Transcript Buying An Existing Business

BUYING AN EXISTING BUSINESS
1. INTRODUCTION
1.1 ACQUIRING A BUSINESS
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Analyze your skills, abilities, and interests.
Prepare a list of potential candidates (Remember the
“hidden market”).
Investigate and evaluate candidate businesses and
select the best one.
Explore financing options.
Ensure a smooth transition.
Ray’s Market
1.2 PROS AND CONS
ADVANTAGES
DISADVANTAGES
1. Customers familiar with
location
2. Planning can be based on
known historical data
3. Established customer base
at present location
4. Supplier relationships
already in place
5. Inventory and equipment in
place
6. Experienced employees
7. Possible owner financing
1. Image difficult to change
2. Employees may be ones whom
you would not choose
3. Business may not have operated
the way you like and could be
difficult to change
4. Possible obsolete inventory
and equipment
5. The business’s location may be
undesirable - or a good location
may be about to become not so good
6. Potential liability for past business
contacts
7. Financing costs could drain your cash
flow and threaten the business’s
survival
1.3 Advantages of Buying a Business
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Less Risk
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Starting a business brings with it the possibility of a critical element
in the operation of the enterprise being overlooked or not
adequately addressed.
With the purchase of an ongoing business, this kind of planning
omission is less likely to occur.
Less time and effort
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For a business to establish operations requires considerable
attention to a wide range of details.
The management of an existing business has developed
relationships and procedures that allow the business to operate.
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The Possibility of Buying at a Bargain Price
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The prospective buyer of an organization can uncover candidates for
purchase that are under priced.
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The likelihood of finding such a bargain depends on who is
doing the selling and the conditions under which the sale is
made.
1.4 Disadvantages of Buying a
Business
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The environment
Some businesses are available for sale because they face
a difficult set of problems.
 When these problems are outside the firm, a shrinking
market for example, the outlook can be quite bleak.
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Departure of the Current Owner
Many small firms have an existence that is closely
associated with the founder.
 These businesses may suffer greatly with the departure of
the owner.
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Internal Problems
One thing that is likely to prompt an owner to sell his/her
business is difficulty with its current operations.
 Anyone who intends to buy a business with internal
problems would be well advised to develop the means to
cope with these problems before proceeding
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2. FINDING THE BUSINESS
2.1 Businesses that are on the market
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There is an active market for the sale and purchase of small
businesses.
Among the more prominent channels for these businesses to
use are business brokers and the classified ads of many
newspapers.
2.2 Businesses that are not on the
market
According to the view of some people, the best
opportunities for acquisition of a business are
those that are not on the market.
 This reasoning leads to the recognition of the
importance of finding the right business from
among those in operation without restricting the
search.
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2.3 Five Critical Areas for Analyzing an
Existing Business
Why does the owner want to sell.... the real
reason?
What is the physical condition of the business?
What is the potential for the company's products
or services?
Customer characteristics and composition.
Competitor analysis.
What legal aspects must I consider?
Is the business financially sound?
2.4 What Do You Look For in a
Business?
How long has the business existed?
Who founded it?
How many owners has it had?
Why have others sold out?
What is the profit record?
Is profit increasing or decreasing?
What are the true reasons for the increase or
decrease?
What is the condition of the inventory?
Are the goods new or obsolete?
Is the equipment in good condition?
Who owns it?
Are there liens against any of it?
How does it compare with competitors’ equipment?
How long does the lease run?
Is it a satisfactory lease?
What are its conditions?
Can it be renewed?
Are there dependable sources of supply?
Are any franchises or other special arrangements expiring
soon?
What about present and future competition?
Are new competitors or substitute materials or methods
visible on the horizon?
What is the condition of the area around the business?
Are traffic routes or parking regulations likely to change?
Does the present owner have family, religious, social,
or political connections that have been important to the
success of the business?
Why does the present owner want to sell?
Where will he or she go?
What is he or she going to do?
What do people (customers, suppliers, local citizens) think
of the present owner and of the business?
Are personnel satisfactory?
Are key people willing to remain?
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How does this business, it its present condition,
compare with one that you could start and develop
yourself in a reasonable amount of time?
4. LEGAL ASPECTS OF BUYING A
BUSINESS
4.1 What is involved?
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Lien - creditors’ claims against an asset.
Bulk transfer - protects business buyer from the claims
unpaid creditors might have against a company’s
assets.
Contract assignment - buyer’s ability to assume rights
under seller’s existing contracts.
4.2 Bulk Transfer
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Seller must give the buyer a sworn list of creditors.
Buyer and seller must prepare a list of the property
included in the sale.
Buyer must keep the list of creditors and property for
six months.
Buyer must give notice of the sale to each creditor at
least ten days before he takes possession of the goods
or pays for them (whichever is first).
4.3 From legal perspective
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Restrictive covenant - contract in which a business seller
agrees not to compete with the buyer within a specific
time and geographic area.
Ongoing legal liabilities - physical premises, product
liability, and labor relations.
