Entrepreneurship 1: Lecture 9 Buying an Existing Business Avimanyu (Avi) Datta, Ph.D

Entrepreneurship 1: Lecture 9Buying an Existing Business

Avimanyu (Avi) Datta, Ph.D.

Why buy an existing business?May continue to be successful

Best location

Equipment installed

Hit the ground running

Use previous experience

Easier financing

Why buy an existing business?Established Customer base

Established customer base at present location

Supplier relationships already in place

Experienced Employees

Inventory is in place and trade credit is established

Why buy an existing 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. ◦ NOTE: Buy a great Business when they are in financial distress.

Disadvantages of Buying a BusinessThe 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.

Disadvantages of Buying a BusinessInternal 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

Disadvantages of Buying a BusinessPrevious owner may have created ill will“Inherited” employees may be

unsuitableLocation may have become

unsatisfactoryEquipment may be obsoleteChanges can be difficult to implementInventory may be staleAccounts receivable may be worth less

than face valueIt may be overpriced

Key Questions to Consider Before Buying a Business

Is the right type of business for sale in the market in which you want to operate?

What experience do you have in this particular business and the industry in which it operates?

How critical is experience in the business to your ultimate success?

What price and payment method are reasonable for you and acceptable to the seller?

Key Questions to Consider Before Buying a Business

Should you start the business and build it from the ground up rather than buy an existing one?

What is the company’s potential for success?

What changes will you have to make – and how extensive will they have to be – to realize the business’s full potential?

Will the company generate sufficient cash flow to pay for itself and leave you with a suitable return on your investment?

Five Critical Areas for Analyzingan Existing Business1. Why does the owner want to sell.... the

real reason?2. What is the physical condition of the

business?3. What is the potential for the company's

products or services?• Customer characteristics and

composition.• Competitor analysis.

4. What legal aspects must I consider?5. Is the business financially sound?

Why Does the Owner want to sell

Why does the owner want to sell.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

Why does the owner want to sell.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?

Physical Conditions

Physical ConditionsIs 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?

What is the condition of the area around the business?◦ Are traffic routes or parking regulations likely to

change

Physical ConditionsBuildingInventoryAccounts receivableLease arrangementsBusiness recordsIntangible assetsLocation and appearance

Potential for Company’s products and Services

Potential for Company’s products and ServicesCustomer characteristics and composition-

who, why, how often, loyalty, new customers, well-defined, growing?

Competitor analysis-number and intensity, saturation point reached, reason for survival, sales comparison, uniqueness?

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?

Legal Aspects

Legal AspectsLiensBulk TransfersContract assignmentsCovenants not to compete Ongoing legal liabilities

Legal Aspects: What are 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.

Bulk Transfer Seller must give the buyer a 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).

Contract AssignmentRestrictive 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.

Financial Matters

Financial Matters

Value of Tangible AssetsValue of Tangible Assets

Value of Intangible AssetsValue of Intangible Assets

Profit PotentialProfit Potential

Purchase PricePurchase Price

+

+

Tangible AssetsThe inventory

◦timely, fresh, and well balancedThe equipment

◦current, usable machines and equipment

Intangible AssetsGoodwill

◦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

Financial Matters: 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.

Financial Matters: 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

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

Determining Value of Business: Balance Sheet Technique

Book Value of Net Worth = Total Assets - Total Liabilities = $266,091 - $114,325 = $151,766 (value)

Variation: Adjusted Balance Sheet Technique: (Adjusted for negatives or positives from balance sheet

in inventory, equipment, land/buildings/receivables, etc)

Adjusted Net Worth = $274,638 -

$114,325

= $160,313 (value)

Determining Value of Business: Earnings Approach

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 - 65,078

== $8,922

Determining Value of Business: Earnings Approach

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.

Determining Value of Business: Capitalized earning 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.

Value = $74,000 - $25,000 = $196,000

25%

Determining Value of Business: Discounted earning method

Variation 3: Discounted Future Earnings Method:

Compute a weighted average of the earnings:

Step 1: Project earnings five years into the future:

Pessimistic + (4 x Most Likely) + Optimistic 6

$$

3 Forecasts:PessimisticMost LikelyOptimistic


Step 1: Project earnings five years into the future:

$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

1

2

3

4

5

Year Pess ML Opt Weighted Average


(continued)

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

Present Value Factor = (1 +k)

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

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

1


Year Weighted Average x PV Factor = Present Value

1

2

3

4

5

.8000

.6400

.5120

.4096

.3277

$75,500

$89,167

$99,000

$107,333

$111,667

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

$60,400

$57,067

$50,688

$43,964

$36,593

Total $248,712


Step 3: Estimate the earnings stream beyond five years:

Weighted Average Earnings in Year 5 x 1 Rate of Return

= $111,667 x 1

25%

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

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


Step 5: Compute the value of the business:

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

Estimated Value of Business = $365,828

Value =

Discounted earnings in years 1 through 5

+ Discounted

earnings in years 6 through ?

Determining Value of Business: Market Approach

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

Company P-E Ratio1 3.3 2 3.8 Average P-E Ratio =

3.9753 4.74 4.1

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

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

Negotiation

Negotiations ProcessThe 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.

Sources of Power in NegotiationsAmong 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.

Documents

Entrepreneurship 1: Lecture 9 Buying an Existing Business Avimanyu (Avi) Datta, Ph.D