Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 1 Buying An Existing Business

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 2 Buying a Business Advantages Advantages  Business may continue to be successful  Can use experience of previous owner  “Hit the ground running”  Business may have best location  Employees and suppliers are in place

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 3 Buying a Business Advantages Advantages  Equipment is installed  Inventory is in place and trade credit exists  Easier time finding financing  It’s a bargain

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 4 Buying a Business Disadvantages Disadvantages  It’s a loser  Possible “ill will” from previous owner  Employees may not be suitable  Location may be unsatisfactory  Equipment may be obsolete

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 5 Buying a Business Disadvantages Disadvantages  Change and innovation can be difficult  Inventory may be obsolete  Accounts receivable may be worth less than face value

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 6 Valuing Accounts Receivable Age of Accounts (days) Amount Probability of Collection Value Total $40,000 $25,000 $14,000 $10,000 $7,000 $5,000 $101, $38,000 $22,000 $9,800 $4,000 $1,750 $500 $76,050

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 7 Buying a Business Disadvantages Disadvantages  Change and innovation can be difficult  Inventory may be obsolete  Accounts receivable may be worth less than face value  Business may be overpriced

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 8 How to Buy a Business Analyze your skills, abilities, and interests. Analyze your skills, abilities, and interests. Develop a list of criteria. Develop a list of criteria. Prepare a list of potential candidates (Remember the “hidden market”). Prepare a list of potential candidates (Remember the “hidden market”). Ray’s Market

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 9 How to Buy a Business Investigate and evaluate candidate businesses and select the best one. Investigate and evaluate candidate businesses and select the best one. Negotiate the deal. Negotiate the deal. Explore financing options. Explore financing options. Ensure a smooth transition. Ensure a smooth transition. Ray’s Market

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 10 Five Critical Areas for Analyzing an Existing Business 1. 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?

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 11 The Legal Aspects of Buying a Business Lien - creditors’ claims against an asset. Lien - creditors’ claims against an asset. Bulk transfer - protects business buyer from the claims unpaid creditors might have against a company’s assets. Bulk transfer - protects business buyer from the claims unpaid creditors might have against a company’s assets.

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 12 Bulk Transfer Seller must give the buyer a sworn list of creditors. Seller must give the buyer a sworn list of creditors. Buyer and seller must prepare a list of the property included in the sale. 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 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). 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).

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 13 The Legal Aspects of Buying a Business Contract assignment - buyer’s ability to assume rights under seller’s existing contracts. Contract assignment - buyer’s ability to assume rights under seller’s existing contracts. Lien - creditors’ claims against an asset. Lien - creditors’ claims against an asset. Bulk transfer - protects business buyer from the claims unpaid creditors might have against a company’s assets. Bulk transfer - protects business buyer from the claims unpaid creditors might have against a company’s assets.

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 14 Restrictive covenant - contract in which a business seller agrees not to compete with the buyer within a specific time and geographic area. Restrictive 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. Ongoing legal liabilities - physical premises, product liability, and labor relations. The Legal Aspects of Buying a Business

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 15 Five Critical Areas for Analyzing an Existing Business 1. 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?

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 16 Determining the Value of a Business Balance Sheet Technique Balance Sheet Technique  Variation: Adjusted Balance Sheet Technique Earnings Approach Earnings Approach  Variation 1: Excess Earnings Approach  Variation 2: Capitalized Earnings Approach  Variation 3: Discounted Future Earnings Approach Market Approach Market Approach

Balance Sheet Techniques "Book Value"of Net Worth = Total Assets - Total Liabilities = $266,091 - $114,325 = $151,766

"Book Value"of Net Worth = Total Assets - Total Liabilities = $266,091 - $114,325 = $151,766 Variation: Adjusted Balance Sheet Technique: Adjusted Net Worth = $274,638 - $114,325 = $160,313 Balance Sheet Techniques

Earnings Approaches Variation 1: Excess Earnings Method.

Adjusted Net Worth = $274,638 - $114,325 = $160,313 $160,313 Step 1: Compute adjusted tangible net worth: Earnings Approaches

Variation 1: Excess Earnings Method. Adjusted Net Worth = $274,638 - $114,325 = $160,313 $160,313 Step 1: Compute adjusted tangible net worth: Step 2: Calculate opportunity costs of investing: Investment $160,313 x 25% = $40,078 Salary $25,000 Total $65,078 Earnings Approaches

Variation 1: Excess Earnings Method. Step 3: Project earnings for next year: Adjusted Net Worth = $274,638 - $114,325 = $160,313 $160,313 Step 1: Compute adjusted tangible net worth: Step 2: Calculate opportunity costs of investing: Investment $160,313 x 25% = $40,078 Salary $25,000 Total $65,078 $74,000 Earnings Approaches

(Continued) EEP = Projected Net Earnings - Total Opportunity Costs Step 4: Compute extra earning power (EEP): = $74, ,078 = $8,922 Excess Earnings Method

