions of a bulk transfer? Negotiate a restrictive covenant? Consider ongoing legal liabilities?Negotiate a restrictive covenant? Consider ongoing legal liabilities?

5. 5. Analyze the financial condition of the business, looking at financial Analyze the financial condition of the business, looking at financial statements, income tax returns, and especially cash flow. statements, income tax returns, and especially cash flow.



4. Describe the various techniques for determining the 4. Describe the various techniques for determining the value of a business.value of a business.

Placing a value on a business is partly an art and Placing a value on a business is partly an art and partly a science. There is no single "best" method for partly a science. There is no single "best" method for determining the value of a business.determining the value of a business.

The following techniques (with several variations) are The following techniques (with several variations) are useful: the balance sheet technique (adjusted balance useful: the balance sheet technique (adjusted balance sheet technique);sheet technique);

the earnings approach (excess earnings method, the earnings approach (excess earnings method, capitalized earnings approach, and discounted future capitalized earnings approach, and discounted future savings approach);savings approach);

and the market approach. and the market approach.



5. Understand the seller's side of the buyout decision 5. Understand the seller's side of the buyout decision and how to structure the deal.and how to structure the deal.

Selling a business takes time, patience, and Selling a business takes time, patience, and preparation to locate a suitable buyer, strike a deal, preparation to locate a suitable buyer, strike a deal, and make the transition. Sellers must always structure and make the transition. Sellers must always structure the deal with tax consequences in mind. Common exit the deal with tax consequences in mind. Common exit strategies include: a straight business sale, forming a strategies include: a straight business sale, forming a family limited partnership, selling a controlling interest family limited partnership, selling a controlling interest in the business, restructuring the company, selling to in the business, restructuring the company, selling to an international buyer, using a two-step sale, and an international buyer, using a two-step sale, and establishing an employee stock ownership plan establishing an employee stock ownership plan (ESOP). (ESOP).



6. Understand how the negotiation process works and 6. Understand how the negotiation process works and

identify the factors that affect the negotiation processidentify the factors that affect the negotiation process..

The first rule of negotiating is never confuse price with The first rule of negotiating is never confuse price with value. In a business sale, the party who is the better value. In a business sale, the party who is the better negotiator usually comes out on top. Before beginning negotiator usually comes out on top. Before beginning negotiations, a buyer should identify the factors that negotiations, a buyer should identify the factors that are affecting the negotiations and then develop a are affecting the negotiations and then develop a negotiating strategy. The best deals are the result of a negotiating strategy. The best deals are the result of a cooperative relationship between the parties based on cooperative relationship between the parties based on trust. trust.


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