chapter 5 buying a business copyright 2006 prentice hall publishing company 1 buying an existing...
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Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 11Chapter 5 Buying a BusinessChapter 5 Buying a Business
Buying An Existing Business
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 22Chapter 5 Buying a BusinessChapter 5 Buying a 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
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 33Chapter 5 Buying a BusinessChapter 5 Buying a Business
Buying a BusinessBuying a Business
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
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 44Chapter 5 Buying a BusinessChapter 5 Buying a Business
Buying a BusinessBuying a Business
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
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 55Chapter 5 Buying a BusinessChapter 5 Buying a Business
Buying a BusinessBuying a Business
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
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 66Chapter 5 Buying a BusinessChapter 5 Buying a Business
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
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 77Chapter 5 Buying a BusinessChapter 5 Buying a Business
Buying a BusinessBuying a Business
DisadvantagesDisadvantages Change and innovation can be difficultChange and innovation can be difficult Inventory may be obsoleteInventory may be obsolete Accounts receivable may be worth Accounts receivable may be worth
less than face valueless than face value Business may be overpricedBusiness may be overpriced
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 88Chapter 5 Buying a BusinessChapter 5 Buying a Business
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
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 99Chapter 5 Buying a BusinessChapter 5 Buying a Business
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
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 1010Chapter 5 Buying a BusinessChapter 5 Buying 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 composition.Customer characteristics and composition. Competitor analysis.Competitor analysis.
4.4. What legal aspects must I consider?What legal aspects must I consider?
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 1111Chapter 5 Buying a BusinessChapter 5 Buying a Business
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.
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 1212Chapter 5 Buying a BusinessChapter 5 Buying a Business
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).
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 1313Chapter 5 Buying a BusinessChapter 5 Buying a Business
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.
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 1414Chapter 5 Buying a BusinessChapter 5 Buying a Business
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
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 1515Chapter 5 Buying a BusinessChapter 5 Buying 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?
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 1616Chapter 5 Buying a BusinessChapter 5 Buying a Business
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.
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:
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:
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
Earnings Earnings ApproachesApproaches
Variation 1: Excess Earnings Variation 1: Excess Earnings Method.Method.
Step 3Step 3: Project earnings for next year:: Project earnings for next year:
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:
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
Earnings Earnings ApproachesApproaches
(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
Discounted Future Earnings Discounted Future Earnings MethodMethod
(Continue(Continued)d)
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).
Discounted Future Earnings Discounted Future Earnings MethodMethod
(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
Discounted Future Earnings Discounted Future Earnings MethodMethod
(Continue(Continued)d)
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
Discounted Future Earnings Discounted Future Earnings MethodMethod
(Continue(Continued)d)
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
Discounted Future Earnings Discounted Future Earnings MethodMethod
(Continue(Continued)d)
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 ?
Discounted Future Earnings Discounted Future Earnings MethodMethod
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
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 3737Chapter 5 Buying a BusinessChapter 5 Buying a Business
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)
Copyright 2006 Prentice Hall Publishing CompanyCopyright 2006 Prentice Hall Publishing Company 3838Chapter 5 Buying a BusinessChapter 5 Buying a Business
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.