Chapter 11 buying an existing sm es-esbm10e-05

C5 Buying an Existing BusinessC5 Buying an Existing Business 5-5-11Copyright Copyright ©2012 Pearson Education, Inc. publishing as Prentice ©2012 Pearson Education, Inc. publishing as Prentice HallHall

Buying an Existing Small and Medium

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?


Buying a BusinessBuying a Business AdvantagesAdvantages

Business may continue to be Business may continue to be successfulsuccessful

Leverage the experience of the Leverage the experience of the previous ownerprevious owner

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


Buying a BusinessBuying a Business 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


Buying a BusinessBuying a Business 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


Buying a BusinessBuying a Business 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


Buying a BusinessBuying a Business 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 and candidate businesses and select the best oneselect the best one

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

transitiontransitionRay’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 claims business buyer from the claims unpaid creditors might have unpaid creditors might have against a company’s assetsagainst a company’s assets


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 Business (continued)Business (continued)

5.5. Is the business financially sound?Is the business financially sound? Income statements and balance sheets Income statements and balance sheets

for the past three to five yearsfor the past three to five years Income tax returns for the past three to Income tax returns for the past three to

five yearsfive years Owner’s Compensation (and that of Owner’s Compensation (and that of

relatives)relatives) Cash FlowCash Flow


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

Copyright ©2012 Pearson Education, Inc. publishing as Prentice HallChapter 5 Buying an Existing Chapter 5 Buying an Existing BusinessBusiness 5-185-18

"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 = $279,738 - Adjusted Net Worth = $279,738 - $114,325$114,325 = = $165,413$165,413

Balance Sheet Balance Sheet TechniquesTechniques


Earnings Earnings ApproachesApproaches

Variation 1: Excess Earnings Variation 1: Excess Earnings MethodMethod

Copyright ©2012 Pearson Education, Inc. publishing as Prentice HallChapter 5 Buying an Existing BusinessChapter 5 Buying an Existing Business 5-5-2020


Adjusted Net Worth = $279,738 - Adjusted Net Worth = $279,738 - $114,325 = $114,325 =

$165,$165,413413

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





$165,$165,413413


Step 2Step 2: Calculate opportunity costs of : Calculate opportunity costs of investing:investing:Investment $165,413 x 25% = $41,353Investment $165,413 x 25% = $41,353

Salary Salary $35,000$35,000 Total $76,353Total $76,353




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


$165,$165,413413


Step 2Step 2: Calculate opportunity costs of : Calculate opportunity costs of investing:investing:Investment $165,413 x 25% = $41,353Investment $165,413 x 25% = $41,353

Salary Salary $35,000$35,000 Total $76,353Total $76,353

$88,000$88,000


Copyright ©2012 Pearson Education, Inc. publishing as Prentice HallChapter 5 Buying an Existing Chapter 5 Buying an Existing BusinessBusiness 5-5-

2323

(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):

= $88,000 - 76,353 = $11,647= $88,000 - 76,353 = $11,647

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*

= $88,000 - 76,353 = $11,647= $88,000 - 76,353 = $11,647

* 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

= 11,647 x 4.1 = = 11,647 x 4.1 = $47,752$47,752

Excess Earnings Excess Earnings MethodMethod

Copyright ©2012 Pearson Education, Inc. publishing as Prentice HallChapter 5 Buying an Existing Chapter 5 Buying an Existing BusinessBusiness

5-255-25

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 = $213,165$213,165

= $165,413 + 47,752 = = $165,413 + 47,752 = $213,165$213,165

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 = =

$88,000 - $88,000 - $35,000$35,00025%25% = =

$212,0$212,00000

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$75,00$75,00

00$78,00$78,00

00$82,00$82,00

00$85,00$85,00

00$88,00$88,00

00

$88,0$88,00000

$91,0$91,00000

$95,0$95,00000

$103,0$103,00000

$110,0$110,00000

$92,0$92,00000

$98,0$98,00000

$105,0$105,00000

$109,0$109,00000

$115,0$115,00000

$86,5$86,50000

$90,0$90,00000

$94,5$94,50000

$101,0$101,00000

$107,1$107,16767

1122334455




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

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



5-5-3131

(Continued(Continued))

Year Weighted Average x PV Factor = Present Value Year Weighted Average x PV Factor = Present Value

1122334455

.8000.8000

.6400.6400

.5120.5120

.4096.4096

.3277.3277

$86,500$86,500 $90,000$90,000 $94,500$94,500$101,000$101,000$107,167$107,167

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:

$69,200$69,200$57,600$57,600$48,384$48,384$41,370$41,370$35,119$35,119

Total Total $251,673$251,673




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 ==

= $107,167 = $107,167 x x

112525

%%= =

$428,668$428,668




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 ==

= $107,167 = $107,167 x x

112525

%%= =

$428,668$428,668

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:

$428,668 x .2621 = $428,668 x .2621 = $112,354$112,354




Step 5: Compute the value of the business:Step 5: Compute the value of the business:

= $251,673 + $112,354 = = $251,673 + $112,354 = $364,027$364,027

Estimated Value of Business = Estimated Value of Business = $364,027$364,027

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 1234

3.33.84.34.1

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 = 3.8753.875


5-365-36

Company P-E Ratio Company P-E Ratio 11223344

3.33.33.83.84.34.34.14.1

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 = 3.8753.875

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 = 3.875 x $88,000 = Estimated Value = 3.875 x $88,000 =

$341,000$341,000

Market Market ApproachApproach


5-5-3737


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 an employee stock Establish an employee stock

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


All rights reserved. No part of this publication may All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, electronic, mechanical, photocopying, recording, or otherwise, without the prior written or otherwise, without the prior written permission of the publisher. Printed in the United permission of the publisher. Printed in the United States of America.States of America.

Copyright ©2012 Pearson Education, Copyright ©2012 Pearson Education, Inc. Publishing as Prentice HallInc. Publishing as Prentice Hall

Small Business & Entrepreneurship

Chapter 11 buying an existing sm es-esbm10e-05