Forms of Business Ownership and Buying an Existing Business Chapter 6

Issues entrepreneurs should consider when evaluating forms of business ownership Tax Considerations Liability Exposure Start-up and future capital requirements Control Managerial ability Business goals Management succession plans Cost of formation

Sole Proprietorship a business owned and managed by one individual; the business and the owner are one and the same in the law

Advantages of a Sole Proprietorship Simple to create Least costly form of ownership to begin Profit incentive Total decision making authority No special legal restrictions Easy to discontinue

Disadvantages of a Proprietorship Unlimited personal liability Limited skills and capabilities Feelings of isolation Limited access to capital Lack of continuity of the business

The Partnership A partnership is an association of two or more people who co-own a business for the purpose of making a profit. A Partnership Agreement is a document that states in writing the terms under which the partners agree to operate the partnership and that protects each partner’s interest in the business.

Advantages of the Partnership Easy to establish Complementary skills Division of profits Larger pool of capital Ability to attract limited partners General Partners share owning/operating/managing a business and have unlimited liability, while Limited Partners make financial investments, don’t take an active role in management, and their liability is limited to the amount they have invested.

Disadvantages of the Partnership Unlimited liability of at least one partner Capital accumulation Difficulty in disposing of partnership interest Potential for personality and authority conflicts Partners are bound by the law of agency

Limited Partnerships A Limited Partnership is a partnership composed of at least one general partner and at least one limited partner. A Limited Liability Partnership (LLP) is a special type of Limited Partnership in which all partners are limited partners. In many states they must be professionals.

Corporations A corporation is a legal entity apart from its owners that receives the right to exist from the state in which it is incorporated. A corporation may be Closely Held (shares held by just a few people - often family, employees, etc.) or Publicly Held (large number of shareholders)

Advantages of Corporations Limited liability of stockholders Ability to attract capital Ability to continue indefinitely Transferable ownership

Disadvantages of the Corporation Cost and time involved in the incorporation process Double taxation Potential for diminished managerial incentives Legal requirements and regulatory red tape Potential loss of control by the founder

Other Forms of Ownership The S-Corporation is a corporation that retains the legal characteristics of a regular C corporation but has the advantage of being taxed as a partnership if it meets certain criteria. The Limited Liability Company (LLC) is like a S-Corporation (a cross between a corporation and a partnership), but it is not subject to many of the restrictions imposed on S-Corporations. The Professional Corporation is designed to offer professionals the advantages of corporate ownership The Joint Venture is much like a partnership, but formed for a specific purpose.

The Advantages of Buying an Existing Business Success existing businesses often continue to be successful. Superior location Employees and suppliers are in place. Installed equipment with known production capacity Inventory in place

The Advantages of Buying an Existing Business (p.2) Trade credit is established The turnkey business The new owner can use the experience of the previous owner Easier access to financing High value

Disadvantages of Buying an Existing Business Cash requirements The business is losing money. Paying for ill will Employees inherited with the business may not be suitable. Unsatisfactory location

Disadvantages of Buying an Existing Business (p.2) Obsolete or inefficient equipment and facilities The challenge of implementing change Obsolete inventory Worthless accounts receivable may be worth less than face value. The business may be overpriced.

The Steps in Acquiring a Business (7 steps) Conduct a self-inventory, objectively analyzing skills, abilities, and personal interests to determine the type(s) of business that offer the best fit. Develop a list of the criteria that define the “ideal business” for you. Prepare a list of potential candidates that meet your criteria.

The Steps in Acquiring a Business (7 steps) Thoroughly investigate the potential acquisition targets that meet your criteria. This due diligence process involves practical steps, such as analyzing financial statements and making certain that the facilities are structurally sound. The goal is to minimize the pitfalls and problems that arise when buying any business.

The Steps in Acquiring a Business (7 steps) Explore various financing options for buying the business. Negotiate a reasonable deal with the existing owner. Ensure a smooth transition of ownership.

Evaluating an Existing Business: The Due Diligence Process The process of reviewing, investigating, and analyzing the relevant details about the top acquisition candidates to determine which one best meets a buyer’s purchase criteria.

Evaluating an Existing Business: The Due Diligence Process Motivation. Why does the owner want to sell? Asset valuation. What is the physical condition of the business? Market potential. What is the potential for the company’s products or services? Legal issues. What legal aspects of the business represent known or hidden risks?

Asset Valuation Accounts receivable Lease arrangements Business records Intangible assets Location and appearance

Market Potential Customer characteristics and composition Competitor analysis

Lien: a creditor’s claim against an asset Liens Lien: a creditor’s claim against an asset Legal Issues (p.1)

Legal Issues (p.2) Contract assignments Due-on-sale clause: a local contract provision that prohibits a seller from assigning a loan arrangement to the buyer. Instead, the buyer is required to finance the remaining loan balance at prevailing interest rates.

Covenants not to compete Legal Issues (p.3) Covenants not to compete Covenant not to compete (restrictive covenant or non- compete agreement): an agreement between a buyer and seller in which the seller agrees not to compete with the buyer within a specific time and geographic area.

Ongoing Legal Liabilities, such as: Physical premises Legal Issues (p.4) Ongoing Legal Liabilities, such as: Physical premises Product liability claims Labor relations

Financial Condition Income statements and balance sheets for the past three to five years Income tax returns for the past three to five years Owner’s compensation (and that of relatives) Cash flow

Valuing a Business - 3 methods Adjusted Balance Sheet Technique A method of valuing a business on the basis of the market value of the company’s net worth (net worth = total assets – total liabilities)

Valuing a Business - 3 methods Balance Sheet Technique A method of valuing a business on the basis of the value of the company’s net worth (net worth = total assets – total liabilities)

Valuing a Business - 3 methods Earnings Approach A method of valuing a business that recognizes that a buyer is purchasing the future income (earnings) potential of a business.