(Continued) EEP = Projected Net Earnings - Total Opportunity Costs Step 4: Compute extra earning power (EEP): Step 5: Estimate the value of the intangibles ("goodwill"): Intangibles = Extra Earning Power x "Years of Profit" Figure* = $74, ,078 = $8,922 * Years of Profit Figure ranges from 1 to 7; for a normal risk business, it is 3 or 4. = 8,922 x 3 = $26,766 Excess Earnings Method

Value = Tangible Net Worth + Value of Intangibles Step 6: Determine the value of the business: Estimated Value of the business = $187,079 = $160, ,766 = $187,079 Excess Earnings Method (Continued)

Variation 2: Capitalized Earnings Method: Value = * Rate of return reflects what could be earned on a similar-risk investment. Net Earnings (After Deducting Owner's Salary) Rate of Return* Capitalized Earnings Method

Variation 2: Capitalized Earnings Method: Value = * Rate of return reflects what could be earned on a similar-risk investment. Net Earnings (After Deducting Owner's Salary) Rate of Return* Value = $74,000 - $25,000 25% = $196,000 Capitalized Earnings 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:   Pessimistic   Most Likely   Optimistic Discounted Future Earnings Method

Step 1: Project earnings five years into the future: (Continued) Year Pess ML Opt Weighted Average $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, Discounted Future Earnings Method

(Continued) Step 2: Discount weighted average of future earnings at the appropriate present value rate: Present Value Factor = 1 (1 +k) t where... k = Rate of return on a similar risk investment. t = Time period (Year - 1, 2, 3...n). Discounted Future Earnings Method

(Continued) Year Weighted Average x PV Factor = Present Value $75,500$89,167$99,000$107,333$111,667 Step 2: 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 Discounted Future Earnings Method

(Continued) Step 3: Estimate the earnings stream beyond five years: 1 Rate of Return Weighted Average Earnings in Year 5 Weighted Average Earnings in Year 5 x = = $111,667 x 1 25% = $446,668 Discounted Future Earnings Method

(Continued) Step 3: Estimate the earnings stream beyond five years: 1 Rate of Return Weighted Average Earnings in Year 5 Weighted Average Earnings in Year 5 x = = $111,667 x 1 25% = $446,668 Step 4: Discount this estimate using the present value factor for year 6: $446,668 x.2622 = $117,116 Discounted Future Earnings Method

(Continued) 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 1 through 5 + Discounted earnings in years 6 through ? Discounted earnings in years 6 through ? Discounted Future Earnings Method

Market Approach Company P-E Ratio Company P-E Ratio Step 1: Compute the average Price-Earnings (P-E) Ratio for as many similar businesses as possible: Average P-E Ratio = 3.975

Company P-E Ratio Company P-E Ratio Step 1: Compute the average Price-Earnings (P-E) Ratio for as many similar businesses as possible: Average P-E Ratio = Step 2: Multiply the average P-E Ratio by next year's forecasted earnings: Estimated Value = x $74,000 = $294,150 Market Approach

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 37 Exit Strategies Straight business sale Straight business sale Family limited partnership (FLP) Family limited partnership (FLP) Sell controlling interest Sell controlling interest Restructure the company Restructure the company Use a two-step sale Use a two-step sale Establish and employee stock ownership plan (ESOP) Establish and employee stock ownership plan (ESOP)

Chapter 5 Buying a Business Copyright 2006 Prentice Hall Publishing Company 38 The Five Ps of Negotiating. Preparation - Examine the needs of both parties and all of the relevant external factors affecting the negotiation before you sit down to talk. Poise - Remain calm during the negotiation. 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 what your most important positions are, articulate them, and offer support for your position. Persistence - Don’t give in at the first 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 such a 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.

Chapter 5 Buying a Business Chapter Objectives Copyright 2006 Prentice Hall Publishing Company Understand the advantages and disadvantages of buying an existing business. 2. Define the steps involved in the right way to buy a business. 3. Explain the process of evaluating an existing business. 4. Describe the various techniques for determining the value of a business. 5. Understand the seller's side of the buyout decision and how to structure the deal. 6. Understand how the negotiation process works and identify the factors that affect the negotiation process.

Chapter 5 Buying a Business Chapter Overview Chapter Overview Copyright 2006 Prentice Hall Publishing Company 40

Chapter 5 Buying a Business 1. Understand the advantages and disadvantages of buying an existing business. The advantages of buying an existing business include: A successful business may continue to be successful; the business may already have the best location; employees and suppliers are already established; equipment is installed and its productive capacity known; inventory is in place and trade credit established; the owner hits the ground running; the buyer can use the expertise of the previous owner; and the business may be a bargain. The disadvantages of buying an existing business include: An existing business may be for sale because it is deteriorating; the previous owner may have created ill will; employees inherited with the business may not be suitable; its location may have become unsuitable; equipment and facilities may be obsolete; change and innovation are hard to implement; inventory may be outdated; accounts receivable may be worth less than face value; and the business may be overpriced. The advantages of buying an existing business include: A successful business may continue to be successful; the business may already have the best location; employees and suppliers are already established; equipment is installed and its productive capacity known; inventory is in place and trade credit established; the owner hits the ground running; the buyer can use the expertise of the previous owner; and the business may be a bargain. The disadvantages of buying an existing business include: An existing business may be for sale because it is deteriorating; the previous owner may have created ill will; employees inherited with the business may not be suitable; its location may have become unsuitable; equipment and facilities may be obsolete; change and innovation are hard to implement; inventory may be outdated; accounts receivable may be worth less than face value; and the business may be overpriced. Copyright 2006 Prentice Hall Publishing Company 41

