Chapter 5 Buying an Existing Business 1 Copyright ©2009 Pearson Education, Inc. Publishing as Prentice Hall Buying an Existing Business

Chapter 5 Buying an Existing BusinessChapter 5 Buying an Existing Business 11Copyright Copyright ©©2009 Pearson Education, Inc. Publishing as Prentice 2009 Pearson Education, Inc. Publishing as Prentice HallHall

Buying an Existing Business


Buying a BusinessBuying a Business

Average business acquisition Average business acquisition requires 19 months from starting requires 19 months from starting the search to closing the deal the search to closing the deal

Important questions:Important questions: Does the business meet your Does the business meet your

lifestyle and financial expectations?lifestyle and financial expectations? Do you have the ability to operate Do you have the ability to operate

the business successfully? the business successfully?



AdvantagesAdvantages Business may continue to be Business may continue to be

successfulsuccessful Leverage the experience of previous Leverage the experience of previous

ownerowner ““Turn key” businessTurn key” business Superior locationSuperior location Employees and suppliers in placeEmployees and suppliers in place



Advantages:Advantages: Equipment installed Equipment installed Inventory in place Inventory in place Trade credit establishedTrade credit established Easier access to financingEasier access to financing High valueHigh value



Disadvantages:Disadvantages: Cash requirementsCash requirements Business is losing moneyBusiness is losing money Paying for “ill will”Paying for “ill will” Unsuitable Employees Unsuitable Employees Unsatisfactory location Unsatisfactory location



Disadvantages:Disadvantages: Obsolete equipment and facilitiesObsolete equipment and facilities Change and innovation challengesChange and innovation challenges Obsolete inventoryObsolete inventory Value of accounts receivableValue of accounts receivable


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 Obsolete equipment and facilitiesObsolete equipment and facilities Change and innovation challengesChange and innovation challenges Obsolete inventoryObsolete inventory Value of accounts receivableValue of accounts receivable 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 interestsand interests

Develop a list of criteriaDevelop a list of criteria Prepare a list of potential Prepare a list of potential

candidates candidates Remember the hidden market of Remember the hidden market of

companies that may be for sale companies that may be for sale but are not listed as “for sale”but are not listed as “for sale”

Rays Market


How to Buy a BusinessHow to Buy a Business

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

Negotiate the dealNegotiate the deal Explore financing optionsExplore financing options Ensure a smooth Ensure a smooth

transitiontransition

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 and its assets?business and its assets?

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


The Legal Aspects ofThe Legal Aspects ofBuying a BusinessBuying a Business

Lien - creditors’ claims against Lien - creditors’ claims against an assetan 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 assetsassets


Bulk TransferBulk Transfer

Seller must give the buyer a sworn list of Seller must give the buyer a sworn list of creditorscreditors

Buyer and seller must prepare a list of the Buyer and seller must prepare a list of the property included in the saleproperty included in the sale

Buyer must keep the list of creditors and Buyer must keep the list of creditors and property for six monthsproperty 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 contractsseller’s existing contracts

Lien - creditors’ claims against an Lien - creditors’ claims against an assetasset

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 assetscompany’s assets


Covenant not to compete Covenant not to compete (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 areaspecific time and geographic area

Ongoing legal liabilities - physical Ongoing legal liabilities - physical premises, product liability, and premises, product liability, and labor relationslabor 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 and its assets?business and its assets?

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

= $278,990 - = $278,990 -

$114,325$114,325= = $164,665$164,665

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall

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

= $278,990 - = $278,990 -

$114,325$114,325= = $164,665$164,665

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

Adjusted Net Worth = $264,638 - Adjusted Net Worth = $264,638 -

$114,325$114,325 = = $150,313$150,313

Balance Sheet Balance Sheet TechniquesTechniques


Earnings Earnings ApproachesApproaches

Variation 1: Excess Earnings Variation 1: Excess Earnings MethodMethod



Adjusted Net Worth = $264,638 - Adjusted Net Worth = $264,638 - $114,325 = $114,325 =

$150,$150,

313313

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





$150,$150,

313313


Step 2Step 2: Calculate opportunity costs of : Calculate opportunity costs of investing:investing:Investment $150,313 x 25% = $37,578Investment $150,313 x 25% = $37,578

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

$62,578$62,578




Step 3Step 3: Project earnings for next year:: Project earnings for next year:


$150,$150,

313313


Step 2Step 2: Calculate opportunity costs of : Calculate opportunity costs of investing:investing:Investment $150,313 x 25% = $37,578Investment $150,313 x 25% = $37,578

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

$62,578$62,578

$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 - 62,578 = $11,422= $74,000 - 62,578 = $11,422

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 - 62,578 = $11,422= $74,000 - 62,578 = $11,422

* 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 4a normal risk business, it is 3 or 4

= 11,422 x 3 = = 11,422 x 3 = $34,299$34,299

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 = $184,612$184,612

= $150,313 + 34,299 = = $150,313 + 34,299 = $184,612$184,612

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 investmentearned 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 investmentearned 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 investmentinvestment

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



The Art of the DealThe Art of the Deal

Establish the proper mindsetEstablish the proper mindset Understand the rules of successful Understand the rules of successful

negotiationsnegotiations Develop a negotiating strategyDevelop a negotiating strategy Be creativeBe creative Keep emotions in checkKeep emotions in check Be patientBe patient Don’t become a victim Don’t become a victim

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 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


Exit StrategiesExit Strategies

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

ownership plan (ESOP) ownership plan (ESOP) International buyerInternational buyer


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Copyright ©2009 Pearson Education, Copyright ©2009 Pearson Education, Inc. Publishing as Prentice HallInc. Publishing as Prentice Hall

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Chapter 5 Buying an Existing Business 1 Copyright ©2009 Pearson Education, Inc. Publishing as Prentice Hall Buying an Existing Business