buying an existing business 1. introduction 1.1 acquiring a business analyze your skills,...

BUYING AN EXISTING BUSINESS

1. INTRODUCTION

1.1 ACQUIRING A BUSINESS

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 CONSADVANTAGES DISADVANTAGES

1. Customers familiar with location2. Planning can be based on known historical data3. Established customer base at present location4. Supplier relationships already in place5. Inventory and equipment in place6. Experienced employees7. Possible owner financing

1. Image difficult to change2. Employees may be ones whom you would not choose3. Business may not have operated the way you like and could be difficult to change4. Possible obsolete inventory and equipment5. The business’s location may be undesirable - or a good location may be about to become not so good6. Potential liability for past business contacts7. Financing costs could drain your cash flow and threaten the business’s survival

1.3 Advantages of Buying a Business

Less Risk 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 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. 

The Possibility of Buying at a Bargain Price The prospective buyer of an organization can uncover

candidates for purchase that are under priced. 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

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.

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.

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

2. FINDING THE BUSINESS

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.

2.1 Businesses that are on the market

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.

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?

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?

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

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

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 AssetsValue of Tangible Assets

Value of Intangible AssetsValue of Intangible Assets

Profit PotentialProfit Potential

Purchase PricePurchase 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 assetPatents, Copyrights, and Trademarks

intellectual property can be a valuable intangible asset

5.4 Determining the Price of a Business

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 $224,000

2. Earning power at 15% $33,600

3. Reasonable salary for owner or manager 40,000

$73,600

4. Average annual net earning before subtracting owner’s salary

(83,600)

5. Extra earning power of business $10,000

6. Value of intangibles, using four-year profit figure for moderately well- established firm (4 x line 5)

40,000

7. Offering price 264,000

5.6 Determining Value of BusinessBalance 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 MethodStep 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 - 65,078

== $8,922

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.

Variation 2: Capitalized Earnings Method:

Value =

CAPITALIZED EARNINGS METHOD

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

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

5.6.4 Capitalized Earnings MethodValue =Net Earnings (After

Deducting Owner's Salary)---------------------------------------------------Rate of Return*

=74000-25000----------------------- 25%

=196000

• 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

2

3

4

5

$65,000

$74,000

$82,000

$88,000

$88,000

$74,000

$90,000

$100,000

$109,000

$115,000

$92,000

$101,000

$112,000

$120,000

$122,000

$75,500

$89,167

$99,000

$107,333

$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

2

3

4

3.3

3.8

4.7

4.1

Average P-E Ratio = 3.975

Value = Average P/E Ratio X Estimated Net EarningsValue = 3.975 X $74,000 = $294,150

6. NEGOTIATION STEP

6.1 The negotiation process

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

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.