Chapter 5 Buying a Business 2. Define the steps involved in the right way to buy a business. Buying a business can be a treacherous experience unless the buyer is well-prepared. The right way to buy a business is: analyze your skills, abilities, and interests to determine the ideal business for you; prepare a list of potential candidates, including those that might be in the "hidden market"; investigate and evaluate candidate businesses and evaluate the best one; explore financing options before you actually need the money; and finally, ensure a smooth transition. Buying a business can be a treacherous experience unless the buyer is well-prepared. The right way to buy a business is: analyze your skills, abilities, and interests to determine the ideal business for you; prepare a list of potential candidates, including those that might be in the "hidden market"; investigate and evaluate candidate businesses and evaluate the best one; explore financing options before you actually need the money; and finally, ensure a smooth transition. Copyright 2006 Prentice Hall Publishing Company 42

Chapter 5 Buying a Business 3. Explain the process of evaluating an existing business. Rushing into a deal can be the biggest mistake a business buyer can make. Before closing a deal, every business buyer should investigate five critical areas: Rushing into a deal can be the biggest mistake a business buyer can make. Before closing a deal, every business buyer should investigate five critical areas: 1. Why does the owner wish to sell? Look for the real reason. 1. Why does the owner wish to sell? Look for the real reason. 2. Determine the physical condition of the business. Consider both the building and its location. 2. Determine the physical condition of the business. Consider both the building and its location. 3. Conduct a thorough analysis of the market for your products or services. Who are the present and potential customers? Conduct an equally thorough analysis of competitors, both direct and indirect. How do they operate and why do customers prefer them? 3. Conduct a thorough analysis of the market for your products or services. Who are the present and potential customers? Conduct an equally thorough analysis of competitors, both direct and indirect. How do they operate and why do customers prefer them? 4. Consider all of the legal aspects which might constrain the expansion and growth of the business - Did you comply with the provisions of a bulk transfer? Negotiate a restrictive covenant? Consider ongoing legal liabilities? 4. Consider all of the legal aspects which might constrain the expansion and growth of the business - Did you comply with the provisions of a bulk transfer? Negotiate a restrictive covenant? Consider ongoing legal liabilities? 5. Analyze the financial condition of the business, looking at financial statements, income tax returns, and especially cash flow. 5. Analyze the financial condition of the business, looking at financial statements, income tax returns, and especially cash flow. Copyright 2006 Prentice Hall Publishing Company 43

Chapter 5 Buying a Business 4. Describe the various techniques for determining the value of a business. Placing a value on a business is partly an art and partly a science. There is no single "best" method for determining the value of a business. Placing a value on a business is partly an art and partly a science. There is no single "best" method for determining the value of a business. The following techniques (with several variations) are useful: the balance sheet technique (adjusted balance sheet technique); The following techniques (with several variations) are useful: the balance sheet technique (adjusted balance sheet technique); the earnings approach (excess earnings method, capitalized earnings approach, and discounted future savings approach); the earnings approach (excess earnings method, capitalized earnings approach, and discounted future savings approach); and the market approach. and the market approach. Copyright 2006 Prentice Hall Publishing Company 44

Chapter 5 Buying a Business 5. Understand the seller's side of the buyout decision and how to structure the deal. Selling a business takes time, patience, and preparation to locate a suitable buyer, strike a deal, and make the transition. Sellers must always structure the deal with tax consequences in mind. Common exit strategies include: a straight business sale, forming a family limited partnership, selling a controlling interest in the business, restructuring the company, selling to an international buyer, using a two-step sale, and establishing an employee stock ownership plan (ESOP). Selling a business takes time, patience, and preparation to locate a suitable buyer, strike a deal, and make the transition. Sellers must always structure the deal with tax consequences in mind. Common exit strategies include: a straight business sale, forming a family limited partnership, selling a controlling interest in the business, restructuring the company, selling to an international buyer, using a two-step sale, and establishing an employee stock ownership plan (ESOP). Copyright 2006 Prentice Hall Publishing Company 45

Chapter 5 Buying a Business 6. Understand how the negotiation process works and identify the factors that affect the negotiation process. The first rule of negotiating is never confuse price with value. In a business sale, the party who is the better negotiator usually comes out on top. Before beginning negotiations, a buyer should identify the factors that are affecting the negotiations and then develop a negotiating strategy. The best deals are the result of a cooperative relationship between the parties based on trust. The first rule of negotiating is never confuse price with value. In a business sale, the party who is the better negotiator usually comes out on top. Before beginning negotiations, a buyer should identify the factors that are affecting the negotiations and then develop a negotiating strategy. The best deals are the result of a cooperative relationship between the parties based on trust. Copyright 2006 Prentice Hall Publishing Company 46