5. FINANCIAL MATTERS INVOLVED
5.1 Total payment
Value of Tangible Assets
+
Value of Intangible Assets
+
Profit Potential
Purchase Price
5.2 Tangible Assets
The inventory
timely, fresh, and well balanced
The equipment
current, usable machines and equipment
5.3 INTANGIBLE ASSETS
Goodwill
enables a business to earn a profit in excess
of the normal rate of return earned by other
businesses of the same kind
Leases and Other Contracts
a lease on a favorable location is a
valuable business asset
Patents, Copyrights, and Trademarks
intellectual property can be a valuable
intangible asset
5.4 Determining the Price of a Business
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Anyone considering the purchase of a business
must recognize and understand the difference
between price and value.
Any system of evaluation of a business should
incorporate the value of the firm’s assets and its
expected flow of future earnings.
5.5 Calculating the purchase price for
an existing business
1. Adjusted value of tangible net worth
2. Earning power at 15%
3. Reasonable salary for owner or manager
$224,000
$33,600
40,000
$73,600
4. Average annual net earning before
subtracting owner’s salary
5. Extra earning power of business
(83,600)
$10,000
6. Value of intangibles, using four-year
profit figure for moderately wellestablished firm (4 x line 5)
40,000
7. Offering price
264,000
5.6 Determining Value of Business
Balance Sheet Technique
Variation: Adjusted Balance Sheet
Technique.
Earnings Approach
Variation 1: Excess Earnings Approach.
Variation 2: Capitalized Earnings Approach.
Variation 3: Discounted Future Earnings
Approach.
Market Approach - Willing buyer & willing seller
5.6.1 BALANCE SHEET TECHNIQUES
"Book Value"of Net Worth = Total Assets - Total
Liabilities
= $266,091 - $114,325
= $151,766
5.6.2 Earnings Approaches
"Book Value"of Net Worth
= Total Assets - Total Liabilities
= $266,091 - $114,325
= $151,766
Variation: Adjusted Balance Sheet Technique:
Adjusted Net Worth
=$274,638 - $114,325
= $160,313
5.6.3 Excess Earnings Method
Step 1: Compute adjusted tangible net worth
Adjusted Net Worth =
=$274,638 - $114,325
= $160,313
Step 2: Calculate opportunity costs of investing
Investment
=$160,313 x 25%
= $40,078
+ Salary
=$25,000
Total
=$65,078
Step 3: Projected earnings for next year: $74,000
Step 4: Compute extra earning power =Projected Net Earnings - Total Opportunity Costs
=Step 3 - Step 2
=$74,000 == $8,922
65,078
Step 5: Estimate the value of the intangibles ("goodwill"):
Intangibles
= Extra Earning Power x "Years of
Profit Figure*"
= 8,922 x 3
= $26,766
Step 6: Determine the value of the business:
= $160,313
+
26,766
= $187,079
Estimated Value of the business = $187,079
* Years of Profit Figure ranges from 1 to 7; for a normal risk
business, it is 3 or 4.
CAPITALIZED EARNINGS METHOD
Variation 2: Capitalized Earnings Method:
Value = Net Earnings (After Deducting Owner's
Salary)Rate of Return*
* Rate of return reflects what could be earned on a
similar-risk investment.
5.6.4 Capitalized Earnings Method
Value
=Net Earnings (After Deducting Owner's
Salary)
--------------------------------------------------Rate of Return*
=74000-25000
----------------------25%
=196000
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Rate of return reflects what could be earned on a similar-risk investment.
Normal business  25% to 33%
High risk  > 50%
5.6.5 Discounted Future Earnings
Method
Step 1: Project earnings five years into the future:
3 Forecasts:
•Pessimistic
•Most Likely
•Optimistic
Compute a weighted average of the earnings:
Pessimistic + (4 x Most Likely) + Optimistic
6
Year
Pessimistic
Most likely
Optimistic
Weighted
Average
1
$65,000
$74,000
$92,000
$75,500
2
$74,000
$90,000
$101,000
$89,167
3
$82,000
$100,000
$112,000
$99,000
4
$88,000
$109,000
$120,000
$107,333
5
$88,000
$115,000
$122,000
$111,667
Step 2: Discount weighted average of future earnings at the appropriate
present value rate:
Year
Weighted Average
x PV Factor
=
Present Value
1
$75,500
.8000
$60,400
2
$89,167
.6400
$57,067
3
$99,000
.5120
$50,688
4
$107,333
.4096
$43,964
5
$111,667
.3277
$36,593
TOTAL
$248,712
Step 3: Estimate the earnings stream beyond five years
Step 4:
Discount this estimate using the present value factor for year 6:
Step 5: Compute the value of the business:
5.6.6 Market Approach
Step 1: Compute the average Price-Earnings (P-E) Ratio for as many
similar businesses as possible:
Company
P-E Ratio
1
3.3
2
3.8
3
4.7
4
4.1
Value = Average P/E Ratio X Estimated Net Earnings
Value = 3.975 X $74,000 = $294,150
Average P-E Ratio =
3.975
6. NEGOTIATION STEP
6.1 The negotiation process
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The way in which the process leading to a deal
proceeds affects the satisfaction experienced by
both the buyer and the seller.
Price Versus Value
Many business owners do not know the value of the
business but must nonetheless set the price when it is
time to put it on the market.
The price of the business is whatever the owner
chooses; its value, however, is established in the
market only when a buyer agrees to pay the price.
6.2 Sources of Power in Negotiations
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Among the sources of power held by the parties in
negotiations, the most important is probably
information
Others factors affecting the power of the parties
are timing and the availability of alternatives.